Mutual funds are often associated with long-term wealth creation, but they also offer smart options for investors looking to park their money for the short term. If you have surplus funds for a few days or months and want potentially better returns than a savings account, money market funds can be a practical choice. These funds invest in high-quality, short-term debt instruments and are popular among young investors and corporates for managing idle cash efficiently. Curious to learn more about money market funds? Dive into this blog to explore what money market funds are, how they work, and how they can add stability and balance to your investment portfolio.
Money Market Funds are a type of debt mutual fund that invests in very short-term and high-quality financial instruments. They are designed for investors who want to park surplus money for a short period, usually a few weeks to a few months, while aiming for better returns than a savings account. These funds focus on capital safety, liquidity, and stable returns rather than high growth. As these funds invest in instruments with short maturity, their interest rate risk is low, making them suitable for conservative investors, corporates managing idle cash, or individuals building an emergency or short-term parking portfolio.
Instruments Used in Money Market Funds
The various debt instruments that these funds usually invest in include,
Treasury Bills (T-Bills) - Treasury Bills are short-term debt instruments issued by the Government of India with maturities of up to one year. They are considered one of the safest investments because they carry sovereign backing. Money market funds use T-Bills to maintain safety and liquidity while earning modest returns.
Commercial Papers (CPs) - Commercial Papers are unsecured short-term instruments issued by financially strong companies to meet their working capital needs. They usually offer slightly higher returns than T-Bills but carry a small amount of credit risk. Money market funds invest only in high-rated CPs to balance safety and return.
Certificates of Deposit (CDs) - Certificates of Deposit are issued by banks and financial institutions for short durations, generally ranging from a few months to one year. They offer predictable returns and are relatively safe, especially when issued by well-rated banks. These instruments help money market funds generate stable income.
Repurchase Agreements (Repos) - Repos are short-term borrowing arrangements between banks or the RBI, where one party sells securities with an agreement to repurchase them at a fixed price later. They are typically backed by government securities or high-credit-rating corporate bonds, making them low-risk. Money market funds use repos to manage liquidity efficiently.
Money market funds are like any other mutual fund that collects money from many investors and invests in short-term, high-quality debt instruments, i.e., specified securities such as Treasury Bills, Commercial Papers, and Certificates of Deposit. These instruments usually have short maturities, generally up to one year, which helps keep the risk low and the value of the investment relatively stable.
The fund earns interest from these instruments, and this income is reflected in the fund’s Net Asset Value (NAV), which typically moves slowly and steadily. Fund managers actively manage the portfolio by buying and selling instruments as they mature, ensuring regular cash flow and liquidity. Since the investments mature quickly, the impact of interest rate changes is limited compared to long-term debt funds.
Investors can invest and redeem their money easily, making these funds suitable for short-term parking of surplus cash. Returns from money market funds are not fixed or guaranteed and depend on prevailing interest rates and the quality of instruments held. Any gains earned are passed on to investors after deducting fund expenses, and the returns are usually slightly higher than a savings account over time. Thus, money market funds aim to preserve capital while offering stable and predictable returns rather than high growth.
Money market funds belong to the debt funds category and hence are typically a lower risk investment option as compared to equity mutual funds. The top features of these funds that make them an attractive option to park short-term funds are,
Short-Term Investment Horizon - Money market funds are meant for short-term investments, usually ranging from a few weeks to a few months. They are ideal for parking surplus money that may be needed soon, such as emergency funds or temporarily idle cash.
High Liquidity - These funds offer high liquidity, allowing investors to withdraw their money easily, often within one working day. This makes them suitable for investors who want quick access to their funds without locking in their money for long periods.
Low Risk Profile - Money market funds invest in high-quality and short-term debt instruments, which helps keep credit risk and interest rate risk relatively low. While they are not completely risk-free, they are considered safer than many other mutual fund categories.
Stable Returns - The short maturity of the underlying instruments helps reduce sharp fluctuations in returns. As a result, money market funds generally provide steady and predictable returns over time, though these returns are not guaranteed.
Professional Fund Management - Experienced fund managers actively manage these funds by selecting well-rated instruments and adjusting the portfolio based on market conditions. This helps in maintaining safety, liquidity, and consistent performance.
Better Alternative to Savings Accounts - Over time, money market funds may offer returns that are slightly higher than traditional savings accounts, especially for short-term surplus funds. They also provide a more efficient use of idle money for investors.
Diversification of Instruments - Money market funds invest in a mix of government and corporate short-term instruments. This diversification helps spread risk across different issuers and instruments.
Suitable for Conservative Investors - Because of their focus on capital preservation and low volatility, money market funds are suitable for conservative investors, first-time mutual fund investors, and corporations managing short-term cash needs.
Money market funds primarily offer capital preservation and relative stability in terms of returns. However, it is important to consider a few factors while investing in these funds to ensure that the fund objectives and performance align with the investor's goals. These factors include,
Investment Horizon - Money market funds are best suited for short-term goals, usually a few weeks to a few months. Investors should ensure that the money invested will not be needed immediately, as staying invested for a short period helps in earning reasonable returns.
