Money Market Funds: Understand benefits and investment risks

Many investors prefer to invest in short-term debt securities even though they offer relatively lower returns than equity and equity-related instruments. The simple reason is that these investment vehicles have high liquidity and are relatively less impacted by market volatility.
Some of the common debt funds that belong to this category include overnight funds, liquid funds, and money market funds among others. In this article, we will have a close look at the benefits and risks associated with money market funds.

Table of contents

• What are money market funds?
• How does a money market fund work?
• Types of money market funds
• What are the benefits of investing in money market funds?
• Taxation on Money Market Funds
• Who should invest in money market funds?
• What are the risks associated with money market funds?
• Why should you invest in Bajaj Finserv Money Market Fund?
• Things to Consider before Investing in Money Market Funds
• When to invest in a money market fund?
• How to invest in a money market fund?

What are money market funds?

Mutual funds that invest in debt and money market instruments with a maturity period of up to 12 months are known as money market funds. They are characterised by relatively low volatility and high liquidity over a short investment horizon of 1 year. The fund manager invests in short-term fixed-income instruments such as Treasury Bills, Commercial Papers (CP), Certificates of Deposit (CD), Repurchase Agreements (Repos), and so on.

How does a money market fund work?

Money market funds work by pooling funds from multiple investors to create a diversified portfolio of short-term debt securities. The interest earned from the underlying investments is distributed among the investors in the form of Income Distribution cum Withdrawal (IDCW). The securities held by money market funds typically have maturities of one year or less, which helps to mitigate the risk associated with interest rate fluctuations.

Types of money market funds

Money market funds invest in a variety of short-term instruments, each serving a specific purpose in the financial ecosystem. Some of the commonly utilized money market instruments include:

Treasury bills (T-bills): These are short-term debt instruments issued by the government to raise funds. T-Bills have maturities ranging from a few days to one year and are considered one of the safest investments, as they are backed by the government's creditworthiness.

Commercial papers (CPs): CPs are unsecured money market instruments issued by well-established corporations to meet their short-term funding requirements. They usually have maturities ranging from 15 days to one year, making them highly liquid.

Certificates of deposit (CDs): CDs are time deposits offered by banks and financial institutions with fixed maturity dates and specified interest rates. They are negotiable and can be sold in the secondary market before maturity.

Repurchase agreements (Repos): Repos are short-term agreements where one party sells securities to another with an aim to repurchase them at a specified date and price. They are commonly used for overnight borrowing and lending between banks and other financial institutions.

What are the benefits of investing in money market funds?

Here are the five main advantages of investing in money market funds:

Relatively low volatility: Money market funds can be a suitable option for all types of investors, but they work especially well for conservative investors who are okay with relatively lower returns while keeping their corpus relatively stable.

High liquidity: Like most debt funds, money market funds are characterised by high liquidity. They invest in high-rated debt instruments and have a short maturity period of up to 12 months. Money market funds usually offer relatively better return potential than savings account, but at a comparatively higher risk. Also, since most money market funds do not charge an exit load, you can easily liquidate your investment.

Relatively stable return potential: Money market funds invest in debt and money market instruments such as Certificates of Deposit (CD), treasury bills and so on; thus, you can expect relatively stable returns from your investment.

Low expense ratio: While the actual expense ratio depends on the mutual fund scheme and the Asset Management Company (AMC), money market funds usually have a lower expense ratio as compared to equity funds.

Short investment horizon: If you are just getting started with investing in mutual funds, money market funds can prove to be a suitable starting point for you. They offer relatively low risk and high liquidity over a shorter duration of 12 months. This means that you are free to change your investment strategy at any time without losing money.

Taxation on money market funds

Taxation of Income Distribution cum Capital Withdrawal (IDCW)

IDCW by money market funds are taxed as per the investor's income tax slab. This means IDCW is added to the investor's total income and taxed at the applicable slab rate.

Taxation of capital gains:

When you redeem units of a money market fund, you may realize a capital gain or loss. This is the difference between the purchase price and the redemption price. Capital gains are also taxed as per the investor's income tax slab.

Who should invest in money market funds?

Now that you know about the benefits associated with investing in money market funds, you may be wondering if you should invest in them too.

You should invest in money market funds if:

• You are a conservative investor.
• You have an investment horizon of up to 12 months.
• You are looking for an investment option offering low volatility as compared with long term debt funds and high liquidity.
• You want to potentially earn more than the meagre interest rate applicable to a savings account.
• You want to diversify your investment portfolio to balance out the overall risk.

What are the risks associated with money market funds?

The main types of risks associated with investing in money market funds are:

Inflation risk: In case the inflation is high, the loss of purchasing power is going to affect you if the return from money market funds is less than the inflation rate. This is one of the top reasons why you should diversify your portfolio and try different investment instruments, even as a conservative investor.

Interest rate risk: Interest rate risk measures the impact of changes in rates on the securities held by money market funds. If interest rates increase, the value of a money market fund’s investments generally decreases, and vice versa. Securities with longer maturities usually offer higher yields but have greater interest rate sensitivity.

Credit risk: While the credit risk associated with money market funds is low when compared to many other types of debt mutual funds, it is still higher than savings accounts and fixed deposits.

Why should you invest in Bajaj Finserv Money Market Fund?

