Mutual funds are a great option for inexperienced investors. Basically, this is a “pool” where lots of different people put their money and an experienced professional manages the fund and invests in different asset classes – securities, stocks, etc.
If you want to know more about mutual funds and how it works – check out our article, written by the great Russell White, and find out more about what mutual funds are.
The Difference Between Mutual Funds Types
Depending on an investor's goal and future strategy, there are several different types of mutual funds. Let's take a look at the most common ones.
1. Stock Funds
There are different types of stock funds based on the risk and the potential profit on the stock they chose to invest in:
Fixed income funds primary objective is to focus on buying fixed-income securities like government bonds, obligations, and corporate bonds. The aim of these funds is to provide their investors with a monthly income, generated by the interest the bonds earn. This type of investment is very common among the elderly and retired because it's safe and guarantees a stable additional income.
Is it risk-free?
Nothing is. For example, prices of bonds depend on the movement of interest rates – if rates go up, bonds go down. Another risk is if the borrower defaults on their payment. Income funds’ main goal is the provision of income, that’s why they invest in stocks that would pay a regular dividend.
Index funds invest in portfolios of stocks designed to mirror and track the performance of a particular market index such as the Nasdaq Composite or the S&P 500. The stocks are “interconnected” with the index, and their performance is entirely dependent on it. Many people prefer it due to its minimal management costs and fees. Usually, this type of investment is considered a passive one because a fund just purchases all shares making up an index.
Types of Stock Funds
- Growth funds invest in undervalued, small-cap companies with above-the-average growth because their primary goal is capital appreciation.
- Value funds invest in stocks of companies that are considered undervalued because they want to have greater safety and potential for appreciation.
- Blue-chip funds main goal is income and safety, that’s why they invest in well-established and financially solid companies.
- Sector funds invest in a particular area of the economy or an industry, such as technology, healthcare, real estate, agriculture, etc. These funds usually offer higher appreciation potential but there is also a higher risk involved due to lack of diversification. However, some investors choose to put their money on them on account of their specific knowledge in the sector, or they could predict its bright future.
Sectors of Stock Funds
Green funds offer an investment in “green” and environmentally friendly companies (e.g. renewable energy sector). Even though they avoid investing in conventional companies with a less environmentally friendly attitude, it's arguable if they yield returns worth investing. This investment scheme has more symbolic value than real one representing a more socially and environmentally responsible approach.
Cyclical funds invest in stocks whose value is driven and affected by the economic ups and downs. For example, enterprises that are hugely dependent on discretionary spendings, such as hotels and airlines, tend to see their stock value rise when the economy is strong because people have greater spending power.
And vice versa: when the economy is weak, people cut spending that’s deemed unnecessary, which leads to lower earnings for businesses that sell discretionary items and services. This, of course, results in a decrease in their stock value.
Paying Stock Funds are mutual funds which invest in companies whose stocks distribute their shareholders a qualified dividend. This is yet another low-risk, passive investment opportunity. Therefore, these funds suit primarily retired individuals due to the stable income they offer (the dividend).
But this is not the only reason. Often, the taxes imposed on the dividend are lower than the fees one should pay when withdrawing from their retirement account.
Stock Funds Vs Bond Funds
In comparison to bond funds, these are not as profitable but have a greater potential for an increase in the value of their assets. As an example, Goldman Sachs Growth and Income Fund are currently yielding about 1.5%, but its total returns through October 31, 2006, is 17.5 %.
On the other hand, foreign companies often pay a higher dividend, which encourages funds to invest in their stocks: for example, Alpine Dynamic Dividend Fund, yielded 12.6% through October 31, with total gains of 14%.
2. Bond Funds
This type of mutual funds primarily focuses on bonds. Investors often choose this option because of its relatively low cost, which allows to easily build a diversified portfolio. You can include different classes of bonds with different maturity – investment-grade corporate, junk, government, sector, international, gold and precious metals.
Generally, there are two types of bond funds:
A. Government Bond Funds
These kinds of funds buy government securities, treasury bonds, agency securities like Freddie Mac or Ginnie Mae. Usually, government bonds are considered risk-free because they are backed up b the country. These funds guarantee their investors a stable income in a relatively safe environment. It's valuable to know that, in contrast to safety they offer, there is a minimal opportunity for capital gains.
B. Municipal Bond Funds (also known as tax-free or tax-exempt)
Municipal bond funds invest solely in municipal bonds. Their type depends on the objective of the fund. What they offer is a return free of federal taxes, and if an investor is a resident of a particular state they are also exempt from state taxes. The opportunities these funds offers are quite limited. Usually, this opportunity is preferred by people who live in states imposing high taxes on their residents – New York, California
Bonds Funds Risks
Now, let's discuss the risks associated with bond funds:
There is always a serious risk of a borrower to default on their debt, which means they cannot keep up with their payments. This is defined as a credit risk. It depends on the borrower's credit rating. According to this, US treasuries pose a little risk, while corporate bonds are not as safe and predictable.
Consider The Interest Rates
Having bonds in mind, we have to consider interest rates. The basic rule is simple – if rates go up, the value of bonds goes down. There is a strong and unbreakable connection between bonds and rates. Keep in mind that the longer a bond's maturity, the greater the risk. Nevertheless, compared to stocks and their prices, bonds are not as inconsistent and volatile.
There is another risk associated with bond funds – prepayment risk, and it's closely connected to the movement of interest rates. If they go down, the chances are high that a debtor would like to preliminary pay off their debt, which accordingly causes losses in interest on the bonds.
3. Money Market Mutual Funds
The strategy of this type of mutual funds is to purchase fixed income securities and earn interest for their investors. The income they produce is paid out in the form of a dividend (here we can put the article about dividends).
Experts think this is one of the safest options and poses lower risks. They usually invest in debt securities with minimal risk and short term, without a commission or charge when selling. In addition, they are highly liquid which makes them attractive to investors who need cash.
In the USA, their net asset value is kept at 1USD per share. One of their drawbacks is that these funds are not insured by The Federal Deposit Insurance Corporation (FDIC). Moreover, inflation and negative interested rates might also have a negative effect on the yields they earn.
4. Balanced Funds
If you don't opt strictly for a fixed income fund or one which invests primarily in stocks, then a balanced fund is a good idea. These funds offer a portfolio consisting of both equities and fixed income securities. As its name suggests, these funds try to balance out between high return and low risk of investments.
The fund manager decides how to distribute the fund's investment policy, which depends on the market's movements. These funds are less volatile than stock funds, at the same time pose more risk to losses than fixed income funds. There are two types depending on their strategy: aggressive invest more in stocks, whereas conservative in securities.
5. Target-date funds
These are mutual funds which have a target date as their name suggests, including a mix of different asset classes – stocks, securities, reals estate. Primarily the date which this fund is aiming at is retirement – approx. 90% of the cases are in retirement accounts.
Fidelity Investments, Vanguard Group, Inc., and T. Rowe Price Group, Inc. are the three most powerful target-date mutual funds.
Initially, Vanguard funds invest 90% in stocks and the remainder in bonds. As the target date draws near, the ratio is 1:1 (50% stocks, 50% bonds). When starting Barclays LifePath has the same strategy in the beginning – 90% stocks, 10% bonds, however, when approaching the target date the ratio is different – 35% stocks and 65% bonds. Expenses vary from fund to fund. For instance, expense ratios range from 0.21% to 1.25% or more.