All you need to know about money market funds

Posted On: 22 May 2023

Money market funds are like a bridge, connecting investors to the world of short-term, fixed income securities. These funds invest in short-term, high-quality, and low-risk debt securities such as bonds, treasury bills, commercial paper, and certificates of deposit (CDs). Apart from retail investors, money market funds are popular with banks and institutional investors who wish to maintain high liquidity while earning a reasonable return on their investment.

Instruments of money market funds

Just like many other funds, the primary objective of money market funds is to provide a highly liquid investment. Let's learn about the variety of instruments money funds invest in:

Government securities: Treasury bills and bonds
Commercial paper: Short-term debt issued by corporations to run their daily operations
Certificates of deposit (CDs): Short-term debt issued by banks and financial institutions
Repurchase agreements (repos): Short-term loans collateralised by government securities or other highly liquid securities

How do money market funds work?

Just like many other funds, a money market fund assembles a portfolio of securities and issues redeemable units to the investors. The fund manager invests the pooled money in money market instruments having maturity up to 1 year. Money market fund investors earn return via the capital appreciation depending on market movement.

Who should invest in a money market fund?

Investors who are looking to park their surplus cash for short-term goals
Investors who seek liquidity and want to keep cash reserves on hand for unexpected expenses
Retired investors who need a stream of income with minimal associated risk

Factors to consider before investing in money market funds in India

It is always advisable to consider the following factors before investing in money market funds in India:
Investment objective: Setting up an investment goal is an absolute pre-requisite when you are looking for a mutual fund scheme. As an investor, you should be aware of why you want to invest in a fund and if it aligns with your goals.

Risk: Money market funds are the relatively less risky than many other mutual funds schemes which have higher duration. However, they do bear certain risks:

Interest rate risk – The fund's Net Asset Value (NAV) can fluctuate based on the market interest rate.
Credit risk – Issuer can default on repayment of debts.
Reinvestment risk – The fund manager is unable to reinvest earnings from a previous investment.

Fund performance: Though money market funds have the potential to generate better returns than a savings account, the returns are not guaranteed. Analysing the fund's previous track record and doing a comparative analysis with other similar funds is a good practice. However, it must be noted that the past performance does not guarantee future performance. Historically, money market funds have struggled to deliver inflation-beating returns, so they may not be a preferred option for long-term investments.

Taxation: Money market funds are treated like debt funds for taxation. Thus, the gains from money market funds are subject to taxation as per the investor's income tax slab.

Characteristics of money market funds

Low risk: Money market mutual funds are relatively low risk investment option as compared to other funds with higher duration as they invest in short-term debt securities.
Liquidity: They are highly liquid, meaning that investors can easily buy or sell units in the fund at any time without penalty, as there is almost nil exit load in this category.
Diversification: These funds invest in various short-term debt securities, diversifying the portfolio and minimising risk.

Money market funds are a viable option for investors who wish to earn a modest return while maintaining liquidity of their investment. However, it's important to note that money market funds are not designed for long-term investment goals, and the returns they offer may not keep pace with inflation over time. Investors with short-term investment goals and those who need access to their funds at any time can consider investing in money market funds

FAQs

Are money market funds good investments?

Money market funds can be suitable investments for investors who seek low-risk, short-term investment options. These funds invest in high-quality, low-risk debt securities such as Treasury bills, commercial paper, and certificates of deposit with an objective to provide relatively steady returns while maintaining liquidity. Money market funds can be an ideal option for investors who wish to park their surplus cash or use them as an alternative to traditional savings accounts. However, it is important to note that money market funds are not entirely risk-free and may still experience fluctuations in value. It’s best to seek expert guidance before investing.

What are some of the advantages of money market funds?

Some advantages of money market funds include relatively lower risk, high liquidity, and the potential to provide better investment experience as compared to the traditional savings accounts. They also offer professional management and easy accessibility. However, their returns may not keep pace with inflation, and they may be subject to credit risk, interest rate risk, and other market fluctuations. It’s advisable to carefully weigh the pros and cons before investing in a money market fund.

Are money market funds risk-free?

While money market funds are considered relatively low-risk investments as compared to schemes with higher duration, they are not entirely risk-free. The value of a money market fund can fluctuate based on changes in interest rates, credit risks, and other market conditions, which can lead to a loss of principal for investors. However, the risk of loss is typically lower than other types of investments.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.