Money Market Funds: Everything You Need to Know

Akansha Gupta

27 Sep, 2021

Investors with a low-risk tolerance are usually on the hunt for investment choices that will provide them with high returns while keeping their assets liquid. Many debt funds have been created with this consideration in mind. Furthermore, most investors compare the profits on their debt fund investments to the returns on bank deposits. When it comes to investing in short-term debt, Money Market Funds are a popular choice among such investors. Here, we shall examine and discuss the many forms of money market funds in India, as well as their advantages and disadvantages.

Meaning of Money Market Funds?

Money Market Funds, also called as Money Market Mutual Funds (MMF), are high-quality short-term debt funds, cash, and cash equivalents. They invest in different money market assets with the goal of providing strong returns over a one-year period while retaining high levels of liquidity. A Money Market Fund’s typical maturity is one year. As a result, money market mutual funds are regarded as secure investments with little to no risk. These funds provide a predictable risk-free return rate since they invest in high-quality securities.

The fund portfolio must have a weighted average maturity (WAM) of 60 days or less, according to Securities and Exchange Commission (SEC) guidelines. Money market funds, like other mutual funds, issue redeemable units (shares) to investors and must adhere to SEC requirements. A money market mutual fund has all of the characteristics of a mutual fund, with the exception of its net asset value (NAV). We’ll go through this exception in more detail later.

Money Market Funds vs. Money Market Accounts

A money market account (MMA) and a money market fund are not the same thing, despite their similar names. A money market fund is a type of investment which is sponsored by a fund company or organisation. As a result, there is no main assurance. A money market account is a form of savings account that pays interest. Financial organisations provide money market accounts. In the United States, they are FDIC-insured (the Federal Deposit Insurance Corporation) and usually have restricted transaction capabilities.

How do Money Market Funds work?

Money market mutual funds (MMMF) are intended to meet short-term cash requirements. In the debt fund category, these funds are open-ended and solely deal in cash or cash equivalents. Money market securities have a one-year average maturity, which is why they are referred to as money market instruments.

The fund management makes investments in high-quality liquid securities such as treasury bills (T-Bills), repurchase agreements (Repos), commercial papers, and certificates of deposit. MMF are primarily concerned with producing interest for their unit holders. The basic goal of money market funds is to keep the fund’s Net Asset Value (NAV) as stable as possible.

Money market funds function similarly to mutual funds. They sell redeemable units or stocks to investors and are required to meet financial authorities’ requirements.

In India, Investment in money market instruments is out of reach for the average individual investor. These instruments need a significant initial investment. Because the returns on these instruments are determined by the appropriate market interest rates, the overall returns on money market funds are likewise determined by interest rates. Money Market Mutual Funds enable individual investors to invest in such assets with small amounts of money. Experts regarded it as a safer investment because it is issued by the government, banks, and large companies.

Unique Qualities of Money Market Funds

Money market funds are unique in three ways:

• Safety

These funds’ investments in securities are steady and typically secure. Money market securities offer a set rate of return and have short maturities. Money market funds provide a minimal default risk while still providing a respectable return by acquiring debt instruments issued by banks, big businesses, and the government.

• Low initial investment

Money market assets often have high minimum purchase requirements, making them inaccessible to the overwhelming majority of ordinary investors. Money market funds, on the contrary, have significantly lower criteria that are even lower than the typical mutual fund minimum requirements. As a consequence, money market funds enable investors to benefit from the safety of a money market investment at reduced risk levels.

• Availability

Money market funds shares can be purchased and sold during any time and are not restricted by market timing. Most of these funds allow investors to write checks and offer same-day settlement, which is comparable to trading money market instruments.

Who should invest in Money Market Funds?

A money market fund seeks to provide the best short-term income possible by investing in a diverse range of money market instruments. These types of funds are suitable for investors with a 1-year investment horizon.

People with a low risk tolerance who have excess cash in a savings account can consider investing in money market funds. These funds have the potential to provide better returns than a traditional savings account. The investors might be both corporate and retail.

