Money Market Funds:

An Introduction to the Literature

Viktoria Baklanova,∗ CFA, PRM

PhD Candidate

January 2010

∗ Viktoria Baklanova is currently employed as an analyst by Fitch Ratings. The views and opinions expressed in this

article are those of Ms. Baklanova and are not intended to, and do not represent, the opinions, views or policies of

This article provides an overview of the literature on various

aspects of the money market fund industry. It also serves as an

introduction to a much larger research project on comparative

regulation in the context of the global money market and cash

management. The study of a relationship between MMFs and an

efficient global financial market is in its early stages. Here we

provide just a glimpse of the major driving forces behind the

MMFs popularity.

The article examines studies related to funds’ investment

management practices, but also explores a number of issues raised

by the emerging money market fund industry under the securities

and banking laws in the U.S. and Europe. An open question is

whether the MMFs will continue to play an important role as one

of the major cash management vehicles and a source of financing

given certain structural deficiencies and unresolved regulatory

issues. We hope that our further research will help to better

understand the role of money market funds in more efficient

functioning of the global financial markets and capital formation.

Introduction

Prior to the events of the financial crisis unfolding since July 2007, there was surprisingly

little systematic research on money market funds (“MMF”). No established schools or research

traditions existed on the subject. Instead, there were a relatively small number of unrelated

empirical studies conducted by finance scholars and professionals with an almost exclusive focus

on the U.S. market. The main objective of these studies was to test market efficiency and the

rational expectations hypothesis as it applied to money markets. In addition, there were several

descriptive articles on legislative debates and money market regulations produced by practicing

attorney and ex-regulators. All this does not amount to any established legal theory or

hypotheses that would have been tested by different methods and in different markets.

However, the financial market crisis of 2007 – 2009 exposed MMFs as one of the major

factors of global systemic risk and prompted various regulators to focus on the subject of MMF

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regulation.1 Today analysis of money market funds and policy recommendations are among the

most commented subjects of legal research in financial market regulation. In our quest for a

better understanding of the driving force behind an explosive growth of money market funds

over the last forty years, we turned to historical essays written by those who evidenced the birth

of the money market funds industry. In addition, we studied works of market practitioners to

establish whether the correlation exists between the strength of money funds regulations and

market efficiency.

While money market funds are predominantly the U.S. phenomenon,2 we observed an

increase in a number of recent studies on money market funds operating in the financial markets

outside of the U.S.3 Literature on the non-U.S.-domiciled funds is reviewed in the last section of

1 On June 16, 2009, President Obama announced a comprehensive regulatory reform plan to modernize and protect

the integrity of the U.S. financial system. The white paper titled “Financial Regulatory Reform – A New

Foundation: Building Financial Supervision and Regulation,” contained recommendations for the SEC to

“… move forward with its plans to strengthen the regulatory framework around MMFs to reduce the credit

and liquidity risk profile of individual MMFs and to make the MMF industry as a whole less susceptible to

runs. The President’s Working Group on Financial Markets should prepare a report assessing whether more

fundamental changes are necessary to further reduce the MMF industry’s susceptibility to runs…”

www.financialstability.gov/docs/regs/FinalReport_web.pdf accessed on November 2,

2009.

2 According to “Worldwide Mutual Fund Assets and Flow” quarterly report by the Investment Company

Institute (ICI), the national association of U.S. mutual funds and other investment companies, at the end of the

first quarter of 2009, the assets under management of money market funds globally were $5.8 trillion

including assets under management of the U.S.-registered money market funds, which accounted for $3.9

www.ici.org/research/stats/worldwide/ww_03_09

accessed on October 31, 2009.

3 See, e.g. STEPHAN JANK, MICHAEL WEDOW, Sturm und Drang in Money Market Funds: When Money

Market Funds Cease to be Narrow, Deutsche Bundesbank: Discussion Paper Series 2: Banking and

Financial Studies, (2008). (study of German money market funds), KAUKO KARLO, The Demand for

Money Market Mutual Funds, 14 Bank of Finland Research Discussion Papers, (2005). (study of Finnish

money market funds), MAGNUS DAHLQUIST, STEFAN ENGSTROM, PAUL SODERLIND, Performance and

Characteristics of Swedish Mutual Funds, 35(3) Journal of Financial and Quantitative Analysis (2000).

