InvestorQ : What are the advantages and risks of investing in money market funds or liquid funds and are there any unique factors I need to look at before investing in these money market funds?
Sam Eswaran made post

What are the advantages and risks of investing in money market funds or liquid funds and are there any unique factors I need to look at before investing in these money market funds?

swati Bakhda answered.
11 months ago

Money market funds are the very short term mutual funds that invest in money market instruments like call money, treasury bills of 91-day and 364 day maturity. They also invest in very short term CPs and CDs also and long term debt with short residual maturity. Before we embark on understanding some of the key advantages of Money Market Mutual Funds, at the outset, it needs to be understood that liquid funds are also popularly referred to as money market funds. The terms are used interchangeably but mean one and the same thing. The following are the key advantages of Money Market Funds…

· While Money Market Funds / Liquid Funds can be technically classified as risk-free, they are actually extremely low risk instruments. Since they invest in call money markets and in 91-day T-Bills, there is almost no risk of default in these instruments, although volatility risk does exist.

· Money market funds are highly liquid. In fact, these funds can be cashed at short notice of just one day and the money actually gets credited to your bank account the same day.

· Since money market funds do not carry any exit load and entry load, they have no entry or exit barriers. This makes these products simpler and more convenient to the individuals looking to park their money.

· Money Market funds yield more than savings bank accounts and almost as much as bank FDs currently. This makes them very suitable for parking short term funds with almost no risk of default and negligible interest rates risk.

· Lastly, money market funds are more tax efficient compared to bank savings. The interest on your savings account or bank FD is taxed at your peak rate of 30%. However, since liquid funds predominantly distribute dividends, they are tax-free in the hands of the investor. This gives money market funds a distinct advantage over other debt products.

But it is not like money market funds are free of risk. They have their own set of risks too and this how the risks get into our calculation when we invest in money market funds.

· While liquid funds / money market fund are virtually free from default risk, they do run a volatility risk. We have seen in the past cases where the call money rates have shot up sharply due to a liquidity crunch in the financial markets. Such events can make the NAV of the liquid fund volatile.

· Most liquid fund managers have the leeway to invest a small portion of the corpus in higher risk instruments and most fund managers use this to generate additional returns. That may expose the liquid fund to additional risk.

· There is the AMC risk that any fund has. We have seen cases where debt funds of some leading AMCs in India have got impacted (example of JP Morgan), because they were exposed to a debt instrument that got downgraded (Amtek in this case). While the liquid fund may not have a problem, the financial risk of the AMC translates into risk for the liquid fund investors too.

· Lastly, one needs to match the maturity profile before investing. If you money is idle for a few days or weeks, then liquid funds may be the right choice. But if your money is idle for 1-2 years then you have better options like debt funds with better yields. Liquid funds will be a sub-optimal choice in that case.

One way to protect your investment interest in a money market mutual fund is to run it through some basic tests before putting your money. While selecting a money market mutual fund, remember that there is normally not much to choose between two money market funds. Since most of the money market funds invest in similar short-term liquid instruments, their returns do not differ too much. However, there are 3 basic rules for evaluating which liquid fund to buy.

· Does the Liquid fund come from an AMC with pedigree and a fairly large AUM? Remember, even though liquid funds are low risk products, it is better to stick to the mutual fund industry leaders.

· Keep an eye on the liquidity in the financial markets. If the financial markets become too tight, then it may not be the right time to invest in liquid funds as volatility risk increases substantially.

· Lastly, keep an eye on the past performance. When it comes to liquid funds, returns over a shorter time frame are more relevant than long period returns. While we do caution that past is not indicative of future returns, in case of liquid funds, past returns may be fairly indicative of how returns could pan out.

That should help you to take a more informed decision with respect to money market mutual funds.