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Mutual funds have become a very popular choice of investment in India. Falling bank interest rates, good returns and ease of investing in mutual funds online or through mobile app are some of the basic reasons why more and more investors are inclining their interests towards mutual fund investments. Mutual funds come in different types and one of the types is money market mutual funds.
A money market mutual fund is basically an open-ended scheme, which puts your cash invested in a very safe and high-quality liquid instruments like commercial paper, treasury bills, and certificate of deposits and repurchase agreements, which have short maturity period, which is usually less than one year. Money market mutual funds especially, the liquid fund, invests your money in very short-term market instruments, having a maturity period of up to 91 days where the investor can actually keep his/her money for a very short span of one to three months period and it can serve as an emergency fund.
The money invested in a liquid fund can be used for emergency cases like sudden hospitalisation or saving up for short term goals like child’s summer camp fees, vacation planned over the next 2 months or even for temporary living expenses if the investor loses job suddenly.
There are also different types of money market instruments. Let’s have a look at different money market instruments.
The main purpose of investing in a debt fund is to earn a better interest rate and additionally, enjoy capital appreciation. Debt funds make an excellent investment option for conservative investors and are suitable for both medium-term investment and short-term horizons. Short-term horizons, consider liquid funds which give a better rate of returns than Savings Bank accounts. For instance, in the range of 6.5-7.5%, with similar kind of liquidity to meet a financial emergency. In case of medium-term horizons like three to five years, an investor should consider debt funds like dynamic bond funds, where the fund manager keeps altering the portfolio of the fund duration by buying and selling securities with higher and lower maturities. The Dynamic bond funds’ goal is to give investors good returns on the investment during both rising and falling interest rates. Dynamic bond funds are great for investors who have a hard time predicting the rate of interest.
Gilt funds are a type of debt mutual funds, which invest your money in safe securities and Government Bonds. Gilt funds give investors the dual advantage of good returns on investment and low-risk factor. Gilt funds invest in Government Bonds which are absolutely safe like a house and carry no risk on investment. It also allows the investor to diversify the portfolio and earn definite returns on the investment. Gilt funds are great investment option in a falling interest rate trend because as the yields fall, the price rises. This is the time the Net Asset Value (NAV) of the gilt fund rises. An investor should go for gilt funds if he/she anticipates a fall in interest rate in the coming period.
Fixed maturity plans have maturity duration of 1 to 5 years and are close-ended debt funds. The portfolio of investment of FMP consists of AAA-rated corporate bonds, certificate of deposits, commercial paper, Bank Fixed Deposit and money market instruments. This type of funds are highly suitable for investors who don’t want to take much risk on investment. Investment in FMP is suitable to meet specific short term financial goals. People who have retired from work and want an investment with regular return can consider investing in this mutual fund. FMPs also offer the advantage of saving tax if the investor falls in the high-income tax bracket. The FMP attract a low tax rate due to the indexation benefit which they get in long term capital gains. The rate of return of FMP is more or less similar to FDs.
Money markets across the world mostly function over the counter, which basically means that these trades cannot be done online. Therefore, the investment in these markets are done physically by authorised representatives and a physical certificate is given to the buyer of the money market instrument.
This basically means that money markets are designed to provide and accept bulk orders, thus very few retail investors have sufficient capital to directly participate in money markets. However, individual investors can make money by choosing to invest in debt mutual funds which invest in the money market.
Money market trade is multiple instruments, unlike the capital market which normally trades in an individual type of instruments such as securities. Multiple instruments feature different debt structure, maturities, credit risk, and even currencies. Due to this diversity, money market instrument is best for diversification through the distribution of exposure.
One the highlighted feature of the money market which makes it unique is the level of liquidity it offers. It is fairly easy to make money market trade across debt structure, currencies, and maturities in addition to credit risk. All these features make it easy and is best suited for institutions that are looking to invest or borrow for short term duration.
As mentioned above, money markets are not exactly open to individual investors as they deals in bulk orders and the trades are not carried out online. As a result, a variety of institutional investors participate in buying and selling money market instruments. Major investors in money markets thus comprise of financial institutions as well as dealers looking to borrow or lend money for a short term. The typical period of these instruments is up to thirteen months.
