Mutual funds can be classified as either diversified or non-diversified. In order to be considered diversified, a fund must meet the following criteria:

  • At least 75% of assets must be invested in securities.
  • No more than 5% of assets may be invested in any one issuer.
  • The fund must not hold more than 10% of voting securities of any one issuer.

These criteria are required only at the time of investment. Therefore, if a fund invests 4% of its assets in a single stock and the stock rises in value, the fund is still considered a diversified fund - even if the stock now represents 6% of the fund's assets.

There are more than 8,000 mutual funds on the market today. The objectives of these mutual funds vary depending on the goals of the portfolio manager. Determining which mutual fund best suits a particular investor requires knowing the financial needs, investment objectives and risk tolerance of that person. The most common types of mutual funds include:

Money Market Funds
Money market funds invest in short-term debt instruments of one year or less. Investors can withdraw money at any time with almost no risk of loss of principal. In other words, money market funds are extremely liquid and are used for portions of an investor's portfolio that require safety of principal. Returns will vary with short-term interest rates, but the common goal of most money market funds is to maintain a net asset value of $1 per share.

Bond Funds
As the name suggests, bond funds are mutual funds that invest solely in bonds. An investor who purchases a bond fund seeks current income along with preservation of capital. Because bond funds are made up of individual bond issues, they are subject to the same types of risks associated with individual bonds, such as credit risk, call risk, interest rate risk and reinvestment risk.

They are grouped into categories according to the types of bonds in which they invest:

  • Government Bond Funds: Government bond funds invest in Treasury securities, agency securities like Freddie Mac or Ginnie Mae, and cash and equivalents. Government bond funds will provide investors with a source of current income, along with a greater amount of credit safety than other types of bond funds. While these funds are relatively less volatile than other bond funds and have little credit risk, they are still very interest-rate sensitive.

  • Municipal Bond Funds: Municipal bond funds consist exclusively of municipal bonds. They can be state-specific, national or insured; this will depend on the objective of the fund. For instance, a management company may issue a fund that invests only in municipal bonds from a single state, such as Illinois or New York, in which case investor residents of those states will receive double tax-free - and in some instances, even triple tax-free - income. These funds are known as single-state municipal bond funds. A national municipal bond fund will contain bonds from all U.S. states, and income from the fund will be federally tax free. Insured municipal bond funds have a portfolio made up of municipal bonds that are insured for the timely payment of principal and interest, making them AAA rated and very safe investments. Like national municipal bond funds, these funds also provide income that is free of at least federal tax.

  • Corporate Bond Funds: Corporate bond funds invest in bonds issued by numerous corporations. There are several types of corporate bond funds, depending on the investment grade of the bonds within the fund portfolio. For instance, one corporate bond fund may have most of its holdings weighted in higher-grade corporate bonds, such as those rated A and better, while another corporate bond fund may contain a greater mix of investment-grade corporate bonds, including BB grade through AAA. These funds are appealing to investors who want a higher return than what a government bond fund can provide.

  • High-Yield Bond Funds: High-yield bond funds invest in bonds that are rated below investment grade by Standard & Poor's or Moody's (i.e. junk bonds). That is, most of these funds' holdings are below BBB grade. They may pay higher returns, but there is greater credit risk associated with the bonds that make up the mutual fund. These funds tend to do well as the economy improves because the risk of default decreases for companies that issue junk bonds.

Balanced Funds
Balanced funds divide their assets between stocks and bonds. The proportions of each investment vehicle will vary with market conditions and decisions made by the portfolio manager. Balanced funds tend to be less volatile than funds that invest only in stocks. Usually, the goal of a balanced fund is to even out market advances and declines.

Equity Income Funds
Equity income funds invest in companies that pay high stock dividends. Many of the holdings will be mature companies that have less potential for capital appreciation but also are more stable than growth companies. These funds may also include securities from industries that traditionally pay higher dividends than other sectors, such as utilities, REITs, energy stocks and financials. The primary investment objective is current income.

Other Types of Mutual Funds

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