Understanding Money Market Funds

What is a Money Market Fund?

A money market fund is a kind of debt mutual fund which invests mainly in money market instruments with a remaining maturity of a maximum of one year. These are treasury bills, commercial papers and certificates of deposit, repos and other securities of the money market. Their main aim is to ensure high liquidity and to make returns through the investment in short-term debt instruments.

Money market funds are used for managing short-term liquidity, typically for investment horizons of up to one year. Individual investors, business organisations, and institutions use them to fulfil short-term cash needs. The Securities and Exchange Board of India (SEBI) prescribes investment regulations to ensure adequate liquidity, high credit quality, and controlled risk.

How Money Market Funds Work

The functioning of money market funds is shaped by their portfolio construction, return mechanism and taxation framework, as outlined below.

1. Investment Strategy

   These funds collect money from several investors and invest it in a variety of short-term money market instruments. Fund managers carefully watch credit quality, maturity schedules and liquidity to ensure stability. Under SEBI guidelines, money market funds maintain a short weighted average maturity to minimise the impact of interest rate shifts.

2. Returns and Redemption

   The units can be bought and sold by the investor at the prevailing net asset value. Many money market funds do not levy exit loads, although this depends on the specific scheme. Interest earned on the underlying securities produces returns and this is captured in the variation of net asset value of the fund. The portfolio generally shows lower volatility than many other debt fund categories due to shorter maturities and lower duration risk. However, the Net Asset Value (NAV) can still fluctuate.

Taxation of Money Market Funds

For investments made on or after 1 April 2023, capital gains from money market funds are taxed at the investor's applicable income tax slab rate, regardless of the holding period. Dividend income, if opted for, is taxed in the hands of the investor at the applicable income tax slab rate and may be subject to Tax Deducted at Source (TDS) as per prevailing tax rules.

Tax Treatment and Compliance

For taxation purposes, international mutual funds are generally treated as non-equity funds because they do not meet the requirement of investing at least 65% of their assets in Indian equities. Capital gains from international mutual funds purchased on or after 1 April 2023 are taxed at the investor's applicable income tax slab rate, regardless of the holding period. The existing tax regime does not provide any benefit of indexation. SEBI directs international investment funds to publish foreign assets, expense ratios, benchmarks, and performance results within their scheme information materials.