In April 2023, the debt mutual fund industry in India witnessed a dramatic turnaround as it garnered ₹ 1.06 lakh crore during the financial year 2023. Liquid mutual funds, a category of debt funds, accounted for a majority of this influx. Another popular category of debt mutual funds are money-market funds that invest in money-market instruments that have a year-long maturity. Money-market mutual funds are suited for investors who wish to invest in debt securities for the short term.
What do money-market funds invest in, and how do they function?
Money-market funds invest their capital in “money-market instruments” and aim to earn moderate-to-high returns in a short term by minimising NAV (net asset value) fluctuations. A money-market instrument is a mutual fund investment instrument that trades on stock exchanges and can have a maturity period ranging from overnight to a year. Here are the four key types of money-market instruments in which money-market funds invest:
- Money-market mutual funds invest in T-Bills: Treasury Bills raised by the Government of India have a maturity of up to a year. These are safe investments that are less risky and that generally offer low-to-moderate returns.
- They invest in Certificates of Deposit: Scheduled commercial banks in India offer Certificates of Deposit which offer customers the choice of premature redemption. The minimum investment amount in a Certificate of Deposit (CD) is ₹1 lakh. CDs have a short tenure.
- Money-market funds invest in repurchase agreements: Scheduled banks in India can obtain loans from the Reserve Bank of India (RBI) by selling their securities to the central bank at a set price. This agreement is called a repurchase agreement.
- Commercial Papers also qualify as money-market instruments: Companies with high credit ratings issue Commercial Papers (CPs) to raise money for a time period of up to a year. CPs raise money in the form of promissory notes and help investors diversify their short-term borrowings.
Money-market funds invest their capital in money-market instruments like the ones enlisted in this section. These funds pose a lesser risk to investors and have an investment horizon of up to a year.
Points that investors must consider before investing:
First-time investors must consider three features of money-market funds before investing in them:
- Investors should choose a money-market fund with a lower expense ratio
The expense ratio of a mutual fund scheme is the amount that the mutual fund house charges from the investor for managing their investment. Investors must choose money-market funds with low expense ratios to grow their wealth by maximising their returns.
- They must know how their money-market fund investment will be taxed
Investors will incur short-term capital gains tax if they remain invested in a money-market fund for less than three years. If they remain invested in the investment for more than three years, long-term capital gains tax will be levied on their investment.
- Investors must be aware of interest-rate risk and credit risk
Debt mutual funds carry two significant risks for the investor – the interest-rate risk and the credit risk. The interest-rate risk is due to the negative correlation between the interest rate and the bond price in the market and the credit risk is the risk associated with the credit repayment capability of the investor.
If you are an investor who wishes to invest their short-term savings in a low-risk investment instrument, you must consider investing in a money-market mutual fund scheme.