The most commonly discussed mutual funds on the market are stock (or equity) funds, but they are certainly not the only funds available. They’re not even necessarily the best funds.
Regardless of the primary fund asset, your profit potential often comes from a successful fund manager, one who has accumulated more winners than losers in the funds—and more shares of the winners. And, as with any investing, your job is to understand what you’re investing in, even when you have a fund manager to do the heavy lifting for you.
In an age when there are numerous types of Coca-Cola—Classic, Diet, Cherry, Caffeine-Free, Caffeine-Free Diet, Zero, and so on—it should not be surprising that there is also a wealth of mutual fund categories. As the market continues to grow, more and more types of funds are created, which adds further confusion.
This article will help you clear this up. When choosing a stock fund, you first want to know its overall goal. For example, does it aim for conservative long-term growth or aggressive short-term growth?
Before purchasing a fund, you should ask to look at a listing of the stocks currently owned so you can see if the fund managers are indeed following the plan of action they have listed as their goal. Whether you’re interested in index investing, current income, capital growth, good value, or superstar sectors, you can find it in the world of stock mutual funds.
1. Index Funds
Index funds strive to match a specific index, and they do that by holding the same securities as the one the named index tracks. These funds are passively managed, meaning that there’s not a lot of trading going on, and that translates to lower expenses for you. The investment objective of this fund type is to mirror an index, the most popular of which is the S&P 500.
From 1987 through 1997, the S&P 500 performed better than 81 percent of general equity funds. Then from 2001 through 2007, the S&P 500 trailed about half of the actively managed funds. Index funds proved their worth during the down markets of 2008 as well, disproving the commonly held belief that active management does better in bear markets.
In fact, S&P indexes outperformed managed funds in all categories but one (large-value stocks) during the 2008 bear market. That includes the gold standard itself: The S&P 500 Index outperformed 54.3 percent of all large-cap funds in 2008.
Index funds offer an easy way to stick with a successful benchmark that everyone uses—and they are not limited to popular benchmarks. There’s an index to track virtually every kind of investment there is, from micro-cap stocks to South American stocks to natural-resource stocks. They allow you to be in specific sectors and to invest in both growth and value stocks, giving you maximum diversification. If the benchmark is the standard, after all, why not go with it?
2. Growth and Income Funds
You’ve entered the investing world to make money, and there are two primary ways to do that: growth and income. Growth securities you buy today will be worth more tomorrow. Income securities will pay you interest or dividends at regular intervals right now. And there are funds designed for each, even for both.
Growth funds don’t focus on the current price of a stock; rather, their concerns center on the sales and earnings of the company and the expectation that both will grow, which will cause the stock price to rise.
The idea is not the traditional “buy low, sell high” principle; rather, it is “buy at whatever price and watch the company build momentum, get on a roll, and grow.”
Growth investors seek out companies that have tremendous potential, based perhaps on new products, unique services, or excellent management. Long-term growth funds seek to capitalize on larger, steadily growing companies like Microsoft. Aggressive growth funds involve smaller companies that are taking off fast like Amazon.
Aggressive Growth Funds
Sometimes called capital appreciation funds, these are the funds that generate the most press. When they go well, they go very well. Some of these have produced tremendous results—but the opposite is also true. Investors should know that this volatile category can turn around very fast. Aggressive growth funds look for companies poised to grow in the short term, which is why they are riskier investments.
Income funds are best for investors who want to see results right away, in the form of steady income. These funds hold dividend-producing stocks and pass those dividends along to fund shareholders. Some of these funds may also hold interest-paying securities, like bonds; these earnings are also passed on to the fundholders.
Even though that income is yours right away, you can choose to reinvest it rather than receive a regular check. Be aware, though, that these earnings are taxed whether you take the cash payment or reinvest it.
Straight income funds are considered conservative by nature, seeking as their primary objective to pay you dividends from consistently well-performing companies. One of the nicest aspects of an income fund is that the companies that pay dividends, hence those in the portfolio, are usually not affected greatly by downturns in the market.
Combination Growth and Income Funds
You might also choose to go with a fund that specifically seeks out companies whose stock is not only expected to grow but also pays dividends. Such a fund provides steady income, which is attractive to anyone who likes to maintain cash flow even during major dips in the market.
A growth and income fund can also work very well for an individual who may be retiring but still wants to have money in the market. Such a fund will provide cash toward living expenses while allowing the investor to maintain some capital.
3. Value and Sector Funds
A value mutual fund invests in stocks that are undervalued. These are companies that—for one reason or another—are struggling, and while the stock prices are low, the actual value of the company may be much higher.
Sometimes it’s a matter of too much market competition; in other cases, a company may be lagging behind in the latest technology or has not made a major impact of late. However, if the P/E ratio and the book value of the stocks in the portfolio are good, the fund can be worthwhile. Although in recent years value funds have been outperformed by growth funds, they adhere to the old adage “buy low, sell high.”