If one has a medium to long-term investing goal, a money market fund is not the best choice. Instead, one may invest in dynamic bond funds or balanced funds, which can provide better and higher returns.

Advantages / Disadvantages

Types of Money Markey Instruments

A money market is an exchange wherein cash and cash-equivalent instruments are traded. The maturities of the products traded in the money markets range from overnight to 1 year. Here are some of the most important money market instruments in India:

• Treasury Bills or T-Bills

The Indian government distributes treasury bills to generate funds for up to 365 days. Because they are issued by the state, they are thought to be quite safe. However, reduced risks imply lower returns, which is also true for treasury bills. T-bill returns are lower than those of other money market securities.

• Certificate of Deposit or CD

A CD is a term deposit, similar to a fixed deposit, that is issued by scheduled commercial banks and does not allow for premature redemption. The main distinction between a CD and an FD is that CDs are freely negotiable.

• Repurchase Agreements or Repos

To enable short-term loans, a bank and the RBI enter into a repurchase agreement. It is an agreement in which the Reserve Bank of India (RBI) loans money to commercial banks. It is also possible to make it between two banks. It entails the simultaneous selling and buying of an agreement.

• Commercial Paper or CP

Commercial paper is a short-term, unsecured promissory note that can be issued by companies and financial institutions with a great credit rating. It enables such companies to diversify their sources of short-term financing. CPs are often given at a reduced rate, with redemption taking place at face value. The difference is earned by the investor.

Factors to consider before investing in Money Market Fund

Here are some critical factors to consider before investing in money market funds in India:-

• Risks and Returns

Money Market Funds are debt funds and so bear all of the risks associated with debt funds, such as interest rate risk and credit risk. In order to boost returns, the fund manager may also invest in securities with a little greater risk component. MMF typically outperform traditional savings accounts in terms of returns. The Net Asset Value (NAV)^[1] of these funds fluctuates in response to changes in the interest rate environment.

Money market fund, while generally low-risk, are not completely risk-free. The Community Bankers U.S. Government Money Market Fund of Denver ran into difficulty in 1994 when the values of the derivatives that dominated its portfolio fell dramatically. The fund was liquidated by the Securities and Exchange Commission, and investors (all institutional) earned just $0.96 on the dollar.

In another instance, in September 2008, the Reserve Primary Fund collapsed. The famous fund held hundreds of millions of dollars in short-term loans to Lehman Brothers, and when that investment firm went bankrupt, there was a frantic sell-off among Reserve’s own investors. The fund’s share price fell to $.97; unable to fulfil redemptions, Reserve was forced to close. To keep the sector from collapsing, the US Treasury had to step in and insure other money market fund.

This is known as “breaking the buck,” which occurs when a money market fund’s net asset value (NAV) falls below the customary $1 level it is meant to maintain, resulting in the fund’s liquidation.

• Expense Ratio

Because the returns are low, the expense ratio is crucial in calculating your profits from a money market fund.

‘The expense ratio is a tiny proportion of the fund’s total assets levied by the fund house for fund management services.’

To optimise your profits, you should seek for funds with a lower expense ratio.

• Invest according to your Investment Plan

Money market funds are often suggested to investors with a time horizon of 90-365 days. A significant investment in MMF is not ideal for a long-term investor establishing a retirement fund. These funds provide income that is just slightly higher than the rate of inflation on average, which is insufficient to establish a substantial nest egg. Rather, these schemes might assist you in diversifying your portfolio and investing excess funds while maintaining liquidity. Make certain that you invest in accordance with your investing strategy.

• Tax on Gains

Investing in debt funds generates taxable capital gains. The tax rate is determined by the holding period, or how long you were invested in the fund. When you invest for less than 3 years, you earn a short-term capital gain (STCG).

Long-term capital gains (LTCG) are earned when you hold an investment for more than 3 years. STCG from money market fund is added to your income and taxed according to your tax bracket. After indexation, LTCG from money market fund is taxed at a flat rate of 20%.

Conclusion

Read our article:Difference between Stocks and Mutual Funds