Mutual funds are a well-known investment option that allows you to invest your money with the objective of earning returns. Mutual funds use money collected from investors to buy securities. A money market fund is a type of mutual fund that invests money in the money market. The money market is part of the financial market where trading happens in liquid instruments that mature in a short-term. This includes cash, short-term deposits, commercial bills and papers, treasury bills, and other such government securities.
The money market offers low risk to investors and investments in this market can be redeemed quickly. Since the risk is very low, returns are not very high but are usually higher than the interest from a bank savings account. Money market funds invest all their money in instruments that are liquid and of short-term duration (usually less than 13 months).
How does it work?
A money market fund works just like a regular mutual fund. It offers units or shares for the public at a particular price or NAV (net asset value). The money you invest is used to buy units or shares of the fund. In the US, money market funds keep the value of one share equal to $1. Excess money earned is given back to investors as dividend. The fund manager invests money collected to buy money market instruments. This includes:
- Certificate of deposit of short durations.
- Commercial papers issued by private organizations that have a high rating by credit agencies.
- Treasury bills offered by the Government or equivalent instruments.
- Repos or Repurchase agreements that are instruments representing money lent by central banks to commercial banks.
- Banker acceptance, which is a short-term debt instrument issued by a bank.
Once you buy a money market fund, shares or units of the fund are transferred to your account. As the value of the funds rises, so does your investment. In the US, when the fund value increases, dividend is paid to investors and the price remains at $1. You can sell your investments in the fund at any time. In most other countries, the NAV of the fund increases and as an investor, you can sell at any time and earn profits.
Why should you invest in money market funds?
You may be having excess cash that you do not want to use for long-term investments. In such a situation, you may keep the money in a savings account that does not generate much interest. As an alternative, you can invest in money market funds. Since these funds are liquid, you can get back your money quickly. You get returns higher than savings account interest for taking a small risk.
If you want to invest your money for anywhere from three to twelve months, you can consider investing in money market funds. Before you invest money, you need to keep in mind taxes. Most countries charge a capital gains tax for profits earned from money market funds.
Is there any risk involved?
There is usually less risk involved. The interest you earn depends upon various conditions and is usually more than the interest you earn from a bank savings account. Like all investments, there is a possibility of risk where you lose your capital. While this is rare, there is a probability of it happening that you should consider before investing.