The Bajaj Finserv Money Market Fund aims to generate regular income by investing in a portfolio comprising money market instruments. It can generate reasonable returns in comparison to savings accounts and fixed deposit at a higher risk. The scheme carries low-to-moderate risk and offers high liquidity. You can get started with just Rs. 1,000. The best part is that there is no exit load applicable to the Bajaj Finserv Money Market Fund.Finserv Money Market Fund.

In conclusion, you can use money market funds as a tool for portfolio diversification. Whether you are a seasoned investor or a novice, you can consider investing in money market funds since the principal amount is relatively less impacted by market volatility compared with long term debt funds.

Things to consider before investing in money market funds

Money market funds may be suitable for investors looking for relatively liquid investments with lower risk than other debt fund categories. However, it’s essential to assess several aspects before investing:

Investment horizon: These funds are generally relatively suitable for short-term investments, typically lasting from a few days to a few months. They are often used to temporarily hold surplus funds or meet short-term financial needs. Since they invest in very short-term instruments, they tend to be less volatile than longer-duration debt funds.

Risk tolerance: While these funds are relatively less risky than other debt funds, they still carry risks. Credit risk arises if the issuer of a debt instrument defaults, while interest rate risk refers to the impact of changing rates on the fund’s value. However, as they invest in short-term instruments, interest rate risk is limited.

Liquidity needs: Money market funds offer high liquidity, allowing investors to redeem their units quickly. This feature makes them suitable for funds that might be required in the near future.

Expense ratio: Like other mutual funds, money market funds charge an expense ratio, which is the annual management fee. Comparing expense ratios among different funds is important, as a lower fee can contribute to relatively better net returns.

Fund manager’s expertise: The experience and past performance of the fund manager play a key role in the fund’s returns. Reviewing their investment approach and track record can provide insight before making an investment decision.

Credit quality of investments: These funds invest in various debt instruments, making it important to review the credit quality of the underlying investments. Funds with exposure to higher-rated instruments are generally considered less risky.

Interest rate environment: Fluctuations in interest rates can influence money market fund returns. Typically, rising rates can lower the value of existing debt instruments, while falling rates can have the opposite effect. However, since these funds focus on short-duration instruments, they are less impacted by interest rate changes.

Investment objectives: Ensure that investing in a money market fund aligns with your broader investment plans. If your goal is long-term wealth accumulation, you may need to explore options that offer the potential for higher returns, though they also involve higher risk.

When to invest in a money market fund?

The decision to invest in a money market fund depends on your financial objectives, risk tolerance, and time horizon. Here are some scenarios in which a money market fund might be a suitable investment:

• Building an emergency fund is a vital aspect of financial planning. Money market funds offer a comparatively stable and liquid option to park your emergency savings.
• If you have specific short-term financial goals, such as saving for a vacation, a down payment on a house, or purchasing a car, a money market fund can help mitigate impact on your invested capital.
• During periods of economic uncertainty or stock market volatility, investors often seek refuge in money market funds.
• Retirees or investors seeking a relatively stable source of income can allocate a portion of their portfolio to money market funds.

How to invest in a money market fund?

Investing in a money market fund is a straightforward process, and there are several ways to go about it:

Employer-sponsored retirement plans:

Some retirement plans offer money market funds as one of the investment options. You can allocate a portion of your retirement savings to the fund within the plan. Through distributors – You can invest in money market funds with the help of mutual fund distributors. They also evaluate the investor’s risk tolerance levels and financial goals to recommend a suitable investment plan. Brokerage accounts: If you have a brokerage account, you can buy units of money market funds through the platform.

Systematic investment plans:

Some fund providers allow you to set up systematic investment plans, where a fixed amount is deducted from your bank account at regular intervals. Through a fund house: Many mutual fund companies offer money market funds. You can open an account directly with them and invest in the fund of your choice.

FAQs

What are money market funds, and how do they work ?

Money market funds are investment vehicles that primarily invest in short-term, low-risk securities. They aim to provide relative stability and liquidity by investing in instruments like treasury bills and commercial paper.

What are the benefits of investing in money market funds?

Money market funds offer benefits such as relative stability of principal, liquidity, and competitive yields compared to traditional savings accounts. They are suitable for short-term cash management.

What are the risks associated with money market funds?

Risks include interest rate risk, credit risk (the risk of default by issuers), and liquidity risk (when funds face redemption pressures). While they're low-risk/low to moderate risk, returns can vary.

How do money market funds differ from other mutual funds?

Money market funds focus on short-term, low-risk securities, making them relatively less volatile than equity funds. They prioritize relative stability and liquidity over high returns.

Are money market funds suitable for long-term investments?

Money market funds are designed for short-term investments. While they offer relative stability compared to long term debt funds, they may not provide substantial returns over an extended period due to their conservative investment approach. Long-term investors might consider other investment options for potential higher returns.

What are the main characteristics of a money market fund?

Money market funds invest in short-term debt securities like treasury bills and commercial paper etc. They offer low-risk, high liquidity, and are suitable for parking surplus funds

What factors should investors assess before choosing a money market fund?

Investors should consider the credit quality of the underlying securities, liquidity levels, relative stability, and ease of redemption.

How does the fund's maturity and duration impact investment decisions?

Longer maturity or duration in money market funds may lead to slightly better return potential but also may entail higher interest rate risk. Shorter-term funds are more resilient to interest rate fluctuations.

What is the significance of fund management expertise when choosing a scheme?

Experienced fund managers can make informed decisions, which can influence the fund's performance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.