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A liquidity fund is a mutual fund that invests in a diversified portfolio of securities, bonds, and options with high credit ratings for short-term investment. Compared to a traditional bank account, a liquidity fund offers investors and company treasurers a vehicle for cash management that provides a higher rate of return while maintaining, to a large extent, the liquidity and safety of the standard account. The instruments in which a liquidity fund may invest include treasury bills, commercial paper, time deposits, financial floating rate notes, and money market accounts. Most liquidity funds allow same-day access, allowing investors to keep funds invested as long as possible but remove them when needed to meet obligations. Relative to investments in stocks or bonds, however, the promised yield on a liquidity fund is reduced in exchange for lower duration risk and liquidity risk.
The price per share in a liquidity fund varies proportionally to the fund’s net asset value (NAV). The fund manager determines the NAV by dividing the difference in the liquidity fund’s assets and liabilities by the number of outstanding shares. Calculated at the close of each business day, the NAV indicates the performance of the liquidity fund. New investors purchase shares directly from the fund itself, paying the current NAV for each share. Conversely, investors receive an equitable portion of the fund assets when they sell their shares, based on the most recent NAV.
There are risks to consider when investing in liquidity funds. First, because liquidity funds are securities, it is possible for investors to lose the entire principal investment. Although fund managers strive to maintain the NAV at 1 U.S. Dollar per share, funds sometimes do fall below this value, called “breaking the buck.” This can cause wide scale redemption on the fund, with each successive seller receiving an increasingly lower price per share. Most companies that issue liquidity funds, however, preserve their value with their own resources if the price per share drops temporarily.
Other potential drawbacks to liquidity funds include the fluctuating fund rate and inflation risk due to the low rate of return. Earnings can fall short if the fund rate drops. Inflation can eat away at the principal for a long-term investment. For this reason, liquidity funds aim to invest in instruments with short durations from 60 days up to 13 months.
In 2010, the United States Securities and Exchange Commission revised Rule 2a-7, making changes that mitigated the effects of a net asset value that falls below the 1 U.S. Dollar per share threshold. The amendments to the rule limit the medium risk securities permitted in the portfolio to only three percent. Ten percent of the fund assets must be daily assets, while 30 percent must be weekly assets. Fund boards can suspend redemptions temporarily in times of market stress. Additional provisions require a greater degree of transparency in fund disclosures relative to the previous regulations.