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Mutual Funds: Different Types Of Funds
It's
important to understand that each mutual fund has different risks and
rewards. In general, the higher the potential return, the higher the
risk of 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.
This is a fact for all investments.
Each fund has a predetermined investment objective that tailors the
fund's assets, regions of investments and investment strategies. At the
fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For
example, while equity funds that invest in fast-growing companies are
known as growth funds, equity funds that invest only in companies of the
same sector or region are known as specialty funds.
Let's go over 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 short-term debt instruments, mostly
Treasury bills. This is a safe place to park your money. You won't get
great returns, but you won't have to worry about losing your principal.
A typical return is twice the amount you would earn in a regular
checking/savings account and a little less than the average certificate
of deposit (CD).
Bond/Income Funds
Income funds are named appropriately: their purpose is to provide
current income on a steady basis. When referring to mutual funds, the
terms "fixed-income," "bond," and "income" are synonymous. These terms
denote funds that invest primarily in government and corporate debt.
While fund holdings may appreciate in value, the primary objective of
these funds is to provide a steady cashflow to investors. As such, the
audience for these funds consists of conservative investors and retirees.
(Learn more inIncome Funds 101.)
Bond 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.
Balanced Funds
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 combination of fixed income and equities. A typical balanced
fund might 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.
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.
Equity Funds
Funds that invest in stocks represent the largest category of mutual
funds. Generally, the investment objective of this class of funds is
long-term capital growth with some income. 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 is to classify funds based on both the size of the companies
invested in and the investment style of the manager. The term value
refers to a style of investing that looks for high quality companies
that are out of favor with the market. These companies are characterized
by low P/E and price-to-book ratios and high dividend yields. The
opposite of value is growth, which refers to companies that have had
(and are expected to continue to have) strong growth in earnings, sales
and cash flow. A compromise between value and growth is blend, which
simply refers to companies that are neither value nor growth stocks and
are classified as being somewhere in the middle.
For example, a mutual fund that invests in large-cap companies that are
in strong financial shape but have recently seen their share prices fall
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. Such a mutual fund
would reside in the bottom right quadrant (small and growth). (For
further reading, check out Understanding The Mutual Fund Style Box.)
Global/International Funds
An international fund (or foreign fund) invests only outside your home
country. Global funds invest anywhere around the world, including your
home country.
It's tough to classify these funds as either riskier or safer than
domestic investments. They do tend to be more volatile and have unique
country and/or political risks. But, on the flip side, they can, as part
of a well-balanced portfolio, actually reduce risk by increasing
diversification. Although the world's economies are becoming more
inter-related, it is likely that another economy somewhere is
outperforming the economy of your home country.
Specialty Funds
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 categories we've described so far. This type
of mutual fund forgoes broad diversification to concentrate on a certain
segment of the economy.
Sector funds are targeted at specific sectors of the economy such as
financial, technology, health, etc. Sector funds are extremely volatile.
There is a greater possibility of big gains, but you have to accept that
your sector may tank.
Regional funds make it easier to focus on a specific area of the world.
This may mean focusing on a 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 is
otherwise 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. Most socially
responsible funds don't invest in industries such as tobacco, alcoholic
beverages, weapons or nuclear power. The idea is to get a competitive
performance while still maintaining a healthy conscience.
Mutual Funds: What Are They
Mutual Funds: Different Types Of Funds
Mutual Funds: The Costs
Mutual Funds: Picking A Mutual Fund
Mutual Funds: How To Read A Mutual Fund Table
Mutual Funds: Evaluating Performance
Mutual Funds: Conclusion |
