Money Market Mutual Funds (MMMF) Explained: Savings bank accounts offer returns that are too low along with low risk. Stock markets, on the other hand, provide a risk too high for some investors. Have you ever looked for investment opportunities where returns are offered higher than that of banks along with great good security in order to invest some additional cash you may have lying around in your savings account?
Today we discuss one such investment opportunity known as Money market mutual funds (MMMF) that provide the best of both worlds.
What is an MMMF?
Money market mutual funds (MMMF) invest in short-term debt instruments, cash equivalents that are of high quality in order to generate good returns up to a period of one year while maintaining high liquidity. These investments have a good degree of security to offer as the financial instruments invested in are a high quality-low risk hence offering predictable returns.
These funds when first introduced in 1971 were known a reserve funds. This was because they were created for people who believed in the preservation of cash even though it meant earning lesser than those offered by the market. Over time these funds gained popularity as a secure instrument that offered better interest than banks.
The main aim of these funds is to generate higher returns than that offered by savings bank accounts as this is the main reason people invest in MMMF’s. The investments here can even be made for only one day and also longer periods.
How do MMMFs work?
Generally, fund types are named with reference to the type of investments they make. MMMF’s invest in various Money Market securities. This is done with the objective of maintaining high returns and liquidity. These securities generally have a maturity period of one year and are highly liquid. These money market securities, unfortunately, do not come with a collateral baking up the security making it important that instruments with high credit ratings are selected in order to ensure that there is no default.
Examples of securities that the MMMF invests in:
A Treasury Bill is an instrument used by the government in order to raise money in the short term. These T-Bills are issued by The Government on India for their short term financing needs of up to 365 days.
As these are issued by the government they are considered to be one of the safest instruments. Due to the government backing the rate of return from these securities is known as a risk-free return. But this added security also makes the returns from these T-bills low compared to other investment opportunities.
Certificate of Deposit
The certificate of the deposit is a term deposit offered banks where the period of the deposit is predetermined and the investor is not allowed to redeem his money before the period is completed. In exchange for this, interest is paid to the investor.
Companies and financial institutions that have high credit ratings are allowed to issue commercial paper an unsecured promissory note which allows them to borrow money for the short term. Commercial papers are generally issued at a discount rate and later redeemed at face value allowing investors to earn a profit. Say for example that a Commercial paper is of Rs.10 Face value then the CP is issued at Rs.9. On maturity, the CP is redeemed at face value enabling returns.
Role Played by Money Market Instruments
The instruments mentioned above play an important role in providing finance to various institutions. Many industries use financing from the money market in order to raise funds for their short term needs. These are generally for their day-to-day needs operations and meeting working capital requirements. Banks too are able to ensure financial sufficiency in order to meet uncertain demands that may occur in the bank like huge withdrawal of the consumer deposits.
As these functions are performed on one end money markets also allow investors to earn returns higher than those of saving accounts in banks while maintaining added security in comparison to stocks. The best MMMF funds offer interest rates of up to 8.50% which is double the interest offered by most of the saving accounts.
MMMFs and their NAV
The NAV ( Net Asset Value) is the value at which you enter or exit a fund. It represents the market value per unit of a particular mutual fund. Along with maintaining a return rate above that provided by savings accounts an MMMF also ensures that it keeps these NAV fluctuations minimal.
The MMMF’s aim at maintaining a $1 NAV. This is done by making sure that any excess earnings generated as interest are distributed in the form of dividend payments to investors. For an investor, this means that the same amount invested in the fund will be received on redemption. In addition, interest payments will be received on a regular basis. The maintenance of the $1 NAV forced investment managers to ensure regular flow of income.
At times the MMMF may fall below $1. This situation is known as Breaking the Buck. This generally occurs if there is a temporary price fall in the money markets. However, if the condition persists it may create a situation where the fund soon fails to exceed its operating expenses or investment losses.
Returns from MMMF’s.
The interest offered by MMMF’s is calculated on an everyday basis. These are then paid to the investors at the end of each month
Taxation rules on Capital Gains from MMMF
If you remain invested in an MMMF for more than 3 years then on sale the capital gains are taxed as LTCG (Long term Capital Gains). This LTCG is taxed at 20% interest with indexation benefits. If you sell the investments within a period of 3 years the capital gains are considered as STCG ( Short Term Capital Gains).STCG from money market funds is taxed by being added to your income and then taxed accordingly to your income slab.
Examples of MMMF’s in India
- L&T Money Market Fund
- Franklin India Savings Fund
- SBI Savings Direct Fund
- ABSL Money Manager
- Nippon India Money Market
What should investors look for before investing in an MMMF?
It is necessary that the investors are aware of the risks an MMMF possesses before investing. The only reason MMMF’s offer better returns than savings accounts is because they are of slightly higher risk. An investor must consider the following before investing in an MMMF
1. Returns offered
An investor must look for an MMMF with a good track record. This includes both providing good returns and also maintaining a $1 NAV. At the time of investment, the investor must note the relation between the NAV and the interest offered by MMMF’s.
When the money market offers high returns the NAV rises accordingly. Hence investors looking to not just security of funds but also to make a profit must plan accordingly to invest at lower Navs. This is if the cost of purchasing units is outweighed in times when the interest is high.
2. Expenses charged by MMMF’s
Expense Ratio is a small percentage of the total assets of the fund charged by the fund for its management services. It is important that investors look into the expense ratio charged by the MMMF’s. This is because the returns are not high for MMMF’s. A high expense ratio may erase all benefits the MMMF may have over a savings account. SEBI has capped the expense ratio at 1.05%.
3. Securities held in Money Market
Investors must look into the portfolio of the MMMF. This is to ensure that the investments made into Money Markets are into securities with good credit ratings.
4. Period of Investment
MMMF’s are meant to be short-term investment opportunities, i.e. three months to one year. Though money market funds are safe, staying invested in them for a longer period of time will lower the returns in comparison with bonds.
5. Exit Load
Investors must also ensure that there is no exit load present. Although there are not many MMMF’s that impose an exit load there are instances where exit load is imposed based on the period of investment. Say if redemption is made within a week an exit load will be charged.
Money market mutual funds (MMMF) are a great investment opportunity for investors looking to park their investments safely in the short term and earn more than savings accounts. MMMF’s try to ensure the highest short term income.
In addition to this MMMF’s offer liquidity as and when the funds are required. But investors must also ensure that after taking into account fund charges and taxes the net returns offered are above the inflation rates. If MMMF’s are used with proper planning and diversification with other tools from the stock market they can create a perfectly balanced portfolio.
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.