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this article. Though the studies on MMFs are constantly growing, the amount of research

explaining the growth phenomenon and the risks associated with such growth are still

inadequate. The goal of our subsequent studies is to fill this gap.

MMFs as a subject of financial research

Earlier literature on MMFs was mainly produced by financial scholars concerned with

various aspects of portfolio management and corporate governance.4 Kane et al. (1983) studied

relationship between the interest rate forecasting ability of a portfolio management team and the

economic success of money market funds. The authors used a sample of thirty four funds and

found no strong correlation. Similarly, Domian (1992) concluded that MMF’s duration is merely

a reflection of past changes in the level of interest rate rather than ‘a window to the future.’5

Finally, DeGennaro et al. (1996) inferred that the benefits of active MMF portfolio management

are not detectable in the fund return data. The authors concluded that MMF managers in general

are unable to add value by adjusting the duration of a fund portfolio in order to capitalize on

anticipated changes in interest rates.

Over the years, a small army of finance scholars was engaged in finding a Holy Grail of

excess return in mutual funds. Domian et al. (1997) found that a MMFs’ return is highly

correlated with the fund’s expense ratio. From 1990 to 1994 the authors studied various factors

affecting the cross section of net returns on MMFs and the persistence of the funds relative

returns. The study concluded that the funds produced similar gross returns and that the

(study of Swedish mutual funds performance persistency including characteristics driving performance of

money market funds).

4 See e.g. ANDREW B. LYON, Money Market Funds and Shareholder Dilution, 39 Journal of Finance 1011, 1020,

(1984). (Analyzed the effects of amortized cost valuation on institutional MMFs and found the possibility of

arbitrage between securities priced at market value and amortized cost, which resulted in dilution of value for

MMFs’ investors).

5 DALE L. DOMIAN, Money Market Mutual Fund Maturity and Interest Rates 24 (4) Journal of Money, Credit and

Banking, (1992). at 526.

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differences in net returns were largely driven by differences in expenses6 and the funds’ policy

regarding investments in commercial paper (CP).7 In other words, an ability to invest in CP

serves as a proxy for an ability of a fund to invest in risky securities, i.e. CPs are issued by

corporations that are subject to credit risk. The authors divided MMFs in two broad groups: those

investing exclusively in government securities and those investing in commercial paper and other

assets.8 MMF professionals labeled the first group accordingly as “government funds” and the

second “prime funds.” Within both groups MMFs had a limited ability to differentiate

themselves amongst their peers, leading to commoditization of the product. Over time, the

inability to differentiate led to a high degree of concentration of the MMF industry.9

Christoffersen et al. (2002) examined whether funds with different levels of expense

ratios can co-exist in the competitive market. The authors found that MMFs portfolios normally

consist of a number of share classes,10 each carrying a different expense ratio. Trying to explain

6 Operations of a mutual fund incur certain costs. These are regular fund operating costs, such as investment

advisory fees, marketing and distribution expenses, brokerage, custodial, transfer agency, legal, and accountants’

fees. In addition, costs might be incurred in connection with particular investor transactions, such as investor

purchases, exchanges, and redemptions. Total sum of those costs paid by a fund investor is refereed as “fund’s

expenses” or “fund’s expense ratio.” Explanation of mutual fund expenses is available at the SEC web-site at

www.sec.gov/answers/mffees.htm#management.

7 The glossary of statistical terms maintained by the Organization for Economic Cooperation and Development

(OECD) contains the following definition of CP: CP is an unsecured promise to pay a certain amount on a stated

maturity date, issued in bearer form. CP enables corporations to raise short-term funds directly from end investors

through their own in-house CP sales team or via arranged placing through bank dealers. Available at

stats.oecd.org/glossary/detail.asp?ID=6054 accessed on November 1, 2009.

8 DALE L. DOMIAN, WILLIAM REICHENSTEIN Returns From Investing in Money Market Funds, 1990 to 1994, 6

Financial Services Review, (1997). at 169.

9 According to the Investment Company Institute (ICI), as of September 30, 2009 U.S.-registered money market

mutual funds had $3.4 billion in total assets under management. CraneData’s “Money Fund Intelligence” reported in

its October 2009 issue that approximately 95% of those assets was managed by only 25 mutual fund advisors.

10 The SEC web-site contains the following explanation of mutual fund share classes:

“Known as multi-class funds, some mutual funds offer investors different types of shares, known as

classes. Each class will invest in the same pool (or investment portfolio) of securities and will have the