1. How do Money Market Mutual Funds work?
Money market mutual funds (MMMF) are used to manage the short-run cash needs. It is an open-ended scheme in the debt fund category which deals only in cash or cash equivalents. These securities have an average maturity of one-year; that is why these are termed as money market instruments.
The fund manager invests in high quality liquid instruments like Treasury Bills (T-Bills), Repurchase Agreements (Repos), Commercial Papers and Certificate of Deposits. This fund aims to earn interest for the unit holders. The main aim is to keep fluctuations in the funds’ Net Asset Value (NAV) to minimum.
Money market fund can be compared with savings account which comprises of cheque facility, the facility to redeem without lock-in period and electronic money transfer.
2. Types of Money Market Instruments
As an investor, you should know the various money market instruments:
a. Certificate of Deposit (CD)
These are time deposits like fixed deposits that are offered by scheduled commercial banks. The only difference between FD and CD is that you cannot withdraw CD before the expiry of the term.
b. Commercial Paper (CPs)
These are issued by companies and other financial institutions which have a high credit rating. Also known as promissory notes, commercial papers are unsecured instruments which are issued at the discounted rate and redeemed at face value. The difference is the return earned by the investor.
c. Treasury Bills (T-bills)
T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. These are the safest instruments as these are backed by a guarantee of government. The rate of return, also known as risk-free rate, is low on T-bills as compared to all other instruments.
d. Repurchase Agreements (Repos)
It is an agreement under which RBI lends money to the commercial banks. It involves sale and purchase of agreement at the same time.
3. Who should Invest in Money Market Mutual Funds?
Money market fund seeks to provide the highest degree of short-term income via maintaining a well-diversified portfolio of money market instruments. Investors having a short-term investment horizon of up to 1 year can invest in these funds.
Those investors with surplus cash in savings bank account and low-risk appetite can invest in money market funds. These funds will give you higher returns than the savings bank account. The investors could be corporate as well as retail investors.
However, if you have a medium to long-term investment horizon, then money market fund won’t be an ideal option. Instead, you may go for dynamic bond funds or balanced funds which may give you relatively higher returns. Similarly, don’t think of money market funds unless you have short-term surplus cash which you don’t need urgently.
4. Things to Consider as an Investor
These funds suffer from interest rate risk, credit risk and reinvestment risk. In interest rate risk, the prices of underlying asset increase as interest rates decline and decrease as interest rates rise. The fund manager may invest in risky securities which have a higher probability of default.
A Money Market Fund might give you more return than a savings account. However, there are no guaranteed returns. The Net Asset Value (NAV) fluctuates with changes in overall interest rate regime. A fall in interest rates may increase the prices of an underlying asset and deliver good returns.
Expense ratio refers to the fees charged by Money Market Funds to manage your portfolio. Until recently, SEBI had prescribed the maximum limit as 1.05%. An ideal fund is one which keeps its expense ratio at lower levels. As the asset under management (AUM) increases, the scheme tends to reduce the cost of operations.
d. Investment Horizon
Money Market Funds are suitable for very short-term to short-term investment horizons .i.e. 3 months to 1 year. For medium-term horizons, you may invest in other debt funds like dynamic bond funds.
e. Financial Goals
In case you have to make EMI payments or invest extra cash while maintaining liquidity, you can use money market funds. A small portion of your portfolio can be invested in these for diversification.
f. Tax on Gains
Investing in debt funds provides you capital gains which are taxable. The tax rate depends on the holding period i.e. for how long you stayed invested in the fund. You make a Short-term Capital Gain (STCG) when you stay invested for a period of lesser than 3 years.
Long-term Capital Gains (LTCG) are made when you stay invested for over a period of 3 years or more. STCG from money market funds are added to your income and taxed according to your income slab. LTCG from money market funds is taxed at the rate of 20% after indexation.
5. How to Invest in Money Market Mutual Funds?
Investing in Money Market Funds can be paperless and hassle-free at ClearTax, using the following steps, to start your investment:
Step 1: Sign up for an account at cleartax.in
Step 2: Enter your personal details as regards the investment amount and investment period
Step 3: Your e-KYC will be done in less than 5 minutes
Step 4: Invest in your favourite money market fund from amongst the hand-picked mutual funds