Money market funds and cash equivalents: the cash leg of a multi-asset portfolio

Most multi-asset portfolios need a cash-equivalent layer—an allocation that earns the short-term interest rate, can be liquidated immediately, and has minimal price volatility. Money market funds and short-term government bond ETFs are the standard instruments for this layer, and the choice between them matters for both yield and operational simplicity.

What money market funds are

A money market fund is a pooled vehicle that holds short-term, high-quality debt instruments: Treasury bills, government agency paper, commercial paper, certificates of deposit, and short-term repo. The portfolio's average maturity is typically capped at 60 days, with individual holding maturities limited to a few months. The objective is to provide investors with cash-like liquidity and stability while earning the short-term interest rate available to institutional buyers of the underlying paper.

The convention of a USD 1.00 NAV is the structural feature most associated with money market funds. Stable-NAV funds (the dominant retail variety in the US until 2016) hold their NAV at exactly USD 1.00 and pay returns through dividend distributions; floating-NAV funds (now mandatory for institutional prime funds in the US, and the standard in most other jurisdictions) let the NAV fluctuate within a narrow band and pay returns through both NAV change and distributions.

Short-term Treasury ETFs—funds holding T-bills and short-dated Treasury notes—provide a similar economic exposure with a different operational profile. They trade on exchanges with intraday liquidity, have no NAV stabilisation mechanism, and typically carry slightly higher yields than money market funds because they hold only government paper rather than the broader money-market mix.

How they work

Money market funds earn returns from the interest paid on the short-term instruments they hold. As short-term interest rates rise, the fund's holdings roll over into higher-yielding paper, and the fund's distributed yield rises with a lag of typically a few weeks to months depending on portfolio turnover. As rates fall, the fund's yield falls similarly.

The credit quality of the holdings matters most in stress. Government-only money market funds hold Treasury bills and government agency paper exclusively—the safest possible portfolio at the cost of slightly lower yield. Prime money market funds hold a broader mix including corporate commercial paper and bank certificates of deposit, earning a slightly higher yield but with exposure to corporate credit conditions.

The Reserve Primary Fund's 2008 NAV decline below USD 1.00 ("breaking the buck") is the canonical reminder that money market funds are not deposit-insured and not principal-guaranteed. The event was rare—it occurred during the post-Lehman corporate-credit panic when the fund's commercial paper holdings were marked down—and triggered a regulatory response that reformed the structure of US money market funds materially in 2010 and 2016. Government-only funds were never exposed to the same risk.

What the evidence shows

Long-run returns on US money market funds have tracked short-term Treasury yields closely, with a typical gap of 0.10–0.30 percentage points reflecting the small credit premium on the prime varieties. Over multi-decade samples, the gap to inflation has averaged near zero in real terms—money market funds maintain purchasing power but generate little real return.

The post-2008 zero-interest-rate environment compressed money market yields to near zero through most of the 2010s. The asset class produced negative real returns through the decade and forced investors to make explicit choices about whether to accept the negative real yield or to extend duration into longer-dated bonds for higher (but still modest) nominal returns. The 2022–2023 rate cycle restored money market yields to 4–5% nominal, making the cash-equivalent layer attractive again on an absolute basis.

For multi-asset portfolio construction, the cash-equivalent allocation is most useful as a buffer against rebalancing transaction costs and as a source of dry powder for opportunistic deployment in drawdowns. Studies of glide-path strategies typically allocate 5–15% to cash equivalents during the accumulation phase and a larger share during decumulation.

Limitations and trade-offs

The yield on money market funds tracks short-term interest rates, which means the asset class compresses to near zero in low-rate regimes. Investors who hold cash equivalents through such regimes earn negative real returns and must decide whether to accept the cost as the price of liquidity or to extend duration for higher yield at the cost of price volatility.

Money market funds are not deposit-insured. While the historical incidence of NAV stabilisation breakdown has been very rare, the absence of explicit guarantee distinguishes the instruments from bank deposits. For very large balances or for institutions with strict capital-preservation mandates, the distinction matters.

The choice between a money market fund and a short-term Treasury ETF is operationally meaningful. Money market funds typically settle same-day or next-day, with no transaction commission and no bid-ask spread. ETFs settle T+1 with broker commissions (where applicable) and bid-ask spread on each trade. For frequent rebalancing, the operational simplicity of a money market fund typically dominates; for less frequent reallocations, the slightly higher yield of a Treasury ETF can pay off.

Money market funds in pfolio

pfolio's asset universe includes short-term government bond ETFs and money market ETFs as the cash-equivalent layer of a multi-asset allocation. These instruments provide a low-volatility yield-bearing position that approximates cash for portfolio-construction purposes; their performance and yield are visible in the Assets section and tracked alongside other holdings in pfolio Insights.

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