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What Are Money Market Funds And How Do They Work In India?

  • Feb 11, 2024

In the world of finance today, it's important to know how these funds work. So, let's break down Money Market Funds - their types, the stuff they invest in, how they do their thing, and why it's a good idea for investors to think about adding them to their mix. We'll also go over some simple but smart practices and key things to think about before jumping into Money Market Funds in India.

Understanding Money Market Funds

Money Market mutual funds, categorized under short-term debt funds, aim to provide investors with better returns over a year, ensuring high liquidity. These funds invest in various money market instruments, which are short-term, highly liquid assets. The typical money market fund return maturity is one year.

Money Market Instrument Types

  1. Treasury Bills (T-Bills): Issued by the Indian Government, T-Bills have maturities of a year (365 Days). While considered very safe, they offer lower returns compared to more financial market products.
  2. Certificate of Deposit (CD): Provided by banks that are scheduled commercial banks, CDs are term deposits without the choice to redeem early. They are completely negotiable, distinguishing them from fixed deposits.
  3. Repurchase Agreements (Repos): Agreements between banks or the RBI for facilitating short-term loans and a bank.
  4. Commercial Paper (CP): Short-term, unsecured promissory notes issued by businesses and financial establishments with an excellent credit standing. CPs are typically provided at a reduced price, providing returns to investors.

Money Market Funds: How They Operate?

Money Mutual Funds operate as specialized investment vehicles that strategically deploy capital into a diverse range of short-term, highly liquid instruments such as Treasury Bills, Certificates of Deposit (CD), Repurchase Agreements (Repos), and Commercial Paper (CP).

Investment in Money Market Instruments

Money Market Funds meticulously select a combination of money market instruments based on factors such as risk tolerance, market conditions, and fund objectives. Treasury Bills, issued by the government, provide a secure investment avenue with maturities of up to 365 days. Certificate of Deposit (CD) offerings from commercial banks, Repurchase Agreements (Repos), and short-term promissory notes like Commercial Paper (CP) are also key components in the fund's portfolio.

Returns in the Form of Interest Income

The primary source of returns for investors in Money Market Funds is derived from the interest income generated by the underlying money market instruments. Similarly, investments in CDs, Repurchase Agreements, and Commercial Papers contribute interest income to the fund. The aggregated interest income becomes a key component of the overall returns distributed to investors.

NAV Management to Minimize Fluctuations

Net Asset Value (NAV) is a critical metric in evaluating the performance of mutual funds, including Money Market Funds. These funds adopt a prudent approach to managing NAV fluctuations by investing in short-term instruments with relatively stable values. The short tenures of the money market instruments, coupled with the fund's focus on high liquidity, contribute to minimizing NAV volatility.

Balanced Approach and Liquidity Management

Money Market Funds offer investors a balanced approach, providing an attractive combination of modest returns and high liquidity. While the returns may be more favorable than those offered by traditional savings accounts, the emphasis on liquidity ensures that investors can access their funds promptly, catering to short-term financial needs.

Also Read: Stock Market Open and Close Time

Money Market Fund Investing: Who Should Do It?

Money Market Funds are best suited for investors who can tolerate less risk and a short-term maximum one-year investment horizon. They are particularly suitable for individuals with cash that is idle in that person’s savings accounts, offering better returns than traditional bank deposits.

Considerations Before Investing

1. Risks and Returns

A subset of debt funds, Money Market Funds, come with inherent risks that investors must carefully evaluate. Two primary risks associated with these funds are credit rate risk and interest risk:

  • Interest rate risk refers to the impact of fluctuating interest rates on the fund's performance. When interest rates rise, the value of existing bonds in the fund may decline.
  • On the other hand, credit risk is associated with the possibility of default by the issuers of the money market instruments held by the fund.2. Expense Ratio

The expense ratio represents the proportion of the fund's overall assets that the house of fund charges for managing the fund. Investors should seek funds with lower expense ratios, as this can significantly impact the overall returns.

2. Investment Horizon

Strategically designed, Money Market Funds are for short-term investment horizons ranging from 90 to 365 days.

Investors must align their investment plans with the fund's specific objectives and timeframes. These funds are not suitable for those with long-term investment goals.

However, investors with surplus cash that they won't need urgently and who anticipate needing their funds within the next year can benefit from the liquidity and relatively stable returns offered by the best money market mutual funds.

3. Taxation

Capital gains tax applies to the returns earned from these funds, and the holding period determines whether the gains are categorized as short-term or long-term:

  • For holdings lasting 3 years, short-term capital gains are taxed based on the income tax slab and applied to the investor's taxable income.
  • On the other hand, long-term capital gains, applicable for holdings beyond three years, are taxed at a flat rate of 20%, with the benefit of indexation.

The Bottom Line

Money Market Funds offer a compelling option for investors seeking a balance between returns and liquidity. By investing in various money market instruments, these funds cater to individuals with a short-term surplus of cash. However, investors must weigh the risks, consider expenses, and align their investment horizon with the fund's objectives.

Always consult with financial advisors and conduct thorough research before making investment decisions to ensure they align with your financial goals and risk tolerance.

Team Sharekhan
by Team Sharekhan

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