Debt funds like liquid funds, overnight funds, ultra short term funds, and money market funds may seem to invest in the same type of debt instruments.
However, the similarities end when you actually put each fund under the microscope and understand the subtle differences between the debt instruments that a liquid fund invests in and the money market that money market funds invest in.
In this blog, we will help you understand the money market and how money market funds work to generate returns from these money market instruments.
What Is The Money Market?
A money market is an umbrella term used for the exchange of short term debt instruments between financial institutions and banks. The duration of lending in the money market ranges from 1 to 270 days.
The securities exchanged in the money market are typically very short term instruments like Commercial Paper, Certificate of Deposit, Treasury Bills, etc.
Broadly speaking, there are two ways to invest in the money market:
- Buying CP, CD, Treasury Bills, etc. on your own
- Invest in Money Market funds
What Are Money Market Funds?
A money market fund is a debt fund that invests in money market instruments like CD, CPs, repo agreements, etc. It is a fixed income debt instrument with short maturity, high liquidity, and above-average safety.
Money market funds are considered to be safe because they invest in high rated money market instruments, cash and cash equivalents that typically mature in one year.
Investing in a money market fund is convenient because a fund manager handles the buying and selling of money market instruments to generate returns for the investor.
Moreover, a money market fund has a portfolio of money market instruments and may or may not be limited to just one type of money market instrument.
Types of Money Market Instruments In India
1. Treasury Bills (Zero-Coupon Bonds)
Treasury Bills are short term bonds issued by the Reserve Bank of India on behalf of the Central (Union) government. The maturity period of Treasury Bills is generally one year.
2. Certificate of Deposit (CD)
Certificates of Deposit are issued by banks to individuals or companies. CDs are issued in exchange for capital that is locked-in for a short duration of time, typically six months to one year. CDs pay fixed interest and are almost always unsecured loans.
3. Commercial Paper (CP)
Commercial Papers are very short term debt instruments generally issued by large institutions. CPs are promissory notes that mature as quick as 7 days or 1 year. CPs fall under the umbrella of unsecured debt.
4. Repo Agreements (Repurchase Agreements)
A repurchase agreement or repo agreement is a short term debt instrument where someone sells government securities and buys it back in the future for a higher price.
The higher price is usually due to the interest charged by the buyer that’s known as the repo rate. The average duration of repo agreements can range from one day to one year.
5. Commercial Bills
Commercial bills are short term debt certificates issued by corporations in exchange for capital. They are highly liquid and pay a nominal interest based on the debt duration that ranges from 7 days to one year.
How Do Money Market Funds Work?
Money market funds have an average portfolio maturity of 1 year. That’s why they are considered to be safer than other mutual funds like equity funds and even Gilt funds.
The fund manager builds a portfolio of prime money market instruments that pay an interest rate which becomes the gains that a money market fund investor will receive.
The overall aim of a money market fund is to conserve capital and generate predictably stable returns. It would be easy to be fooled by this conservative approach and assume that the returns might be meagre.
On the contrary, money market funds have been known to generate better returns than bank fixed deposits with better liquidity. Historical data indicates that money market funds may generate 4-7% returns over 3+ years and 5-7% over 5+ years.
Who Should Invest In A Money Market Fund?
Before we understand who should invest in a money market fund, let’s look at 3 important features of the fund that might help get a clear picture of the investor profile:
- Average portfolio maturity: 1 year
- Liquidity: High
- Risk: Low
From the three features above, logic would suggest that money market funds may be suitable for conservative investors or investors with a low to moderate risk profile.
But aggressive investors who happen to park their cash in a bank a/c can also benefit from money market funds. Thus, you can Consult A Cube Wealth Coach to know if you should invest in money market funds.
Factors To Consider Before Investing In Money Market Funds In India
1. Interest Rate Risk
Money market funds by virtue of being debt funds are considered to be safer than many other mutual funds but are still prone to interest rate fluctuations based on RBI’s interest rate adjustments.
2. Expense Ratio
You’ll have to pay an expense ratio when you withdraw any mutual fund investment. It’s a fee you pay for the fund manager’s involvement in the day to day running of the mutual fund.
Money market funds generate stable returns of around 5-7% over 5+ years and a high expense ratio can eat into your profits. Thus, you must evaluate the expense ratio to understand if the fund is suitable for you.
3. Investment Goals
Money market funds are generally preferred for the short term (6 months to 1 year) due to their short portfolio maturity. But money market funds have the potential to generate stable long term returns as well.
Thus, you must consult a wealth coach to understand how a money market fund might fit into your short term or long term debt fund portfolio.
Taxation Of Money Market Funds
Since money market funds fall under debt funds, the taxation rules are as follows:
How To Invest In The Best Money Market Funds?
The Cube Wealth app is the smartest way to invest in the best money market funds. Cube helps you gain access to curated money market funds based on your investment goals and risk profile.
All mutual funds on the Cube Wealth app are handpicked by Wealth First, Cube’s mutual fund advisory partner who has a track record of beating the market by ~50%.
Download the Cube Wealth app to invest in the best money market funds today.
List Of Best Money Market Funds Currently Being Recommended On Cube Wealth
1. Axis Money Market Fund
- 1-year returns: 5.92%
- 3-year returns: NA
- 5-year returns: NA
2. HDFC Money Market Fund
- 1-year returns: 6.27%
- 3-year returns: 7.31%
- 5-year returns: 7.16%
*Note: Facts & figures are as of 04-02-2021. The above-mentioned data comprise of publicly available information from Google. Download the Cube Wealth app for the latest information.