Money Market Funds

Table of Content

1. How do Money Market Funds Work?

2. Key Characteristics of Money Market Funds

3. Types of Money Market Instruments

4. Advantages of Money Market Funds

5. Disadvantages of Money Market Funds

6. Who Should Invest in Money Market Funds?

7. How to Invest in a Money Market Fund?

8. Taxation Rules of Money Market Mutual Funds

9. Conclusion

10. Frequently Asked Questions

Considering safer security options, a question may arise about which underlying assets make a money market mutual fund safer? Here, you must note that instead of investing in company stocks like an equity fund, it allocates your money across the Treasury bills, commercial paper, certificates of deposit, and repurchase agreements. 

Government organisations, reputable banks, corporations, etc., usually issue these instruments, which are typically of high quality and carry lower default risk. Note: This article is for general educational purposes only. HDFC Life does not sell, distribute, recommend, or promote mutual funds. Mutual funds and life insurance products are different financial products with different objectives, risks, charges, liquidity features, and regulatory frameworks.They generally offer higher returns than traditional savings options.

Money market funds should not be confused with life insurance products. Life insurance is primarily designed to provide financial protection to the policyholder’s family. Certain life insurance products, such as Unit Linked Insurance Plans, may offer market-linked fund options along with life cover, but they differ from mutual funds in terms of product structure, charges, lock-in period, liquidity, risks, and insurance benefits.

How do Money Market Funds Work?

Money market mutual funds invest in short-term debt and money market instruments with maturities generally of up to one year. These instruments may generate income through interest or price movements, which can reflect in the fund’s Net Asset Value, depending on the scheme structure and market conditions.

Since these securities are typically unsecured by nature and usually do not have collateral as backup, the respective fund managers actively select securities with a higher credit rating. A higher rating is typically an assurance that the chances of defaults from their issuers are lower.

The fund managers invest in high-quality underlying securities with varying maturities and continuously replace maturing instruments with new short-term holdings. Although these are safer investment instruments, the underlyings of such funds are sensitive to interest rates, inflation, and overall economic conditions, which can affect their yields.

Key Characteristics of Money Market Funds

Its characteristics explain how money market funds maintain liquidity, stability, accessibility, etc. These also showcase why these funds suit short-term investment needs for investors:

1. Low Risk & Capital Preservation

Money market funds invest in instruments such as Treasury Bills, commercial papers, certificates of deposit, and repos. These instruments are generally considered lower risk than equity instruments because of their shorter maturity and debt-oriented nature. However, money market funds are not completely risk-free and may still be affected by credit risk, interest rate changes, liquidity risk, and market conditions.

2. High Liquidity

Such funds invest in high-quality securities as their underlying assets, which have shorter maturities. For example, suppose you are investing in such a scheme which is highly liquid and has no lock-in period. Here, the respective fund may invest in money market instruments whose maturity does not exceed 91 days.

3. Modest Returns

Money market funds may generate returns that differ from traditional savings products such as fixed deposits, depending on market conditions, scheme portfolio, expenses, and interest rate movements.However, since their underlyings are not as risky as stocks, they may generate lower returns than investing in equity mutual funds or company stocks. Such funds aim to strike a balance between risk and reward for risk-averse investors.

Types of Money Market Instruments

Different money market instruments serve different short-term investment requirements. Their structure, type of issuers, maturity period and other factors influence liquidity, returns, and portfolio stability:

1. Treasury Bills or T-Bills

The Indian government issues treasury banknotes at a discount, which are traded in the primary and secondary markets. Since T-bills carry a sovereign guarantee, the associated risks are negligible. Money market funds include Treasury Bills as one of the low-risk assets to support liquidity, stability, and short-term return generation.

2. Certificate of Deposit or CD

Commercial banks issue certificates of deposit at a discounted rate. As a short-term instrument, their tenure typically may be as low as 7 days. As CDs typically do not carry market risk like stocks, they serve as an underlying asset in money market funds, potentially ensuring lower risk. While their interest rates may be more than those of a Fixed Deposit.

3. Repurchase Agreements of Repos

These are temporary financial instruments in which one financial institution (party) sells a security to another. Here, the agreement is to repurchase those securities on a specified date in the future. This is a common agreement between a financial institution, such as a bank, and the RBI or the interbank. A money market fund uses this as its underlying asset.

