How Do Money Market Funds Work?

Investors, especially those who have a low-risk appetite, are always looking for investment opportunities where they can earn good returns at a lower risk. One such investment instrument is money market funds.

In this article, we will understand what money market funds are, how they work and who should invest in these funds.

Money market funds are short-term debt mutual funds. These mutual funds invest in different money market instruments to offer good and stable returns in the short term. These money market instruments are highly liquid debt instruments from issuers with strong credit ratings. Money market mutual funds usually come with a maturity of up to 1 year.

Money market funds invest in cash and cash-equivalent instruments that are traded in the market and have a short-term tenure. These instruments may have a maturity period ranging from 1 day to 1 year. In India, money market funds mainly invest in the following instruments:

• Treasury Bills or T-Bills Treasury bills are short-term debt instruments issued by the Government of India. These bills have a maturity period of 1 year and are considered to be a very safe investment as they are backed by the government. However, you must note that with low risk comes lower returns, which is also the case with treasury bills.

• Certificate of Deposit or CD A certificate of deposit is an investment instrument offered by scheduled commercial banks. These term deposits come with a fixed tenure during which the depositor cannot withdraw the invested amount and the interest earned, until maturity. However, unlike fixed deposits (FDs), certificates of deposit are freely negotiable.

• Commercial Paper Financial institutions and organisations with a high credit rating issue unsecured promissory notes. These short-term promissory notes are issued at a discounted price and are later redeemed from the investor at face value. Commercial papers offer high returns are generally have a maturity of up to 270 days.

As mentioned above, money market funds invest in short-term money market instruments like treasury bills, commercial papers and certificates of deposit. The investment objective of money market funds is to earn good returns from the interest income from instruments and minimise the net asset value (NAV) fluctuations.

Also Read: How Do Debt Mutual Funds Work? Understanding Debt Mutual Funds In Detail

Since money market funds invest in short-term low-risk debt instruments, these funds are ideals for investors who have a lower risk appetite and a short investment horizon of up to 1 year. Ideally, investors who have idle cash in their savings account can invest in money market funds to earn better returns.

However, for investors who have a medium to long-term investment horizon, money market funds may not be the most ideal investment option. Instead, they can opt for balanced mutual funds that have a capability to offer better returns.

Money market mutual funds are great investment options to earn stable returns at a very low risk. However, the net asset value of these mutual funds will fluctuate based on the adjustment to interest rates. Moreover, fund houses may charge an exit load on pre-mature withdrawal of funds from the scheme. Hence, investors must keep these factors in mind while allocating a part of their investible capital to money market mutual funds and invest as per their investment plan and financial goals.

Also Read: 10 Popular Short-Term Mutual Funds In 2022