Money market funds are a subcategory of debt mutual funds. These schemes are suitable for risk-averse investors who are seeking stable returns and liquidity. That said, before investing in such schemes, individuals should know about the benefits and returns offered by such funds.

Here we have shared the details to help you make an informed decision regarding your investment. But first things first, let’s understand what are money market funds.

[Source]

A Money market fund allocates its investment corpus to short term, fixed-income securities that are highly liquid. The average maturity period of the underlying financial instruments is not more than 1 year. Accordingly, investments in money market funds are associated with low interest rate risk.

The portfolio of such mutual funds schemes may comprise the following types of financial securities :

• Commercial papers (CP)
• Certificate of deposit (CD)
• Treasury bills (T-bills)
• Banker’s Acceptance
• Commercial bills
• Repurchase agreements (Repo)
• Call and notice money

[Source]

The two main objectives of money market mutual funds in India are:

• Providing risk-averse investors with stable returns
• Catering to liquidity needs of individuals

To understand the workings of money market mutual funds, it is vital for investors to know about the maturity period and the sources of income.

Understanding maturity period

The volatility of a debt fund and the level of interest rate risk associated with the investment have a direct relationship with the Macaulay duration of the portfolio. This means that the longer the duration, the greater the extent of volatility and interest rate risk.

Since a money market fund invests in financial instruments having a maturity period of not more than 1 year, it is subject to low volatility.

Sources of income

Money market funds earn income via  interest and capital appreciation. The former refers to the interest payments received from the underlying securities. There’s scope for offering capital gains as well. Fund managers of these mutual fund schemes actively buy and sell the fixed income securities to take advantage of the changing interest rates in the market. When interest rates go down, such schemes increase their exposure to money market instruments in India  with a longer maturity period, leading to an increase in the fund value.

Similarly, when interest rates increase, these funds invest more in money market securities with a shorter-maturity period. This leads to the reduction of capital losses. Note that since the maturity period of the portfolio constituents is not more than 1 year, there isn’t much scope for earning capital gains.

Here are some investors who might want to consider allocating their savings to money market funds:

• Investors seeking regular income: Money market funds have the potential to provide regular income in the short term. Accordingly, these are suitable for investors seeking stability as well as liquidity.
• Investors looking for an alternative for savings deposits: Individuals seeking higher returns than a savings bank account can consider investing in money market funds. Moreover, these mutual fund schemes can usually offer higher returns than overnight funds or debt funds as the Macaulay duration of the portfolio is higher.
• Investors looking to invest for a short duration: A money market fund offers stability to investors. Accordingly, these schemes are suitable for individuals who wish to park their funds for a short period of time, and earn steady income.

There are two ways to invest in such funds. One can invest in money market funds through any one of the following two investment routes:

• Systematic investment plan (SIP)
• Lump sum

But before choosing the mode of investment, investors must opt for a direct or regular plan. Let’s find out what they are.

• Direct plan: To opt for a direct plan in money market funds or any other type of mutual fund schemes, individuals need to invest directly via the fund house. Alternatively, they can invest via specific mobile-based applications/online platforms.
• Regular plan: Individuals need to invest in a fund via an intermediary (brokers/ distributors) in case they wish to opt for a regular plan.

Consider the following factors before investing  in MMFs -

1. Risk

Money market funds are relatively less risky compared to other types of mutual funds. Still, certain risks associated with these funds are:

• Interest Rate Risk – It refers to the fluctuation in a fund’s NAV based on movement in market rates.
• Credit Risk – It refers to the risk of default, which occurs when issuers of money market instruments or fixed income securities fail to repay the debt.
• Reinvestment Risk – It refers to a situation where the fund manager is unable to reinvest earnings from a previous investment.

2. Returns

Money market mutual funds in India have the potential to provide higher returns than a savings account.  However, the returns are not guaranteed. Changes in the overall interest rate regime can prompt a scheme’s NAV to fluctuate, which impacts investors’ returns.

Investors might want to check the past returns of a fund to figure out whether the scheme has been able to achieve its objectives consistently. But note that the past returns do not indicate whether or not the scheme will perform well in the future.

3. Expense Ratio

Asset Management Companies charge a certain fee known as expense ratio every year to cover the expenses incurred for operating the fund. The costs borne by the fund includes, administrative fees, distribution fees, advertisement expenses, fund managers’ fees, etc. The expense ratio directly impacts the annual returns of investors.

Hence, it is vital for individuals to compare the expense ratio of different money market funds before picking a scheme. That said, make sure to consider other aspects on this list as well to choose the right fund.

4. Taxation

Money market funds are taxed akin to debt funds. Accordingly, if investors sell their units within 36 months, the returns are added to their annual income and taxed according to the slab rate. Conversely, the returns earned from the sale of units after 3 years from the date of purchase attract 20% tax post indexation.

5. Investment Horizon

Individuals should choose an MMF after deciding their investment horizon. In case investors are looking to invest their savings for a short duration, money market mutual fund schemes are certainly worth considering.

Money market funds, like any other investment avenue, involve their fair share of pros and cons. Investors must make sure to identify their financial goals besides gathering thorough knowledge of a preferred fund before investing.