Money Market Mutual Funds: Definition, Benefits and List of Best Funds

Investors with low-risk tolerance seek investment options that offer steady returns and high liquidity. In this regard, money market mutual funds are one of the ideal options. 

These are short-term debt funds that invest in money market instruments which mature within 1 year. Money market instruments are fixed-income securities with very short-term maturities and include commercial papers, treasury bills, certificates of deposits, overnight securities, etc.

Money market mutual funds are relatively safe investment options, offering high liquidity at relatively low risk. Their returns are usually better than that of bank deposits of similar maturity periods.

How Do Money Market Mutual Funds Work?

Money market mutual funds are usually utilised to meet short-term financial needs. These are open-ended debt mutual funds that invest in money market instruments with short-term maturities. 

To understand the meaning of money market mutual funds and how they work, read through the following pointers:

• Where they invest

Such funds invest in various money market securities, such as commercial papers, treasury bills, certificates of deposits and more. Currently, there are no regulations stipulating the credit quality of instruments that a money market fund can hold. However, since these funds entail low risk, they primarily invest in high-quality liquid instruments. Exposure might arise from investments in corporate sector commercial papers or commercial bills. 

• Duration

A debt fund’s duration is linked to the maturity periods of the debt securities in its portfolio. Typically, funds that hold long-term maturity bonds feature a longer duration than funds holding short-term securities. In other terms, duration is the measure of the amount of change in the value of a fund in response to changes in interest rate. 

When it comes to money market funds, they invest in money market securities, which have a maturity of not more than one year. This is why these funds are less volatile and offer steady returns. 

• Returns 

Money market mutual funds generate returns through interest and capital appreciation. You might also gain some potential to have capital gains. Furthermore, such funds can actively manage the fund duration to cope with the moving rates in the market. 

Types of Money Market Instruments

Before you invest in money market funds, it is crucial to understand the different types of instruments this fund trades in. Find details about them below:

• Treasury bills

The Indian Government issues T-bills or treasury bills with maturity periods of up to 365 days to generate money. Since they feature government backing, they are considered a safe investment option. However, the low-risk feature of treasury bills also results in low returns.

• Certificate of Deposit

A certificate of deposit is a type of term deposit offered by scheduled commercial banks and financial institutions through promissory notes. You can invest a certain amount for a pre-decided tenure, while banks and financial institutions pay an interest on the invested amount. 

Commercial paper

Typically, financial institutions and companies issue commercial papers, which are short-term unsecured promissory notes. They can issue CPs at a discounted rate, while the redemption occurs at face value.

Benefits of Investing in Money Market Mutual Funds

Money market funds can be an ideal investment choice, as it offers low chances of loss while providing liquidity. These schemes provide better returns than traditional fixed deposits (FDs) of the same duration.

Here are a few benefits you may derive by investing in money market funds:

• Offers steady returns

One of the significant benefits of money market mutual funds is that they allow steady profits. The returns of money market funds usually remain steady throughout cycles of interest rate easing and tightening. This is because the value of these funds does not change as much in response to changes in market interest rates. 

During lower rates in the market, these funds offset lower interest income by making capital gains. Furthermore, their low credit risk also makes these funds less volatile.

• Minimal to low risk

Money market funds are considered a low-risk investment option, as they hold short-term securities with maturities of up to 1 year. The market value of such funds does not witness significant changes from fluctuations in interest rates. As a result, they provide stable returns.

• Easy to access

These funds allow easy and convenient access to various money market securities. Unlike liquid funds, which invest in securities with maturities of up to 91 days, these funds hold securities for a year. This provides a broader exposure in terms of market maturity to investors. 

As a result, you can earn better returns through these funds. In addition, they also offer high liquidity and come with no lock-in period or exit load.

Risks of Investing in Money Market Mutual Funds

There are two types of risks involved with money market mutual funds. First is the credit risk, which refers to the risk of issuers of debt instruments defaulting on their principal or interest payment obligations. 

Another risk of these debt funds is the risk of reduction of interest payments. As the price of money market instruments is inversely related to interest rates, a rise in interest rates can reduce the returns of these mutual funds. The shorter the maturity period of debt securities, the lower are the corresponding risks.

Who Should Invest in Money Market Mutual Funds?

Money market funds are preferred by individuals with low-risk tolerance and an investment horizon of up to a year. Having said that, these funds are beneficial for:

• Individuals seeking to park their cash surplus

Since these funds offer stable returns, they are ideal for individuals wanting to park their surplus cash for the short term. Their investment remains safe, and they get stable returns.

• Individuals looking for regular short-term income

Money market funds also offer an avenue to earn a regular income with high liquidity and stability. Investors with a low-risk tolerance can put their money in such a scheme and create an SWP to generate regular income flow.

Things to Consider before Investing in Money Market Mutual Funds

Money market funds are a steady return investment option. They also tend to have a low credit risk. However, before you decide to invest in such funds, consider a thorough evaluation through the following factors:

• Past performance

Before making an investment decision, consider evaluating a fund by looking at its past returns. A well-performing scheme will outperform its peers and provide steady returns during adverse market conditions. However, past performance of a fund does not guarantee future returns. 

• Investment objective

Consider devising a clear and effective investment strategy before you choose a money market fund to invest in. Know your investment horizon and risk appetite beforehand and make an informed decision. Remember to seek to diversify your portfolio.

• Expense ratio

The expense ratio is a small percentage of the total assets of a fund that the fund house levies as fees for its services. They play a crucial role in making or breaking your returns. Since money market funds tend to generate steady returns, you should look for a scheme that comes with a low expense ratio.

Taxation of Money Market Funds

Money earned through dividends and capital gains from money market funds are subject to taxes. You need to pay tax on dividends per your applicable tax slab rates. For capital gains, you need to follow the mentioned taxation rules:

• Short term capital gains (STCG)

You earn short-term capital gains if you hold your investment for less than 3 years. In such a situation, you will pay tax as per the applicable income tax slab rate.

• Long term capital gains (LTCG)

If you hold your investment for 3 years or more, whatever returns you earn become long-term capital gains. For such gains, you will have to pay tax at a rate of 20% with the benefit of indexation.

List of 10 Best Money Market Funds Based on Returns

Here is a list of the best money market mutual funds that you can consider investing in:

Final Word

Money market mutual funds are a suitable investment option for individuals wanting to park money for up to a year. These funds help you earn steady returns similar to that of a bank deposit, except it does not come with a lock-in period. Moreover, these funds invest in low-risk fixed-income instruments with high liquidity, so you don’t have to worry about substantial losses.

FAQs about money market funds