4. Commercial Paper or CP

Typically, a strong, well-established corporation issues commercial paper, which a money market fund invests in. Generally, such an underlying instrument yields a bit more than government-backed securities. Money market funds invest in CPs at discounted prices and earn returns when corporations repay the full face value at maturity.

Advantages of Money Market Funds

Money market funds are often discussed in relation to the following features. These should be understood along with the associated risks, costs, taxation, and scheme-specific terms:

High Liquidity

To ensure liquidity, these funds typically have a zero lock-in period. This allows you to redeem or sell your fund units at any time, typically within a T+1 settlement cycle. As an investor, you may use it to fulfil your short-term investment plans or set it up as a potential emergency fund.

Low Risk Exposure

Because money market funds invest in short-term debt and money market instruments, they are generally associated with lower volatility than equity-oriented funds. However, the risk level depends on the quality of the underlying instruments, issuer creditworthiness, liquidity, and interest rate environment.

Stable, Short-Term Returns

Money market funds may generate short-term returns based on the interest income and price movement of the underlying instruments. Their return profile is typically different from equity-oriented funds and may vary depending on interest rates, expenses, credit events, and market conditions.

Easy Accessibility and Low Minimum Investment

Money market funds may be accessible through mutual fund platforms or fund houses, depending on the scheme terms. Minimum investment amounts, SIP availability, expense ratios, and other conditions vary across schemes. HDFC Life does not offer or distribute money market mutual funds.

Disadvantages of Money Market Funds

Since money market funds are market-linked mutual fund products, it is important to understand their risks and limitations from an educational perspective:

Lower Returns Compared to Other Investments

If you compare the potential returns of this fund type with those of an equity fund, the former typically generates a moderate or even slightly lower return. Also, as their focus is on providing a comparatively secure investment option, they are typically not suitable for long-term capital growth.

Not Completely Risk-Free

While this mutual fund investment option is safer than other market-linked funds, they carry some risks. One of them is interest rate risk, in which a rise in interest rates reduces the yields of older, lower-yielding securities. As interest rates decline, returns on newly issued securities may decline. Other risks include credit, reinvestment, liquidity, etc.

Inflation Risk

An increasing inflation is one of the key risks in money market funds. This is because inflation may erode the real value of investments in MMFs. Furthermore, as such funds invest your money in instruments with potential fixed returns, their returns may not keep pace with rising inflation.

Potential Exit Loads or Management Fees

Such mutual funds may include a management fee, which is an ongoing expense covering the management expenses to maintain the fund. The fund house of a money market fund deducts this nominal charge from its daily Net Asset Value (NAV). Some fund houses may also impose a nominal exit load, which adds to the investment expenses.

Who Should Invest in Money Market Funds?

Money market funds are generally evaluated by individuals who want to understand short-term debt-oriented mutual fund options. The following profiles are commonly discussed in relation to such funds, but this should not be treated as a recommendation or investment advice:

• Investors With Short-Term Horizon: Individuals Studying Short-Term Debt Options: Money market funds are commonly discussed in the context of shorter investment horizons because their underlying instruments generally have short maturities.
• Conservative Investors: Individuals Comparing Lower-Volatility Mutual Fund Categories: Money market funds are often compared with other debt mutual fund categories because they generally focus on shorter-duration instruments.
• New Investors: Readers Learning About Mutual Fund Categories: New investors or first-time readers may study money market funds to understand how short-term debt mutual fund categories differ from equity-oriented funds and from life insurance products.

Points to Review Before Evaluating Money Market Funds

Before evaluating any money market fund, readers generally review factors such as the scheme objective, underlying instruments, portfolio maturity, credit quality, expense ratio, exit load, liquidity, taxation, and associated risks. These details are usually available in the scheme-related documents issued by the mutual fund house.

Since money market funds are mutual fund products, individuals should refer to official scheme documents and consult a qualified financial advisor before making any investment decision. HDFC Life does not sell, distribute, recommend, or promote mutual funds.

