A Beginners Guide to Money Market Mutual Funds

Money market mutual funds are among the many types of investment options available in India. These funds are ideal for investors looking for low-risk investment options. However, even if you’re a risk-aggressive investor, you may still choose to add money market mutual funds to your portfolio for diversification. That said, here’s everything you need to know about this unique investment option.

What are Money Market Mutual Funds?

A mutual fund that invests the pooled capital from investors in money market instruments is termed a money market mutual fund. Money market instruments are essentially short-term debt instruments with maturities of up to a year. They’re highly liquid and generate moderate returns.

Some of the most popular money market instruments in India include treasury bills (T-Bills), Certificates of Deposit (CD), Commercial Paper (CP) and Repurchase Agreements (Repos). Since these instruments are issued either by the government, scheduled commercial banks or companies with high credit ratings, money market mutual funds are often considered to be low-risk investment options.

One of the major advantages of investing in money market funds is liquidity. You can quickly and effortlessly purchase and sell units of the fund. In fact, most fund houses credit the funds to your account on the same day the redemption request is placed.

How a Money Market Fund Works 

The primary goal of a Money Market Fund is to provide investors with a low-risk, stable investment option that offers liquidity and slightly higher returns than a traditional savings account. As such, they work by pooling money from multiple investors and using that capital to purchase short-term debt instruments issued by governments, financial institutions, or corporations. These securities typically mature in a year or less, making them highly liquid and less sensitive to interest rate changes, which reduces the risk of capital loss.

Investors in money market funds earn returns in the form of interest income from the underlying securities, and these funds typically maintain a stable net asset value (NAV). However, while they are considered low-risk, they are not entirely risk-free. Fluctuations in interest rates or credit risk from issuers can impact returns, though these risks are minimal compared to other investments. Money Market Funds are ideal for conservative investors looking for liquidity, capital preservation, and stable, but modest, returns.

Types of Money Market Instruments 

There are various types of money market instruments that provide safe, liquid options for short-term investors looking for stable returns:

1. Treasury Bills (T-Bills): Issued by the government, Treasury Bills are considered one of the safest money market instruments. They are sold at a discount and redeemed at face value upon maturity, with terms ranging from 91 days to 364 days. T-Bills are ideal for risk-averse investors seeking security and liquidity.
2. Commercial Paper (CP): Commercial Paper is a short-term, unsecured promissory note issued by corporations to finance their immediate operational needs. It usually has a maturity period of up to one year. CPs are typically issued by companies with high credit ratings, offering a higher return compared to T-Bills but with slightly more risk.
3. Certificates of Deposit (CD): Issued by banks and financial institutions, Certificates of Deposit are time deposits with fixed maturity dates and interest rates. They offer higher returns than savings accounts and are available in short-term tenures, usually from 7 days to 1 year. CDs are suitable for investors looking for a safe and predictable return. 
4. Repurchase Agreements (Repo): In a Repo transaction, one party (like the RBI) sells securities to another party (commercial banks) with an agreement to repurchase them at a fixed price on a future date. These are typically used by banks to manage short-term liquidity. Repos are safe and provide modest returns.
5. Banker’s Acceptance: A Banker’s Acceptance is a short-term debt instrument guaranteed by a bank and often used in international trade. It functions like a post-dated cheque and has a maturity period ranging from 30 to 180 days. It’s considered low risk because of the bank’s backing.

Factors To Consider Before Investing in Money Market Mutual Funds

As an investor, you need to take certain factors into account before you decide to invest in money market funds. Here’s a brief overview of some of the key things that you need to take into account.

• Risk

  Though the risk is far lower than other market-linked investment options, money market funds do carry certain risks. This includes credit risk, interest rate risk and reinvestment risk. That said, funds that invest in riskier money market instruments have the potential to deliver higher returns as well.

• Returns

  The average rate of return of money market funds may be higher than that of savings bank accounts. However, the returns are not guaranteed. The Net Asset Value (NAV) of the fund will change depending on the prevailing interest rates in the market.

• Expense Ratio

  The expense ratio represents the cost associated with the management of money market mutual funds. It is levied as a percentage of your investment capital. According to the Securities and Exchange Board of India (SEBI), fund houses can levy a maximum expense ratio of 2.25%. Investing in funds with high expense ratios can end up lowering your returns. Therefore, remember to always check the costs associated with a fund before investing.

• Tenure

  The tenure of most money market instruments is only up to a year. Investing in these funds would only be ideal if your investment horizon also matches the tenure of the instruments.

• Taxation

  Money market mutual funds are classified as debt funds. The returns from these funds are taxed according to the holding period. For instance, if you hold the funds for less than 36 months (3 years), the gains are categorised as Short-Term Capital Gains (STCG). These gains are added to your total income and are taxed at the income tax slab rates applicable to you. On the other hand, if you hold the funds for more than 36 months (3 years), the gains are categorised as Long-Term Capital Gains (LTCG) and are also taxed at the income tax slab rates applicable to you.

