No matter what type of investor you are, there is bound to be a mutual fund that fits your taste.
It's important to understand that each mutual fund has different risk and reward profiles. In general, the higher the potential return, the higher the risk of potential loss. Although some funds are less risky than others, all funds have some level of risk – it's never possible to diversify away all risk – even with so-called money market funds. This is a fact for all investments. Each mutual fund has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies.
At the most basic level, there are three flavors of mutual funds: those that invest in stocks (equity funds), those that invest in bonds (fixed-income funds), those that invest in both stocks and bonds (balanced funds), and those that seek the risk-free rate (money market funds). Most mutual funds are variations on the theme of these three asset classes.
Let's go over some of the many different flavors of funds. We'll start with the safest and then work through to the more risky.
Money Market Funds
The money market consists of safe (risk-free) short-term debt instruments, mostly government Treasury bills. This is a safe place to park your money. You won't get substantial returns, but you won't have to worry about losing your principal. A typical return is a little more than the amount you would earn in a regular checking or savings account and a little less than the average certificate of deposit (CD). While money market funds invest in ultra-safe assets, during the 2008 financial crisis, some money market funds did experience losses after the share price of these funds, typically pegged at $1, fell below that level and broke the buck.
Income funds are named for their purpose: to provide current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity in order to provide interest streams. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees. Because they produce regular income, tax conscious investors may want to avoid these funds.
Bond funds invest and actively trade in various types of bonds. Bond funds are often actively managed and seek to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down.
The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a portfolio of both fixed income and equities. A typical balanced fund will have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class, so that if stock values increase much more than bonds, the portfolio manager will automatically rebalance the portfolio back to 60/40.
A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle.
Funds that invest primarily in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth. There are, however, many different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below.
The idea here is to classify funds based on both the size of the companies invested in (their market caps) and the growth prospects of the invested stocks. The term value fund refers to a style of investing that looks for high quality, low growth companies that are out of favor with the market. These companies are characterized by low price-to-earning (P/E), low price-to-book (P/B) ratios, and high dividend yields. On the other side of the style spectrum are growth funds, which look to companies that have had (and are expected to have) strong growth in earnings, sales, and cash flows. These companies typically have high P/E ratios and do not pay dividends. A compromise between strict value and growth investment is a “blend,” which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.
The other dimension of the style box has to do with the size of the companies that a mutual fund invests in. Large-cap companies have high market capitalizations, with values over $5 billion. Market cap is derived by multiplying the share price by the number of shares outstanding. Large-cap stocks are typically blue chip firms that are often recognizable by name. Small-cap stocks refer to those stocks with a market cap ranging from $200 million to $2 billion. These smaller companies tend to be newer, riskier investments. Mid-cap stocks fill in the gap between small- and large-cap.
A mutual fund may blend its strategy between investment style and company size. For example, a large-cap value fund would look to large-cap companies that are in strong financial shape but have recently seen their share prices fall, and would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects: small-cap growth. Such a mutual fund would reside in the bottom right quadrant (small and growth).
An international fund (or foreign fund) invests only in assets located outside your home country. Global funds, meanwhile, can invest anywhere around the world, including within your home country. It's tough to classify these funds as either riskier or safer than domestic investments, but they have tended to be more volatile and have unique country and political risks. On the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification since the returns in foreign countries may be uncorrelated with returns at home. Although the world's economies are becoming more interrelated, it is still likely that another economy somewhere is outperforming the economy of your home country.
This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don't necessarily belong to the more rigid categories we've described so far. These types of mutual funds forgo broad diversification to concentrate on a certain segment of the economy or a targeted strategy. Sector funds are targeted strategy funds aimed at specific sectors of the economy such as financial, technology, health, and so on. Sector funds can therefore be extremely volatile since the stocks in a given sector tend to be highly correlated with each other. There is a greater possibility for large gains, but also a sector may collapse (for example the financial sector in 2008 and 2009).
Regional funds make it easier to focus on a specific geographic area of the world. This can mean focusing on a broader region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which can otherwise be difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession.
Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. For example, some socially responsible funds do not invest in “sin” industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get competitive performance while still maintaining a healthy conscience. Other such funds invest primarily in green technology such as solar and wind power or recycling.
Index funds are passively managed funds that seek to replicate the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An investor might consider an index fund if they subscribe to the logic that most active portfolio managers cannot beat the market on a regular basis. Since an index fund merely replicates the market return it also benefits investors in the form of low fees. Index funds have been increasing in popularity since Vanguard pioneered the way for passive indexing in mutual fund form.
Exchange Traded Funds (ETFs)
A twist on the mutual fund is the exchange traded fund, or ETF. These ever more popular investment vehicles pool investments and employ strategies consistent with mutual funds, but they are structured as investment trusts that are traded on stock exchanges, and have the added benefits of the features of stocks. For example, ETFs can be bought and sold at any point throughout the trading day. ETFs can also be sold short or purchased on margin. ETFs also typically carry lower fees than the equivalent mutual fund. Many ETFs also benefit from active options markets where investors can hedge or leverage their positions. ETFs also enjoy tax advantages from mutual funds. The popularity of ETFs speaks to their versatility and convenience.
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