In the money market fund world, the NAV is a bit special as we can distinguish two major types of money market funds with regards to how their NAV behaves over time. There are money market funds with a constant or fixed NAV, and there are money market funds with a variable NAV. Let's first have a look at the fixed NAV funds. As until the global financial crisis, this was pretty much the norm amongst money market funds. A constant NAV money market fund strives to maintain its share price stable, typically at $1 per share. This means that investors can purchase and redeem shares at the same price. That does not change over time, and this fixed price benchmark provides investors with a sense of stability. This means that in fixed NAV money market funds returns aren't realized via a change in the share price as it remains constant. Instead, the number of shares in an investor's account increases. Let's say an investor owns 10,000 shares and a money market fund with a constant NAV of $1 per share and monthly distributions every day. Based on the interest earned by the fund from its investments, a daily dividend is declared. Let's assume for simplicity that the daily dividend equates to $0.0001 per share with 10,000 shares. This means that each day the investor's dividends would be $1 10,000 shares times that $0.0001 per share. Instead of paying out this dividend daily, the fund accrues these dividends. This means that dividends are virtually added to the investor's account daily, but not actually distributed as cash. So by the end of day one, our example investor would have one additional share because they earned $1 and the nav is $1 as well. Over a month, if the dividend remained constant, the investor would accrue approximately $30, 30 days times $1 per day, or 30 additional shares. At the end of the month the money market fund distributes the accumulated dividends. These can be either given as cash or can be reinvested to buy more shares depending on the chosen preference. When the investor bought the money market fund, if our investor opted for a cash distribution, the fund would distribute $30 to the linked bank account. We ignore taxes for simplicity and the number of shares in the money market fund. We'll be reduced by the equivalent $30. So if the investor had $10,030 at the end of the month, there would be 10,000 after the cash distribution. If the investor opted for the reinvestment in shares post distribution, the number of shares would've increased by the number of shares. In our example, the investor would now hold 10,030 shares. A question you might have is how the money market fund can keep their NAVs at the stable $1 if they invest in securities that have a market price that fluctuates daily. The answer lies in amortized cost accounting. In this approach, assuming you intend to hold the security to maturity when you buy a bond for either more or less than its face value, the difference called the premium if you paid more or a discount if you paid less isn't immediately recognized. Instead, the amortized cost method spreads out this difference over the life of the bond. Think of it like evening out the bumps on a path over time by using amortized cost accounting to value the portfolio securities instead of marking them to market money. Market funds can sidestep short-term market price fluctuations and keep their NAV steady. However, a fixed NAV money market fund should not be considered as completely risk-free while they aim for stability. External events can disrupt this. For example, in 2008, significant exposure to Lehman Brothers defunct commercial paper forced the nav of many fixed NAV money market funds below $1. This event known as breaking the buck caused significant ripple effects in financial markets.
