Mutual funds give investors access to some of the brightest minds in finance. There are three major investment groups in mutual funds and within these groups there are two dominant strategies. Understanding the driving logic behind these strategies will allow you to make better investment decisions when selecting a mutual fund.
Styles of Mutual Fund
There are three major groups of mutual funds and within these groups there are different investment strategies. Understanding the right investment choice for you means understanding the possibilities.
1. Equity (stocks): These funds buy stocks, which are small ownership pieces of companies. While equity funds are considered the riskiest of the three major mutual fund groups, they also have historically outperformed the other two groups.
2. Fixed-Income (bonds): These funds invest in income-producing investments such as bonds, preferred shares and mortgages. These are issued from companies or governments who wish to raise money and pay back investors over time. While usually less risky than equity, there can still be sizable risk due to the possibility of a default.
3. Money Market: Short-term bonds or callable cash. These are usually low-duration treasury bonds. The investment pays very little, but has maximum liquidity and safety.
As a note, there are mutual funds that attempt to blend two or three of these groupings together into one investment strategy. The “balanced” fund is a popular example; it’s a 60% equity and 40% fixed-income investment strategy.
Within these three groups of assets there are different investment strategies that are employed to secure profits. The two major strategies are outlined below. Many professional mutual fund managers employ more complex forms of these strategies, so it is always wise to read the prospectus. The prospectus of a fund is a document outlining the strategy’s details and sometimes it’s driving logic.
Types of Investment Strategies
Value investors scour the markets for companies or bonds that are out of favor with the market. The company’s asset value is depressed because the market doesn’t like its current cash flow, or perhaps an adverse news event has shocked the world and is related to the asset’s cash flow. This is where the value investors step in. They spend their time looking at cold hard cash flows and asset values. When the current asset price goes below what the value investor believes to be the liquidation value of the asset, they start to buy. The value investor buys because he or she believes that even if the worst-case scenario occurs, they’ll still make a tidy profit. To a value investor, adverse company news looks like a flashing neon sign saying “Clearance 50% Off! Everything Must Go!” Being smart shoppers, they buy when others are selling.
Key Value Metrics:
- P/E Ratio
- Revenue Generation
- Price-to-book Ratios
Value Mutual Funds:
- Vanguard Equity Income Fund (VEIPX)
- Invesco Diversified Dividend Fund (LCEAX)
- Strategic Advisers Value Fund (FVSAX)
Growth funds are usually riskier than value funds, however, they also have larger return potential. Growth investors are looking for a rapid expansion of the asset’s value in the market because of increasing fundamental signals. Like value investing, growth investing is also trying to find assets that are “on sale,” based on the continued expansion of cash flows coming from the asset. As the fundamentals continue to improve, the profits are reaped from the liquidation of positions whose fundamental indicators have slowed down.
Key Growth Metrics:
- Earnings Growth
- Profit Margins
Growth Mutual Funds:
- T.Rowe Price Institutional Large Cap Core Growth Fund (TPLGX)
- Fidelity Growth Company Fund (FDGRX)
- Vanguard PrimeCap Fund (VPMCX)
The Bottom Line
In conclusion, mutual funds offer a flexible approach to professionally manage portfolios. Investors simply select the asset type, equity, fixed-income, or money market and then the strategy type, growth or value. By making these choices ahead of time, it is easier to understand the risks and rewards for each investment.
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