Mutual Fund Categories
"Mutual funds aren't horses. You don't pick them by name, color or the celebrity who is involved in the ownership group." - Chuck Jaffe, MarketWatch.com, February 27, 2006
Here, we evaluate a mutual fund's investment objective, also referred to as its style, as an indicator of investment quality. In general, analysts look favorably on fund investment managers who maintain a consistent investing style. However, this view, depending on other fund investment qualities, is subject to some flexibility.
After an overview of fund categorization, as determined by investment objective, we will discuss the use of a mutual fund style box. In addition, various aspects of a fund's investing objective and the role these play in determining a fund's investment quality will be analyzed.
Using the fund reports from Morningstar and Value Line, we will identify and pinpoint where to find the relevant fund objective data from these sources. The input of this evaluative information into the Fund I-Q Scorecard is then explained. (For related reading, see Understanding The Style Box.)
We cannot predict which way the markets will move next or which investments will go up or down. However, we can spread our money around in a reasonable mix of mutual funds with a variety of risk and return characteristics that define their investment objectives. Fund categorization helps us do just that.
All mutual funds are established to be managed within the framework of a defined investment style. You can't always tell by the name of the fund which style that is, but they all have one. Figure 1, below, provides a list of commonly used investment objectives for mutual funds and their principal investment characteristics.
Size Categories for Stock Funds
Generally, portfolio managers divide up their investment objectives into nine different approaches, which are categorized by three company sizes and three investing styles. In the case of the former, size is determined by a company's market capitalization, commonly referred to as market cap. One would think that sales, assets or the number of employees would be more logical measurements of company size. Not so in the investment business, where market capitalization is the measure of choice.
|Fund Objective or Style||Investment Considerations|
|Aggressive Growth Stock||High risk-return. High price volatility and very high market valuations. No dividends.|
|Growth Stock||Above average risk and price volatility. Fast-paced price appreciation. Above market valuations. Low or no dividends.|
|Equity Income Stock||Moderate growth and modest dividends. Average market valuations.|
|Value Stock||Average to below average risk. Reliable, dividend-paying companies with relatively low valuations. Modest price appreciation.|
|Blend||A mix of growth and value stocks.|
|Sector or Specialty Stock||Narrow focus on an industry sector.|
|Stock and Bond Index||Broad market or market segments. Passive management.|
|International/Foreign Stock||Foreign companies and world, regional and country markets.|
|Ultra-Short Term Bond||Very short maturities. High credit quality.|
|Short, Intermediate and Long Term Bonds||Government, corporate and foreign issues. Maturities from one to 30 years. Yields vary accordingly. Duration and credit quality matter.|
|Municipal Bonds||Long, intermediate, and short-term maturities. Tax-exempt. Generally of high credit quality.|
|High-Yield Corporate Bond||High risk-return ("junk bonds").|
|Hybrid||A blend of stocks and bonds. Includes balanced, targeted and life-cycle type funds.|
|Money Market Fund||For liquidity and safety. Cash and cash equivalent securities. Low risk-return.|
A company's market cap is computed by multiplying the number of shares outstanding by its stock price. There are no exact definitions of market caps, but this is generally the rule of thumb:
- Large Cap (big company): Over $10 billion
- Mid Cap (medium-size company): Between $2 billion and $10 billion
- Small Cap (small company): Below $2 billion
Of course, on the other side of the coin from risk is return. Here, the general perception is that small companies grow faster, are more agile and, therefore, are capable of producing out-sized investment returns. Large companies are viewed as less spectacular, but steady performers.
Style Categories for Stock Funds
There are three broad mutual fund equity investment styles: value, growth and blend (a mix of value and growth strategies). Each objective performs somewhat differently and has its own risk-return characteristics. Specialty or sector funds, such as healthcare or real estate, fall into categories of their own because of their special, industry-specific investment characteristics.
Mutual Fund Style Box
Types of Bond Funds
Bonds are issued by the U.S. and foreign governments, U.S. government agencies, municipal jurisdictions and corporations. Like the stock funds, investment analysts use nine broad styles to categorize bonds, which reflect three maturity periods (short, intermediate and long term) and three levels of credit quality (high, medium and low). (For more insight, see Evaluating Bond Funds: Keeping It Simple.)
In terms of a bond fund's risk, the longer the maturities and the lower the credit quality, the greater the risk and return. Conversely, short- to intermediate-term maturities and medium- to high-credit quality produce more moderate bond returns, but with a higher level of safety.
In summary, mutual funds with different investment objectives provide a variety of investment risk and return opportunities to the investor. Therefore, it is important for fund investors to thoroughly understand and identify the investing style employed by the funds that they choose to use to build their portfolios.
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