What Are Overnight Mutual Funds And How Do They Work?

While thinking about investments which are safe and stress-free, mutual funds are something which pop up as the first thing in our minds, because of their promised security and the hassle-free management structure. However, there is a variant of mutual funds called overnight mutual funds which investors can consider.

What Are Overnight MFs?

Overnight mutual funds are a type of open-ended debt funds that invest in overnight assets or securities which can be redeemed the next day. At the beginning of every business day, the Asset Under Management or the AUM is converted in cash which the fund manager eventually invests in overnight bonds which achieve maturity on the next business day. The fund managers usually use the cash amount to purchase more bonds overnight and that's how the cycle goes on. 

Investors interested in investing in such schemes purchase units and place redemption requests for their desirable overnight MFs during normal trading hours. The cut-off timing of an overnight MF is 3:00 PM. But on January 21, 2025, the Securities and Exchange Board of India (SEBI) made a proposal to extend the cut-off timings for both repurchase and redemption of units in overnight MFs from 3:00 PM to 7:00 PM. This proposal has been kept open for public comments till February 10, 2025 before its implementation. 

How do these funds work?

Overnight Mutual Funds belong to a category of open-ended debt funds (funds which can be bought or sold any time based on the Net Asset Value or NAV of the fund). The funds put forth by the investors are invested in diverse debt securities, such as overnight reverse repos, Collateralised Borrowing and Lending Options (CBLOs). The investment is made in accordance with SEBI regulations which restrict investing in such instruments which have a maturity period exceeding one day. These restrictions tend to potentially decrease credit risk for investors. 

One can invest in these funds through any mutual fund platform or directly via AMCs. The invested funds earn interest on the securities in which the money is invested. Generally the returns are low but also have a relatively lower risk factor associated with them.

Features of Overnight MFs

The purpose of Overnight Mutual Funds is to enable the investors to put their idle cash reserve to better use while exposing themselves to relatively lower degrees of risk. The features that make this purpose achievable are:

1. Short-term Investment: This feature allows investors to use their extra money for a short period. The invested units can be redeemed the next day with earned interest.

2. Low Risk Factor: These funds pose almost zero risk as the money is invested in debt securities and are managed by professional fund managers.

3. Liquidity: Overnight MFs can be converted in cash after redemption of the units, presenting a high liquidity opportunity to the investor.

Taxation on Overnight MFs

Much like debt funds, the interest earned is subject to taxation. Long-term investments in overnight mutual funds attract capital gains tax with indexation in case the investment is held more than 3 years. These debt funds are taxed at 20 per cent along with indexation. Without indexation, they are taxed at 10 per cent.

If the investor decides to redeem the funds before 3 years, they will be taxed as per their tax slab. If an investor opts for dividends, they will have to pay 29.12 per cent of their dividend as Dividend Distribution Tax. 

How to choose the right fund

The process of selecting the right mutual fund for you from the sea of options available, needs careful consideration. Investors can consider these factors before choosing the right fund for them:

1. Objective: The objective of your investment should align with the purpose of these funds. You cannot expect similar returns generated in the stock market from these funds. 

2.  Past Performance: Even though past performance cannot guarantee any fund's future returns, reviewing the fund's history can help gauge its consistency and reliability. Investors should compare performance of multiple funds over different periods to select those which consistently gave returns close to their benchmark index.

3. Expense Ratios: The annual fee, presented as a percentage, of the fund's average AUM is called an expense ratio. Consider investing in funds with competitive expense ratios but also look for factors like fund size and management quality.

4. Seek Expertise: You can also research a fund manager's background and their approach towards managing such MFs. Don't be shy to ask for professional help whenever necessary.

5. Liquidity: As overnight funds are known for their liquidity, check that the firm maintains its liquidity levels. This ensures quick access to your money without any delay or imposed penalties. 

Overnight mutual funds can be a good choice for those who prioritise wealth preservation, modest returns, and liquidity. These may not be suited for wealth creation but plays a significant role in safeguarding and growing your surplus capital in a stable and secured manner.