What are Money Market Funds and how do they work in India?

What are Money Market Funds?

Money Market Funds (MMF) are debt based mutual funds. They are developed with the intent of providing decent and stable returns while maintaining the liquidity of their investment. The important aspect to note here is that MMF are rather short term in duration with an average ideal maturity period of around 12 months. These are few of the reasons due to which MMF are deemed to be rather low in risk.

How Do Money Market Funds Work?

Money market funds aggregate capital from several investors to form a varied collection of short-term, high-liquidity financial instruments. These funds strive to keep a stable net asset value (NAV) while offering earnings through the interest generated on their holdings. Generally, money market funds provide better returns than ordinary savings accounts, presenting a viable option for investors looking to temporarily allocate excess capital.

Types of Money Market Funds

As the name suggests, Money Market Funds in India invest in short term money market options as described below:-

Treasury Bills

Treasury Bills, also known as T-Bills, are issued by the Government of India. The intent is to raise capital, with a typical time frame of 1 year. Since these are government backed, hence they are considered as one of the safest forms of investment. But as one would expect, since they have absolutely minimal risk associated with them, hence, the returns are also rather on the lower side.

Certificate of Deposit

Certificates of Deposit, also known as CD, are issued by commercial banks that have the requisite permission and authority. These are fixed term based and unlike a standard Fixed Deposit (FD), do not allow for premature redemption. Rest of the underlying principles remain pretty much the same.

Commercial Paper

Commercial Papers, also known as CP or Promissory Notes, are issued by financial companies with typically high credit ratings. These are short term and unsecured. They are offered at discounted rates but redeemed as per the face value of the original note. The investor gets the returns in terms of the delta price between purchase and redemption, while the companies get the benefit of short term borrowing from multiple sources for their investments and operational expenses.

Repurchase Agreements

Repurchase Agreements, also known as Repo, is an agreement between 2 banks. More often than not, one of the two banks is the Reserve Bank of India (RBI). It essentially implies a loan agreement between the two banks involved. As you must have noticed, in all the above mentioned money market instruments, the commonality in principle is – low risk, predictable and steady (albeit lower) returns.

Benefits of Money Market Funds

Now that the reader must have understood the features and workings of Money Market Funds, one must also be aware of the factors to be considered prior to investing in them.

Lower Expense Ratio

Since these debt funds’ main objective is to protect the principal and invest in short term gains, the associated costs of fund management are very low. This is an important aspect since in any case the returns are lower. However, the gains are not further diluted by the fund manager, market research analysts etc. and these are in fact passed on to the investor as part of the returns.

Risks and Returns

As reiterated throughout the article, the prime objective served by Money Market Funds in India is to provide steady returns, protect your principal investment and keep the risk exposure to a minimum. All the risks associated with debt funds are applicable to a certain extent; however, these funds tend to provide higher rates than a Savings Account while giving the same advantage of keeping the investment largely liquid.

Tax

Money Market Funds fall under the main category of Debt Funds. Therefore, they are taxable as per the law of the land and subject to STCG (Short Term Capital Gain) / LTCG (Long Term Capital Gain) along with indexation benefits. If the funds are held onto for a period of up to 3 years then STCG is applicable. For durations longer than 3 years, LTCG is applied.

Investment horizon

These funds are suitable for short-term investment goals of three months to one year. If you have a medium investment horizon, select dynamic bond funds.

Financial goals

If you are looking for a short-term option to park excess investable funds that would earn higher returns than regular savings accounts, you can invest in money market mutual funds. Money market mutual funds compete against the other debt-related investments and traditional investments in the market. However, these funds invest in wider varieties of assets while aiming for higher returns. The primary aim of these funds is to offer safe investment avenues for investing in secure and highly liquid cash-equivalents and debt-based assets using a small portion of the investment. In the mutual fund investment format, these schemes are low-risk, low-return investments. So, on the plus side, these funds are highly liquid, low-cost, and designed to offer better returns than a bank’s savings account. On the flip side, these are unsecured investments whose value can change with the changes in the interest regime. Secondly, capital appreciation is significantly less.

Who Should Invest in Money Market Mutual Funds?

Money market mutual funds help with portfolio diversification. The primary objective is to generate low-risk short-term returns from investing in highly-rated money market instruments. The corpus gets invested in a well-diversified portfolio to produce the highest short-term gain. Investors with a short-term investment horizon of one year and with high liquidity may invest in these funds. Further, low-risk appetite investors seeking higher returns than traditional investment options like fixed deposits can park their investable corpus in money market fund schemes that generate predictable returns in the short term. However, if you have a long-term investment horizon, money market mutual funds may not suit your purposes. Instead, you should invest in dynamic bond funds or balanced funds, which are still low-risk investments capable of generating more returns than money market mutual funds.

Things To Consider Before Investing in Money Market Funds

Risk: Money market funds are known for being relatively safe, but even they can experience small changes in net asset value (NAV) due to interest rate movements or shifts in credit quality, affecting returns to some degree. Expense Ratio: The management cost of a fund, known as the expense ratio, is key in selecting a money market fund since a lower ratio can lead to higher returns. It's beneficial to compare these ratios to ensure you are making a cost-effective investment. Liquidity: The ability to quickly and easily access your money is crucial with money market funds. Review the fund's policies on exit fees and the redemption process to guarantee efficiency. Credit Quality: Evaluating the default risk involves checking the creditworthiness of the securities within the fund's portfolio. Opt for funds that invest predominantly in stable, top-rated securities to reduce the risk to your investment.

Conclusion

MMFs are useful in getting fixed returns and yet having the necessary liquidity (through trading of instruments) to satisfy risk intolerance. Now that you have a good understanding of Money Market Funds, check out Angel One for further information on such investment opportunities. Open a Demat account with Angel One to start investing now!