For individuals seeking financial protection along with long-term savings, life insurance solutions such as Unit Linked Insurance Plans may be evaluated separately. ULIPs are insurance products and differ from mutual funds in terms of life cover, policy charges, lock-in period, fund choices, liquidity, and applicable risks.

How to Invest in a Money Market Fund?

Money market mutual funds are commonly discussed in relation to liquidity management, short-term debt exposure, and temporary cash allocation. The following use cases are for educational understanding only and should not be treated as a recommendation to invest in money market funds:

1. Commonly Discussed User Profiles

Money market funds are commonly discussed for individuals evaluating short-duration debt mutual fund categories. However, they are not risk-free and their suitability depends on individual goals, risk appetite, liquidity needs, taxation, and scheme-specific terms.

2. Suitable Investment Horizon

Aside from avoiding market risks, if you have a short-term investment goal with a potential stable return and easy liquidity, such funds may be ideal. These funds are generally discussed in relation to shorter investment horizons, often up to one year, depending on the scheme’s objective and portfolio maturity.

3. Use Cases for Temporary Cash Parking

Money market funds are often discussed as a category used for temporary cash allocation because of their short-duration portfolio and liquidity features. However, redemption timelines, risks, expenses, and returns vary depending on the scheme and market conditions.

4. Complementing Other Investment Options Expectations

Such funds may complement long-term portfolios with their high liquidity and stability. As you park your surplus cash here, you can use it as a buffer against equity volatility and seize emerging-market opportunities. This strategic liquidity management ensures that your capital is instantly accessible without disrupting your core and higher-yield investments.

Taxation Rules of Money Market Mutual Funds

As you have understood the specifics of this fund, you must be aware of its taxation norms to be compliant:

1. Short Term Capital Gain

If you sell units of money market funds that you have bought after April 1, 2023, your gains fall under an STCG bracket. Here, you must pay this tax based on your applicable tax slab rate.

2. Long Term Capital Gain

Earlier, an LTCG of 20% with indexation benefits applied if you held units for more than 3 years, sold them, and made gains. Since April 1, 2023, gains from selling units of these funds are taxed at your applicable Income Tax slab rate. Hence, after the aforementioned timeline, gains from such funds are taxed at your slab rate, irrespective of your holding period.

3. Dividend Income

The dividends that you may receive by investing in such funds are also taxable. While filing your ITR, you must mention it under ‘Income from Other Sources’. The taxation here is also as per your income tax slab rate.

Conclusion

Money market funds are mutual fund schemes that invest your funds in safer instruments to provide a potentially stable return. Aimed at the needs of risk-averse investors and those with a shorter investment horizon, such funds invest in Treasury Bills, Certificates of Deposit, repurchase agreements (repos), and commercial paper.  

While money market funds focus on liquidity and capital preservation, life insurance solutions such as Unit Linked Insurance Plans (ULIPs) offer a more comprehensive approach by combining market-linked returns with life cover. Within ULIPs, investors can even choose low-risk debt or money market funds, allowing them to benefit from stability, along with long-term wealth creation and financial protection for their family.

Frequently Asked Questions

1. What are money market funds in India?

Such funds are sort of mutual funds that invest in low-risk debt instruments such as T-bills, commercial paper, and certificates of deposit. These are mainly short-term instruments with a maturity period of 1 year or less.

2. Are money market funds a good investment?

It depends on your risk appetite, your investment objectives and other factors. For example, if you want to avoid higher market risks, such as in stocks, and want an investment option with stability, it might suit you. Compared to traditional savings accounts, it can often generate better returns.

3. How safe is my money in a money market fund?

Such funds invest in high-quality debt instruments that are government-backed or have higher credit ratings. These make this type of fund potentially safe. However, these are not entirely risk-free, as risks related to inflation, liquidity, interest rates, etc., remain. These may diminish the potential values of the underlyings of such funds.

4. What are the benefits of using a money market fund?

The Key benefits typically involve higher liquidity, and the risk exposure is typically low. Furthermore, it helps you with capital preservation in the short term. You can also further diversify your portfolio by investing in this fund.

5. Which is the best money market fund?

You may identify money market funds with potential for higher returns by comparing certain factors. Before investing, compare the historical annualised returns of available funds in the market, assess the credit rating of their underlying securities, expense ratio, exit load, etc.