When looking at mutual funds, there are many different types to choose from. It is important to look at each one, its holdings and objectives, and consider the potential for capital gains and risk of loss. As of 2014, there were over 18,000 different mutual funds, but they typically fall under 3 different varieties, with others being variations of the main types. The main varieties of funds are: equity funds, bond funds, and money market funds, whose objectives look at safety of capital, income, and growth.
A fund that seeks to provide a safety of capital will have its main objective as protecting the initial investment from loss. Funds that aim for growth will invest in equities to increase the return on the investment and give investors a capital gain. Bond funds, on the other hand, will provide investors with a stable and regular payment. There are also actively managed funds, index funds, money market funds, bond funds, equity funds, balanced funds and specialty funds.
Be sure to read the 7 Questions to Ask When Buying a Mutual Fund
Actively Managed and Index Funds
Actively managed mutual funds have a portfolio manager buying and selling investments on behalf of the investor to try to outperform the market. Expense fees are higher for actively managed funds.
The alternative is investing in a passive fund or an index fund. Index funds invest in equities or fixed income securities chosen to mimic a specific index such as the S&P 500. Some index funds will track a larger or smaller number of companies in the index. If an investor was looking to match the market rate of growth, these are typically the funds they would be looking at.
Money Market Funds
Money Market Funds are investment vehicles structured as mutual funds that invest in U.S. treasury bills and commercial paper. These funds attempt to maintain a stable net asset value of $1 per share while returning interest in the form of dividends to investors. Since these funds invest in such low risk investments while paying out all gains in dividends (removing the compounding of capital gains), they are considered low-risk, low-return investments.
Investors who are looking for current or short-term returns with great stability should consider these funds as an option. These investors include those close to retirement or those who are already retired. Money market funds are highly liquid investments which can also be used as an emergency cash fund while still obtaining higher returns than savings accounts.
Money market investments are used as short term loans to companies and banks, are extremely secure, and oftentimes guaranteed by the government. This makes them ideal as a replacement for simply holding cash.
Bond funds can also be considered fixed income, or income funds, and the terms are synonymous with each other. Bond funds invest in a combination of treasury bills, debentures, mortgages and bonds. The goal of these funds is to provide a regular income payment through the interest the fund earns with a possibility of capital gains.
Each of these bond mutual funds has a particular emphasis or objective: corporate bonds, government bonds, municipal bonds, agency bonds, and so on. Most of these funds have specific maturity objectives, which relate to the average maturity of the bonds in the fund’s portfolio. Bond mutual funds can either be taxable or tax-free, depending on the types of bonds the fund owns. Bond funds do carry interest rate risk, especially longer-term bonds.
There are many different types of equity funds because there are many different types of equities. They invest in stocks and these funds’ goal is to grow faster than money market or fixed income funds. With higher risk comes higher reward. For the most part, they can be broken down into small-cap, mid-cap, or large-cap, and foreign equity.
Small-cap funds invest primarily in stocks in companies with sizes between $300 million and $2 billion, but the size can vary for each fund. Mutual funds have restrictions that limit them from buying large portions of any one issuer’s outstanding shares, which limits the risk while giving an investor exposure to this segment of the market.
A mid-cap fund invests in companies between $2 billion to $10 billion in market cap, but again this definition can change depending on the fund. These are established businesses that are still considered developing and thus have a higher growth rate than large cap funds.
Large cap funds invest in stocks in the largest companies in the world, with market caps in excess of $10 billion. These can include Apple, Exxon, and Google. They have a lower growth rate than small cap funds and mid cap funds, but they are typically safer and some provide dividends giving an extra boost to returns.
Foreign equity funds, or global/international funds, invest in a specific region outside of an investor’s home country. These funds sometimes have very high returns, but it is hard to classify them as either riskier or safer than domestic investments. There are a number of additional risks that have to be considered, including unique country and political risks. As part of a balanced portfolio, they can add additional returns and are worth considering.
These funds invest in a variety of equities and bond securities. The goal is to balance the safety of bond securities with the return of equities. Most of these funds follow a formula to split money between the two different types of investments, depending on whether their objective is more aggressive or more conservative. Aggressive funds will hold more equities and conservative funds more bonds. As the balanced fund name suggests, they are a mix and thus have more risk than bond funds but lower risk than pure equity funds.
Specialty funds focus on specialized objectives that include sector funds, socially responsible investing, real estate, commodities, quantitative strategies, currencies, and other unique types like funds of funds. Specialty funds favor concentration over diversification, and focus on a certain strategy or segment of the economy.
Sector, commodity, and currency funds are as their name suggests. Sector funds focus on one particular segment of the economy and invest in securities issued by companies concentrated in that segment. Commodity-focused stock funds don’t invest directly in commodities, but they do invest in companies that are involved in commodity-intensive industries, such as energy exploration or mining. As a result, their performance can loosely track the performance of certain commodities. While these funds can be a great hedge against inflation, they can also be much more volatile than most stock funds.
Quantitative strategies are funds focusing on investments that use financial models to determine what to invest in. They tend to try to exploit inefficiencies in the marketplace or try to predict abnormal market events. As with any model, however, it is only as good as the person who programmed it, and comes with higher risk but higher returns.
Real estate funds may invest directly in a property or indirectly through real estate investment trusts (REITs). REITs invest in income-producing properties such as office towers and shopping centers, so in that sense they are similar to bond funds, but they offer a higher return with higher risk.
Socially responsible investing funds are funds that seek to consider both financial return and social good. These funds encourage practices that promote protection of the environment, human rights, and diversity, which is most often known as ESG: environment, social justice, and corporate governance. According to the 2012 Trends Report, there were 333 socially responsible mutual funds, up from 167 in 2001, and it’s an area that is continuing to grow.
Funds of funds are especially unique in that they invest in other funds and achieve a higher diversification than with a single investment fund. However, expense fees for these are a lot higher than normal mutual funds because there are two sets of fees being paid.
The Bottom Line
The large number of mutual funds available to today’s investors provides them with more investment choices than ever before. While some choice is good, it can also be intimidating. By familiarizing yourself with the different types of mutual funds, you can decide which funds appeal to you and your own investment goals and then narrow down your investment selection from there.