How Should You Invest in a Money Market Fund? 

Investing in a Money Market Fund is simple and straightforward. Begin by determining your investment goal, whether it's for liquidity, capital preservation, or as a short-term parking spot for idle cash. Once you’ve set your goal, research various funds offered by different asset management companies.

To invest, you can use online platforms like mutual fund apps, brokerage accounts, or directly visit the fund house’s website. A platform like m.Stock gives you the added advantage of direct investment in Money Market Funds with zero commission. 

After choosing your platform, ensure your KYC (Know Your Customer) documentation is completed, which includes submitting ID proof, address proof, and PAN details. Once this is done, you can start by investing a lump sum or set up a Systematic Investment Plan (SIP) for regular contributions. SIPs are a good option for those looking to invest steadily over time, while a lump sum is more suitable if you have a large amount of cash on hand.

Finally, monitor your investments periodically to ensure they meet your short-term goals and adjust as needed.

Why Should You Invest in Money Market Funds? 

Money Market Funds are an ideal option for investors seeking safety, liquidity, and slightly higher returns than traditional savings accounts. These funds invest in highly liquid and low-risk securities like Treasury bills, certificates of deposit, and commercial paper, making them less prone to volatility compared to equity or long-term debt funds. In general, the benefits of investing in Money Market Mutual Funds include:

• Capital Preservation: Money Market Funds invest in low-risk securities like Treasury bills and commercial papers, making them a safe option for preserving your capital while earning modest returns.
• High Liquidity: These funds offer quick access to your money, making them ideal for short-term investments or emergency funds. You can redeem your investments without significant penalties.
• Stability: Since they invest in short-term, high-quality instruments, Money Market Funds provide stability and are less affected by market volatility compared to equity or long-term debt funds.
• Better Returns than Savings Accounts: Money Market Mutual Funds often provide slightly higher returns than traditional savings accounts while maintaining a similar level of safety and liquidity.
• Diversification: By pooling money to invest in a variety of short-term securities, Money Market Funds offer diversification, which can reduce risk compared to holding a single security.

Taxation Rules of Money Market Mutual Funds 

The taxation rules for debt funds have seen some changes in recent budgets. Previously, the tax on debt fund profits depended on the holding period. If units were held for up to 3 years, they were subject to Short Term Capital Gains (STCG) tax, while units held for more than 3 years incurred Long Term Capital Gains (LTCG) tax. STCG was taxed according to your individual tax slab, whereas LTCG was taxed at 20%, with the benefit of indexation.

However, in April 2023, these rules were revised. The indexation benefit was removed, and now, gains from debt funds are taxed according to your tax slab, regardless of how long you hold the investment.

How to Choose the Best Money Market Mutual Funds? 

Selecting the best Money Market Mutual Fund requires evaluating a few key factors.

• Portfolio Quality: Choose funds that invest in high-quality, short-term securities, such as AAA-rated corporate bonds or government-backed instruments, to minimise credit risk.
• Expense Ratio: Compare the expense ratios across different funds. A lower expense ratio ensures that more of your returns are retained instead of being paid as management fees.
• Past Performance: Review the historical performance of the fund, keeping in mind that consistent returns over time can indicate a well-managed fund.
• Liquidity and Redemption Terms: Check the liquidity options of the fund. The best funds offer easy redemption with minimal or no exit load, ensuring fast access to your capital when needed.
• Fund Size and AUM: Larger funds with higher Assets Under Management (AUM) are often more stable and better positioned to handle market fluctuations effectively.

By assessing these factors, you can choose a Money Market Fund that suits your risk tolerance and investment needs.

How much returns can I expect in a Money Market Mutual Fund?

The returns from a money market mutual fund are dependent on two major factors - the interest rate in the market and the tenure of holding. The higher the market interest rate and the longer the tenure, the greater your returns are likely to be. The average annual returns from money market mutual funds can range anywhere from 5% to 7.5%.

Are Money Market Funds Better Than a Savings Bank Account?

The average savings bank account interest rate ranges from 2.5% per annum to 4% per annum. Compared to a money market fund, the rate of interest on savings bank accounts is considerably lower.

Therefore, if you’re looking for a low-risk and highly liquid investment option with good return generation potential, investing in a money market fund may be better than parking your funds in a savings bank account.

However, it is essential to keep in mind that money market mutual funds are not completely devoid of any risk.

Conclusion

Money market mutual funds are great additions to your portfolio. They’re liquid, less volatile, and produce returns that may potentially be higher than savings bank account rates. Furthermore, there are different types of money market funds that you can choose from.

If you prefer investing in money market mutual funds, m.Stock may be able to help you out. Our superfast trading platform allows you to purchase mutual fund units in just 2 clicks. All you need to do is select the list of money market funds available in the market and place a buy order. With m.Stock, you get to enjoy zero commissions and up to 1% extra return on direct mutual funds.