A stock that is valued at $40 but selling at $20 allows you more room for error. Even at $30 per share, you would still come out ahead. Sector funds concentrate their holdings in one industry. Rather than spreading your investment around among various types of industries, they choose stocks from one particular industry, such as oil, health, utilities, or technology.
Like market timing, the idea behind buying a sector fund is to select an industry that you foresee taking off in the next few years. For example, new health-related technologies have people looking at stock in companies doing new and innovative things in medicine.
Internet sector funds may also generate more attention, but be careful that an overabundance of Internet providers doesn’t bring prices back down to earth. A sector fund can give you a bumpy ride if you are planning to stay there for the long haul.
4. International and Global Funds
Many investors assume international and global funds are the same. They’re not. While global funds include securities from the whole world, international funds do not include securities from the home country of the investor. So, to an American, an international fund would not include U.S. securities, but a global fund might.
Many international funds spread your investment around, buying into markets worldwide, while others look at the economic potential of one country. International specialized funds have not fared well over the past three or even five years. Recent returns are also down, largely as a result of the worldwide financial crisis that started in 2008.
International funds can be further focused on as regional or single-country funds. Regional funds put your investment dollars in a specific geographical area, such as Asia or South America, offering you broad access to a small region. Single-country funds, as the name, clearly states, buy up securities issued in a single country. Mexico, Japan, and Germany are among the most common.
Usually not the place for a beginning investor, international specialized funds can be risky because of the high volatility of many overseas markets. For that reason, it may be best to strictly limit your holdings in these funds to a small portion of your total portfolio.
Remember, other funds you hold may already be investing a small portion into overseas investments, thus dabbling in the arena and letting you have some foreign diversification. Changes in currency and politics make it hard to assess, even for fund managers, what the future investing climate will be on a global basis.
5. Balanced Funds
Balanced funds are characterized by their balanced approach to investing, just as the name suggests. They derive capital gains from a mixed bag of investments, primarily consisting of stocks and bonds.
This is ideal for those investors who do not want to allocate their own portfolios. Balanced funds provide maximum diversity and allow their managers to balance more volatile investments with safer, low-risk investments such as government bonds.
Naturally, since this type of fund can have a wide range of investments, it is important to look over the fund’s portfolio and get an idea of what makes up the balance in your balanced fund. The combination of good returns and nice yields makes these funds worthy of your attention.
Like a balanced fund, an asset allocation fund maximizes diversification. The fund is managed to encompass a broad range of investment vehicles and asset classes. If managed correctly, an asset allocation fund will include a mix of stocks, bonds, and short-term instruments and distribute the percentage of holdings in those areas providing better returns.
Whereas a balanced fund tries to maintain a balance between stocks and bonds, an asset allocation fund can be 75 percent stocks one year and 75 percent bonds the next. This is largely dependent on the market. If the economy slides into a bear market, the percentage of bonds will rise; in a bull market, the percentage of stocks will be higher.
Factoring in each type of investment, the fund manager has a wide range of choices across asset groups. In a broad sense, this is a matter of market timing. These fund managers have more leeway, as they are not locked in to a set percentage allocated to one type of investment.
6. Large-Cap, Mid-Cap, and Small-Cap Funds
In the world of mutual funds, “cap” means “capital,” and it indicates the size of the companies the fund invests in. Large-cap funds invest in the major corporations; small-cap funds seek out smaller, often growing companies; and the investments of mid-cap funds are somewhere in between.
The larger, more established companies usually present less risk, and therefore large-cap funds tend to make safer investments. Small-cap stocks can take off and have often fared better but present a greater risk since these companies are trying to establish themselves.
While some small-cap companies have become huge quickly, others have moved along slowly or vanished into oblivion. Small-cap funds can sometimes be deceiving. A company that starts out small and continues to grow is ultimately no longer a small-cap company.
Yet it still may remain in the fund. After all, why throw out your ace pitcher even though he’s no longer playing in Little League? E*TRADE was a small-cap company found in many small-cap funds, but as it grew and brought the funds high returns, fund managers and investors enjoyed reaping the rewards, so it stayed.
Some small-cap companies, such as those in the technical sector, are also very well known to the computer-friendly population, which is why companies like Intel or Dell Computer can also shine. As the newer online investors become savvier, they too will branch out from safer, more familiar territory and explore the many growing companies.
7. Bond Funds
Bond mutual funds are generally less risky than stock mutual funds, but they generally do not yield the same high rates of return as stock mutual funds. When you purchase a single bond, your money is tied into the bond until maturity.
You can sell the bond, but sometimes bonds can be more difficult to sell because they trade in the bond market. Buying and selling the bonds is the job of the fund manager. A bond fund, thanks to interest, can provide a monthly check, which can also be reinvested into the fund. Remember that your principal is not secured in a bond fund.
Should the fund price drop, you could lose some of your initial investment. The price of the fund dictates the worth of your investment rather than the underlying bond holdings. The value of the bonds in the portfolio will fluctuate until they reach maturity, based inversely on the interest rate.