Paper is the term used for Money market instruments as a group in distinction to “bonds” and “shares” that are traded on capital markets and which refer to long term borrowing instruments. Inter-bank lending is one of the core drivers of money markets. Inter-bank lending relates to one bank lending from another bank and trading with commercial papers and repurchase agreements. The London Interbank or LIBOR Offered rate usually becomes the benchmark for these instruments. In India, the REPO which is RBI (Reserve Bank of India) regulated performs a similar function for domestic banks in the country who are lending and borrowing from one another. The finance companies functioning in money markets secure by pledging various worthy assets. The basic example of such assets are mortgages (commercial or residential), mortgage-backed securities, etc. Nonetheless, these sorts of money markets are found only in developed economies.
Money market mutual funds are basically for short term cash needs. It falls in the category of debt fund which is open ended and only deals in cash or cash equivalents. As the maturity period of these securities, on an average, is one year, this is the reason they are called money market instruments.
The main goal of the fund manager is to earn interest for the unit holders and hence, the investment is done in high-quality liquid instruments like commercial papers, certificate of deposits, treasury bills, etc. The goal of the fund is to keep the changes in the Net Asset Value to a minimum. Money market can be compared to a savings bank account where the account holder does not have a lock-in period or withdrawal limitation on the money kept in the account.
The money market funds have some limitation with regards to reinvestment risk, interest rate risk and, credit risk. In case of interest rate risk, the prices of underlying asset increase as interest rates drop and decrease as interest rates surge. It is also a possibility that the investment done by the fund manager in securities may contain high risk and there could be a likelihood of default.
Although it is said that a money market fund may give you a higher rate of return than a bank savings account, there is actually no guarantee on returns. The constant fluctuation of the NAV (Net Asset Value) may have an effect on the overall interest rate regime. A drop in the interest rate may increase the value of the underlying asset and deliver decent returns.
The expense ratio is the cost which is required to run the portfolio and manage money market fund. Recently, SEBI has put a cap on expense ratio to 1.05%, but an ideal fund is the one which keeps the expense ratio to a bare minimum in order to maximise returns. As the AUM (Asset Under Management) increases, the cost of operations tend to reduce for the unit holders.
Money Market Funds are ideal for short-term investment to medium term horizons .i.e. 3 months to 12 months period. For investors wanting to invest in a slightly longer period, then debt funds like dynamic bond funds are ideal.
In case you, as an investor, want to make extra cash while maintaining liquidity, he/she can invest in money market funds. It is good to dedicate a small portion of the investment portfolio in money market instruments for diversification.
There is capital gains tax on earnings from debt funds. The rate of tax depends on the holding period which means for how long the investment was held in the fund. For an investment period of fewer than 3 years, a short term capital gain (STCG) will be levied. For holding period of more than 3 years, Long term Capital Gains tax (LTCG) will be applicable on the returns from the investment. STCG is added to the income of the individual and tax rate depends on the overall income slab. LTCG is taxed at a rate of 20% after indexation.
Money market instruments provide flexibility in terms of liquidity and emergency cash requirement. It is ideal for an investor looking for short term income and someone looking for a diversified portfolio of money market instruments. Investors looking for short term investment of up to a year can invest in such funds. Money market instruments provide a secure investment option for low-risk appetite investors who have surplus cash lying in their saving bank account making no significant gains. These funds give better returns than saving bank accounts. Corporates, as well as individual investors, can invest in money market mutual funds. Investors who have medium to long term investment goals should not invest in money market funds. Such investors should go for dynamic bonds or balanced funds which may offer a much better portfolio and higher returns.
Can you lose money in a money market mutual fund?
Money market mutual funds can drop in value due to volatile market conditions or if interest rates decrease, but they can produce more income too. Investments in mutual funds are subject to market risks and an investor can lose money as well.
What is the difference between a mutual fund and a money market instrument?
Mutual funds invest in long term securities whereas money market instruments are restricted to investment in treasury bonds and other low-risk liquid investments.
Should I invest in a money market fund?
If the investor has short term financial goals and requires high liquidity in investments, then money market fund can be chosen. The investment in the money market instruments has a maximum maturity period of 13 months.
Are money market mutual funds safe?
Money market mutual funds invest in low-risk government bonds, treasury bills, commercial papers, etc. All these carry relatively low risk compared to other investment. It is to be noted that investment in mutual funds are subject to market risk conditions, although they possess a good track record of returns in the last two decades.