Credit Quality of the Portfolio - It is important to check the credit quality of the instruments held by the fund. Funds that invest in high-rated instruments are generally safer and carry lower credit risk, which is crucial for capital protection.
Risk Appetite - Although money market funds are low risk, they are not risk-free. Investors should align their choice with their comfort level, especially if they prefer stability and capital protection over higher returns.
Expense Ratio - The expense ratio directly impacts returns, especially for short-term investments. A lower expense ratio means more of the interest earned stays with the investor, making it an important factor to compare before investing.
Interest Rate Environment - Returns from money market funds depend on prevailing short-term interest rates. When interest rates are rising, returns may improve over time, while falling rates may lead to slightly lower returns.
Fund House and Track Record - Choosing a fund from a reputed asset management company with a strong track record adds an extra layer of comfort. Experienced fund houses usually follow better risk management and credit selection practices.
Liquidity and Exit Terms - Investors should check how quickly they can redeem their money and whether any exit load is applicable. Most money market funds have no or very low exit loads, making them suitable for easy withdrawals.
Portfolio Diversification - A well-diversified portfolio across multiple issuers and instruments reduces the impact of any single issuer default. Investors should avoid funds that are overly concentrated in one issuer or sector.
Taxation - Returns from money market funds are taxed as per the investor’s income tax slab rate. Investors should consider their tax bracket and compare post-tax returns with alternatives like savings accounts or fixed deposits.
Money market funds are suitable for investors who want a safe and convenient place to park their surplus money for a short period while earning potentially better returns than a regular savings account. They are ideal for conservative investors who prefer low risk and capital protection over high returns. Salaried individuals, young investors, and first-time mutual fund investors can use these funds to manage short-term savings or build an emergency fund. These funds are also ideal for corporates and professionals who invest in money market funds to manage idle cash efficiently and maintain liquidity. Overall, these funds are best for investors with short-term goals who want stability, easy access to money, and steady returns without taking significant market risk.
Money market funds are treated as debt / specified mutual funds for tax purposes in India. The taxation of capital gains from these funds depends mainly on when the units are bought (before or on/after 1 April 2023) and their holding period. Dividends from mutual funds are taxed in the hands of the investor and may attract TDS at 10% above a threshold of Rs. 5000 in a financial year. The taxation of money market funds is tabled hereunder.
Money market funds are affected by the typical risks usually seen while investing in debt mutual funds. These risks include,
Credit Risk - Although these funds invest in high-quality instruments, there is still a small risk that an issuer may delay or default on payments.
Interest Rate Risk - Changes in short-term interest rates can slightly affect returns, even though the impact is much lower than in long-term debt funds.
Liquidity Risk - In stressed market conditions, selling certain instruments quickly may become difficult, which can affect fund liquidity.
Returns Are Not Guaranteed - Unlike fixed deposits or savings accounts, money market fund returns are market-linked and may vary over time.
Reinvestment Risk - When instruments mature, fund managers may have to reinvest at lower interest rates, reducing future returns.
Expense Ratio Impact - Higher expense ratios can eat into returns, especially since money market fund returns are generally modest.
Regulatory or Policy Changes - Changes in SEBI regulations or tax laws can impact fund structure, returns, or post-tax outcomes.
Inflation Risk - Returns may not always beat inflation, especially during periods of high inflation.
Money market funds are a practical option for investors looking to park surplus money for the short term while aiming for safety, liquidity, and stable returns. These funds invest in high-quality, short-term instruments that help keep risk relatively low. While returns from these funds are not guaranteed and can vary with interest rates and expenses, these funds are generally more efficient than leaving idle cash in a savings account, making them suitable for conservative investors and corporates managing short-term cash needs.
This article talks about a very popular category of mutual funds and its finer details. Let us know your thoughts on the topic or if you need further information on the same and we will address it soon.
Till the, Happy Reading!
Read More: Understanding the Riskometer in Mutual Fund Scheme
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
Great explanation of money market funds! ?? I especially like how you highlighted the low-risk and high-liquidity aspects — that’s really important for investors who want to park short-term cash efficiently.
Thank you! We’re glad the key points on low risk and high liquidity resonated. We’ll keep sharing more insights to help investors make informed decisions.
Overall, a very informative post — thanks for sharing!
Thank you! We’re glad you found it informative and appreciate your feedback, more helpful posts are on the way.
Well explained article. very useful for investors looking to park short-term surplus funds
Thank you! We’re glad it was useful, our aim is to keep sharing practical insights for smart investing.
Informative post! Money market funds are often overlooked, so this was a good refresher. A quick comparison with liquid funds or savings accounts would make it even more helpful for first time investors.
Thank you for the feedback! We’re glad you found it helpful and appreciate the suggestion, comparing with liquid funds and savings accounts is a great idea, and we’ll consider adding that in future posts.
Good post. The detail was too good.
Thank you! We’re glad you appreciated the level of detail, more insightful posts are on the way.
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Good post
Thanks! Glad it was useful, more posts coming soon.
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