While looking through bond funds, you will notice the three primary types of bonds represented: municipal, government, and corporate. International bond funds also exist. As is the case with stock funds, there are different levels of risk associated with different types of bond funds.
The greater the risk (when dealing with junk bonds, for example), the greater the potential returns, and vice versa. When dealing with low-risk government bond funds, the rate of return is relatively low.
Municipal Bond Funds
These are bond funds that invest in either intermediate or long-term municipal bonds. Such money is often allocated to worthwhile projects, such as building new roads, repairing older ones, upgrading sewer systems, or other projects that both produce revenue and add to the community.
An incentive of such munis, as they’re often called, is that they generally offer you income that is not taxed. The tax-free bond funds, while paying lower yields, are often paying as much or more than many taxable bond funds because you are not paying those ugly federal—and, in many cases, state—taxes.
Municipal bond funds can be national, investing in municipalities nationwide; statewide, investing in specific state municipalities; or local, investing in local municipalities.
If you are in a state with high taxes, you may find these funds to be appealing because you avoid such taxes. Crossing state lines, however, may require you to pay taxes. In other words, you may be taxed in your home state if you buy a municipal bond from another state.
U.S. Government Bond Funds
You want low risk? Invest in the government. Despite high deficits and outstanding loans to countries that no longer exist, the U.S. government has never defaulted, and there is no risk in the securities in a government bond fund.
These funds hold Treasury securities, bonds, and notes, as opposed to savings bonds. There is some volatility because the fund managers do trade on the market, but for the most part this is a very safe route, and many people will use a government bond fund to balance out other funds they hold.
Since there are not as many choices in regard to government bonds, and since the risks are significantly lower, many investors do not bother looking for such a fund. Instead, they simply purchase their own government investment vehicles from the government directly, since it is so easy to do.
Corporate Bond Funds
The majority of the holdings in this type of fund are, as the name implies, in corporations. Like equity funds, there are a variety of types of corporate bond funds, and they differ depending on the corporations from which they are purchasing bonds and the length of the holdings.
Bond funds that buy high-grade (or highly rated) bonds from major corporations are safer on the fundamental risk scale than other corporate bond funds. They also tend to produce slightly better returns than government bond funds over time.
However, some of these funds cheat a little, albeit legally, by owning a small percentage of lower-grade bonds to balance out their portfolio and —if they pick the right ones—enhance the numbers slightly. As is the case with most funds, there is some flexibility beyond the category in which the fund falls.
Beware of bond funds that buy from corporations issuing bonds that are below investment grade. These junk bonds produce a high-yield fund that can be more volatile than many equity funds.
The risk of the company backing this bond is higher, and therefore, the yield is also higher to compensate. In short, junk bond funds mirror junk bonds (which are high-risk bonds), only the fund contains more of them.
Choosing Bond Funds That Work for You
Just as you would consider the track record of a mutual fund before buying, you need to examine a bond fund’s history before making your investment decision. In addition to learning the fund’s track record, you need to ask some key questions when it comes to picking bond funds:
- Is the fund picking bonds with long or short maturities?
- What quality bonds is it selecting?
- Am I in the market for taxable or nontaxable bonds?
- Who is doing the picking?
- What do interest rates look like today?
- How will the current interest rate environment impact my investment?
Bonds with longer maturities and bonds of a lower grade, or lesser quality, are riskier, which taps into your risk/tolerance equation. Risk tolerance is always a key factor in your investment selection process. Although bonds are generally perceived as a less risky alternative to equity investments, there are risks in the bond market and in bond funds.
Since bond funds do not hold onto most of their bonds until maturity, longer-term bonds will have more time to fluctuate and may therefore be riskier. If the bonds were held until their final maturity, these changing rates would not matter.
The taxable/nontaxable question reflects primarily on municipal bonds. Why in the world would you want a taxable bond if you could own one and pay no taxes? Well, a 12 percent yield on a junkier bond, after taxes, still earns you more than a 5 percent yield on a tax-free bond.
Also, if you are buying the bond fund in a tax-free vehicle, such as your IRA, why purchase a tax-free fund? You are already not paying taxes on your IRA investment, so it’s a useless advantage.
Depending on your current investment strategy and the amount of time you have remaining until retirement, consider holding taxable bonds (to preserve principal) or a bond fund (to balance out an equity-laden portfolio) in your tax-free retirement vehicle. As for management, you must once again evaluate how the fund is run. Bond funds generally have fewer operating costs than equity funds.
However, they generally have fewer high payoffs. Just like the equity fund player, however, someone who is primarily investing in bond funds may allocate a certain amount to safer funds while putting the rest in lower-grade or riskier funds.
The higher-yield funds do have their share of successes, and with the right fund manager, they, like a good equity fund, can be profitable. Unlike owning one junk bond, a high-yield fund will consist of a carefully balanced portfolio.
If one or two of the issuers’ default, you will still be fine due to a great deal of diversification in that area. Like all other areas of investing, bond funds offer higher rewards for higher risk. While there are many funds to choose from, it’s also to your advantage to understand more about bonds in general.