Is money market mutual fund for you?

We see numerous types of mutual funds being introduced in the market every now and then, be it sector focused funds like infrastructure funds or real estate funds, or funds dedicated to values of stocks in which they invest like small cap fund or large cap funds and so on.

Each of these funds has a specific investor class in mind. For instance, growth funds, which generally invest a major portion in shares and growth sectors, suit the requirements of investors who have excess money to be allocated to riskier investments, or are optimistic about economic conditions or scheme objectives, or fall under a young age group (below 30).

Similarly, tax-free MFs target the salaried investor class mainly.

To understand how a Money Market Mutual Fund (MMMF) work and how should one evaluate when to invest in these funds, we need to first figure out what money market is, what investments are traded in money market and who are the players in this field.

Broadly speaking, the money market is a marketplace where money is bought and sold. This market is similar to capital market (where capital or investments having long maturity are dealt with). The money market is a place for large institutions and the government - to manage their short term cash needs.

Money market securities are issued by governments, financial institutions and large corporations. The most common types of money market instruments are shown in side figure.

Since the maturity of these securities is generally below one year, this market is also called cash market. This maturity differentiates money market from fixed-income market which consists of securities having life between one to five years.

To better appreciate the investment model of MMMFs, let us just run through the common money market securities one by one:

It may be noted that risk for PSUs and SCBs is said to be medium due to the strict control of government and regulators on these entities, as compared to corporate.

No risk, no return. This maxim has been suitably modified as some risk, good return. We all know that with every return, there is something that comes for free -- risk.

MMMFs are no exception to this. Some of the most important risks an investor should know about before investing in MMMFs could be explained as below.

Interest rate risk

Since returns on debt instruments is based on interest rates prevailing in the market, any change in interest rate leads to changes in the prices of instrument and hence Net Asset Value (NAV) of funds investing in such instruments.

Generally, the prices of instruments increase as interest rates decline and decrease as interest rates rise. As long-term instruments have more interest rate payment involved, prices of long-term securities fluctuate more in response to such interest rate changes than short-term securities.

Credit risk

This refers to the risk that an issuer of a fixed income security may default (i.e. the issuer will be unable to make timely principal and interest payments on the security).

Because of this risk, corporate debentures are sold at a higher yield above those offered on government securities which are sovereign obligations (in the worst case, government can print money and pay interest to holders) and free of credit risk.

The greater the credit risk, the greater the yield required for someone to be compensated for the increased risk.

Reinvestment risk

This risk refers to the difference in the interest rate levels at which cash flows received from the securities are reinvested. For an investor, it is not only how much her principal investment is earning, but also at what rate the interim earnings from such investment are again invested.

The additional income from reinvestment is the "interest on interest" component. The risk is that the rate at which interim cash flows are reinvested may be lower than that originally assumed.

Generally the investors putting money in MMMFs require a steady flow of income (return), low variability of such income (risk) and ease to withdraw (liquidity).

To satisfy the aforesaid investor goals, MMMFs set their objectives generally as to create a highly liquid portfolio of money market instruments so as to provide reasonable returns and high liquidity to the unit-holders.

MMMFs are usually meant for investments by the charitable, religious or other trusts / provident funds, superannuation funds, gratuity funds, etc. However, for optimum diversification strategy, it is important for retail investors to hold a part of their portfolio in debt markets.

This can be easily done through MMMFs which require minimum investment of Rs 10,000 with some funds offering even lower threshold limits.

How have these performed? Though past performance should never be taken as an assurance for future performance, a glimpse of the former gives a fair idea about how much MMMFs have enriched investors.
 

Should I invest in MMMFs? If yes, then how much?

This could be possible question in mind of reader. But the answer is not very straight-forward and formula-driven. Having a diversified portfolio is what is suggested by fund managers, wealth management experts and theorists. So no doubts about that.

Making MMMFs part of one's portfolio should bring the overall risk down but one also needs to look at when these funds could be more revenue-adding to the portfolio.

In an economic scenario when interest rates are down, money market securities should be pricey (referring to the equation above). This leads to these funds having a higher NAV on which an investor will have to buy them.

Taking a call on the future interest rates, demand for credit in the market and policies of RBI could lend us some cues on when to invest in MMMFs and when to liquidate them.