One of the many options for mutual fund investors is the debt fund. A debt fund invests in fixed income instruments like government securities, commercial paper and debentures. These are meant for investors who do not want to take risks with their investments and expect steady and reliable returns. These funds are generally held for longer periods, say a year or more.
So what if you have come into a sudden windfall and want to park your funds for a short while until you find a profitable investment option? For example, if you are pondering over what equities to buy or waiting for your real estate broker to come up with a great property deal. In that case, the best place to park your money would be money market funds. They don’t carry much risk and offer much better returns than, say, bank savings deposits. You can invest in money market mutual funds for weeks, months or even a year.
HOW DO MONEY MARKET FUNDS WORK?
So what then is a money market fund? Money market mutual funds are a type of debt fund that invest in highly liquid instruments that have short-term of maturities of under a year.
Before we get into more details about money market mutual funds, we must understand the concept of a liquid asset. A liquid asset is one that has many potential buyers and sellers so that it can be bought and sold quickly at full market price. Liquid assets include government securities and money market instruments. Money market funds are liquid funds, those that can be bought and redeemed quickly.
Money market mutual funds are tailor-made for investors with a short-term perspective. They invest in fixed income instruments with short residual maturities of under a year, like treasury bills, certificates of deposit and commercial paper. According to guidelines by the Securities & Exchange Board of India (SEBI), money market funds have to invest in instruments with maturity periods of up to a year.
The focus of these money market funds is basically capital protection, rather than ensuring high returns. So fund managers of money market mutual funds tend to err on the side of caution and invest only in those instruments that have a high credit rating. Mutual fund companies try to keep costs to a minimum so that investors don’t have to pay high expense ratios and reduce their returns. Here are some of the instruments money market mutual funds invest in:
Treasury bills: Treasury bills or T-bills are short-term instruments used by the government to raise funds from the financial markets. T-bills can have maturity periods of 91 days, 182 days or 364 days. Generally, money market mutual funds invest in T-bills of a year or less. T-bills are zero-coupon bills, which means they carry no interest, and are issued at a discount. They are then redeemed at face value on maturity. For example, a 365-day bill may be issued at Rs 92 and redeemed at Rs 100.
Certificates of deposit: A certificate of deposit is a money market instrument issued by specified banks and financial institutions to individuals, companies and other entities. It is basically like a fixed deposit with a bank you deposit the amount, and the bank issues you a certificate of deposit. Generally, this is done in dematerialised form. Certificates of deposit have fixed maturities, ranging from a few months to several years.
Commercial paper: Commercial paper is an unsecured money market instrument issued in the form of a promissory note. It is a short-term paper and can be issued by companies, primary dealers and financial institutions. Maturity periods range from seven days to a year. They are actively traded in the over the counter (OTC) market.
Transactions in the money market are usually done in bulk by institutional buyers and sellers. So retail investors cannot take advantage of money market instruments. The only way retail investors can invest in them is through money market mutual funds.
There are many types of money market funds available for investors, according to risk appetite, time period and the need for liquidity. A liquid fund for instance offers a very high level of liquidity, and these types of money market funds can be redeemed in as little time as a day. Then there are short term and ultra short term funds that also offer a high level of liquidity and park their funds in instruments of a slightly higher maturity.
Like all other debt funds, money market funds too are vulnerable to interest rate risk. When interest rates go up, yields on fixed income instruments go down and your net asset value (NAV) will fall. When interest rates fall, yields will go up, as will your NAV.
Since money market mutual funds invest in fixed income instruments of various entities, there is also the risk of default. If any one company defaults, it will drag the NAV down. But you should remember that the risk is very low since fund managers invest only in paper with high credit rating. Anyway, much of it is government debt, so there is almost no chance of default.
Money market mutual funds are open ended, which means that investors can buy them whenever they choose, and redeem them at any point. There are also growth and dividend options. So if you need cash while you wait, you can choose the dividend option.
You can park your surplus cash in money market funds and use systematic transfer plan (STP) to transfer money in a systematic way to another debt fund or even an equity fund so that you can maximise returns. The funds can be transferred on a daily, weekly, monthly or quarterly basis. You can do the transfer from one fund to another, either of the same asset management company or a different one.
Generally money market funds follow the low risk, low return principle. While these types of funds are good for parking short-term cash, they may not be suitable to meet long term needs like retirement, funding children’s higher education or building a house. They’re more of an alternative to savings accounts parked in banks. For example if you are in your 30s and want to build up a retirement nest egg, investing in a money market mutual fund may not be the way to go! Inflation will eat into any returns you might make from a money market fund, and the expense ratio will whittle away the rest, leaving you with nothing.
WHAT ARE THE ADVANTAGES OF MONEY MARKET FUNDS?
High liquidity: The most obvious benefit of investing in money market mutual funds is, well, the liquidity. These funds are open ended, have no exit loads and can be redeemed quickly. Some even liquid funds offer instant redemption, so the cash could be in your bank account in a matter of minutes! So it’s ideal for parking emergency or contingency funds in your possession.
Good returns: Money market funds offer better returns than bank savings deposits, so your idle cash will earn more money.
Low risk: The fund manager’s focus is on capital protection, so the money market fund will invest only in those instruments that have a good credit rating. So the risks are low. In any case, most of the fund’s investments will be in government paper, which carry minimal risk.
Flexible: Money market mutual funds are very flexible and offer growth and dividend plans. You can get dividends on a daily, weekly or monthly basis.
Protection against inflation: If you want protection against inflation, money market funds are your best bet since the Reserve Bank of India raises interest rates during inflationary times, and you will benefit from that, especially if you invest in a liquid fund.
Low fees: The costs of money market funds are generally low. Mutual funds keep expense ratio and entry and exit loads low to attract investors.