What are money market funds and why are investors buying them

• Money market funds have featured among the most popular investments on AJ Bell's platform
• The funds offer cash like returns and have become increasingly popular with investors as interest rates have increased
• How money market funds work and why they might appeal to some investors

Money market funds have become increasingly popular in recent months, with funds including the Royal London Short Term Money Market, Lyxor Smart Overnight Return ETF and Vanguard Short Term Money Market all among the most popular funds with DIY investors in the last year.

"Money market funds, sometimes described as 'cash funds' may seem like a contradiction in terms - most investors will be familiar with funds that invest in a basket of equities or bonds, but investing in the money markets may not be something they've done before.

"Money market funds invest predominantly in short duration debt and deposits in order to generate a return similar to that of cash savings held in a bank. This includes high-quality, short-term debt like treasury bills, commercial paper and repurchase agreements.

"Rising interest rates have pushed up the cost of borrowing, meaning short duration debt, which are effectively loan notes or IOUs, now offer a higher return. Money market funds simply allow investors to invest in a diversified pool of that short term debt.

"For those who want to earn a return on cash they're waiting to invest, and investors who need to hold some cash or cash-like assets in their portfolio - often the case for drawdown investors - money market funds have subsequently become increasingly popular.

"Generally speaking, money market funds will offer a slightly more attractive rate of return than cash accounts, with yields of around 5% available in some funds at the moment.

Flexibility for investors

"Some may wonder why investors might hold money market funds rather than using cash accounts with a bank or building society. One of the key reasons is that there is no ceiling on the amount of money you can hold - in many cases the best rates available from banks and building societies limit the amount you can deposit, whereas there is no cap on the sums you can hold in cash funds.

"Money market funds also give you the flexibility of holding money within your existing stocks and shares ISA or pension account, without the need to transfer out to a separate cash account.

"While there is always a degree of risk involved in any investment, money market funds have long records of stable and secure valuations, with extremely low levels of volatility. While bonds with longer to maturity are more sensitive to interest rate changes, which we witnessed when bond prices collapsed as rates increased, short duration debt is far less sensitive to changes in rates. However, this does also mean that, if and when interest rates do come down, so too will the yield on money market instruments."