Last Updated on May 25, 2022 by Neera Bhardwaj

Einstein said, “Compound interest is the eighth wonder of the world,” but to be able to relish its benefits you have to start investing. Investment can seem like a daunting business, especially if you’re just starting out. So if you are looking for short-term investments with a lower risk factor consider money market instruments or money market funds.

What are money market funds?

Money market funds (MMF) are short term debt funds that generate good returns and offer high liquidity. Also known as money market mutual funds, money market funds include instruments such as high-quality government securities, commercial papers, treasury bills, and repurchase agreements. These underlying instruments have an average maturity tenure of up to one year.

How do money market funds work?

Money market funds are fitting for those with a low-risk appetite and short-term investment goals. Intending to ensure capital security instead of high returns, these open-ended funds operate on liquid investments which can be easily converted into cash while retaining their value.

As per SEBI guidelines, money market funds in India only operate in cash or their equivalents, which have a maturity period of up to one year. Veering away from other mutual funds that invest in stocks and bonds that are always in flux, money market funds maintain a stable price and pay interest at a rate higher than similar savings vehicles. 

If you are an investor with a low-risk appetite and short-term investment goals, then money market funds are the right fit. Click To Tweet

The following are the instruments that make up the composition of money market funds.

Treasury bills

Treasury Bills or T-bills are short-term money market instruments issued by the Government of India to raise funds from the financial markets. With a maturity period of up to 364 days, these bills are available at zero-coupon rates. Investing in T-bills ensure maximum security as they are backed by the government.

Certificate of deposit

A CD or a certificate of deposit is offered by a commercial bank and other financial institutions wherein you can park a fixed amount of money for a fixed period of time, say about a year or even five. It is on this investment that the bank will pay you interest. Upon maturity, the redemption is done at the face value plus the interest received. Although considered to be a safe option, the CD is also subject to inflation. So in such volatile times, you’re likely to have lower returns.

Commercial paper

Commercial papers are short-term debt instruments, typically 1-270 days, issued by companies and banks to meet their inventories or accounts payable requirements. Usually issued at discounted rates and redeemed at full value, it is the difference that is earned by the investor.

CPs are unsecured, that is to say, if a company fails to pay at maturity, the investor has no claims over its assets. So it is only companies with good credits that can sell commercial papers.

Though the risk factor of money market funds is lean, like any other debt fund these funds are susceptible to the changing market trends. So with higher interest, the NAV (net asset value) goes down and similarly when the interest rates fall the NAV goes up.

Who can invest in money market funds?

Investors with short term investment goals or low-risk appetites can consider investing in money market funds. They are a great way for retail investors to reap the benefits of the money market. The liquidity of the money market fund allows you instant access to your fund which can be liquidated to meet requirements or further to move in and out of investments like stocks or bonds.

However, if you have long term investment goals, you might want to second guess investing in money market funds and look out for dynamic options that yield higher returns.

Features of money market funds

High liquidity

One of the key features of these funds is liquidity. That is, these funds are open-ended and can be redeemed at any point during the tenure. This makes money market funds ideal for parking any emergency or contingency fund.

Higher returns

It is needless to say that money market mutual funds yield higher returns than those of a traditional savings account. The interest payment on these funds is slightly higher than that of checking or a savings account. So parking your idle money in a money market mutual fund is perhaps a better bet.

Low fees

As an investor, you are not bound with any exit loads. The fees levied on entry or exit from these funds is relatively low.

Safety

The primary aim of a money market fund is capital protection. So to maintain the same, the fund manager only invests in instruments with a good credit score which carries minimal risk.

Limitations and risks involved

All investments come with some risk. Unlike a savings account, investing in a money market fund cannot be without risk. The volatile nature of the money market and fluctuating interest rates can directly affect your NAV. As established earlier, a high-interest rate may decrease the prices of the asset, resulting in a subsequent fall in the NAV.

So it becomes imperative to understand your investment goals and thoroughly examine the risks involved before investing in money market funds.

A few things you might want to consider before investing are as follows.

Inflation risk

Since money market funds reap low to medium returns on capital invested and investors are taxed on those returns too, the net returns from such funds may not be able to meet inflation risk, thereby leading to loss of value in capital invested.

Interest risk

While investing in MMFs, it’s imperative to take into consideration the plausible risks, out of which the risk of fluctuating interest rates and its subsequent impact on your returns is the highest.

Low returns

If you are planning to invest with long term goals in mind like retirement planning then investing in money market funds might not be the best option as it comes with low risk and low returns, providing lesser capital appreciation.

Money market mutual funds are tools to manage your cash efficiently; and not multiply your wealth. Click To Tweet

Unlike stocks and bonds, money market mutual funds are not tools to multiply your wealth but tools to manage your cash efficiently. So if you are looking to build an emergency fund or meet a short-term goal, putting your money in MMF is a viable option without exposing it to too much risk. Being highly liquid investments, these funds give you the liberty of moving in and out without any burden of entry or exit costs. Although with money market funds it is very unlikely that you lose money, it is needless to say that no investment opportunity comes with a 0% risk factor. So make sure you do your research before investing your money.