Subject: Mutual Funds - Types of Funds
Last-Revised: 1 Mar 2005
Contributed-By:
Chris Lott (contact me)
This article lists the most common investment fund types. A type of fund is typically characterized by its investment strategy (i.e., its goals). For example, a fund manager might set a goal of generating income, or growing the capital, or just about anything. (Of course they don't usually set a goal of losing money, even though that might be one of the easist goals to achieve :-). If you understand the types of funds, you will have a decent grasp on how funds invest their money.
When choosing a fund, it's important to make sure that the fund's goals align well with your own. Your selection will depend on your investment strategy, tax situation, and many other factors.
- Money-market funds
-
Goal: preserve principal while yielding a modest return.
These funds are a very special sort of mutual fund. They invest in
short-term securities that pay a modest rate of interest and are very
safe. See the article on money-market funds elsewhere in this FAQ for
an explanation of the $1.00 share price, etc.
- Balanced Funds
-
Goal: grow the principal and generate income. These funds buy both stocks and bonds. Because the investments are highly diversified, investors reduce their market risk (see the article on risk elsewhere in this FAQ).
- Index funds
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Goal: match the performance of the markets. An index fund essentially
sinks its money into the market in a way determined by some market
index and does almost no further trading. This might be a bond or a
stock index. For example, a stock index fund based on the Dow Jones
Industrial Average would buy shares in the 30 stocks that make up the
Dow, only buying or selling shares as needed to invest new money or to
cash out investors. The advantage of an index fund is the very low
expenses. After all, it doesn't cost much to run one. See the article
on index funds elsewhere in this FAQ.
- Pure bond funds
-
Bond funds buy bonds issued by many different types of companies.
A few varieties are listed here, but please note that the
boundaries are rarely as cut-and-dried as I've listed here.
- Bond (or "Income") funds
-
Goal: generate income while preserving principal as much as
possible. These funds invest in medium- to long-term bonds issued by
corporations and governments. Variations on this type of fund include
corporate bond funds and government bond funds. See the article on
bond basics elsewhere in this FAQ. Holding long-term bonds opens the
owner to the risk that interest rates may increase, dropping the value
of the bond.
- Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds)
-
Goal: generate tax-free income while preserving principal as much as
possible. These funds buy bonds issued by municipalities. Income from
these securities are not subject to US federal income tax.
- Junk (or "High-yield") bond funds
- Goal: generate as much income as possible. These funds buy bonds with ratings that are quite a bit lower than high-quality corporate and government bonds, hence the common name "junk." Because the risk of default on junk bonds is high when compared to high-quality bonds, these funds have an added degree of volatility and risk.
- Pure stock funds
-
Stock funds buy shares in many different types of companies.
A few varieties are listed here, but please note that the
boundaries are rarely as cut-and-dried as I've listed here.
- Aggressive growth funds
-
Goal: capital growth; dividend income is neglected. These funds buy
shares in companies that have the potential for explosive growth
(these companies never pay dividends). Of course such shares also
have the potential to go bankrupt suddenly, so these funds tend to
have high price volatility. For example, an actively managed
aggressive-growth stock fund might seek to buy the initial offerings
of small companies, possibly selling them again very quickly for big
profits.
- Growth funds
-
Goal: capital growth, but consider some dividend income.
These funds buy shares in companies that are growing rapidly but
are probably not going to go out of business too quickly.
- Growth and Income funds
-
Goal: Grow the principal and generate some income. These funds buy
shares in companies that have modest prospect for growth and pay nice
dividend yields. The canonical example of a company that pays a fat
dividend without growing much was a utility company, but with the
onset of deregulation and competition, I'm not sure of a good example
anymore.
- Sector funds
- Goal: Invest in a specific industry (e.g., telecommunications). These funds allow the small investor to invest in a highly select industry. The funds usually aim for growth.
Another way of categorizing stock funds is by the size of the companies they invest in, as measured by the market capitalization, usually abbreviated as market cap. (Also see the article in the FAQ about market caps.) The three main categories:
- Small cap stock funds
-
These funds buy shares of small companies. Think new IPOs. The stock
prices for these companies tend to be highly volatile, and the
companies never (ever) pay a dividend. You may also find funds called
micro cap, which invest in the smallest of publically traded companies.
- Mid cap stock funds
-
These funds buy shares of medium-size companies.
The stock prices for these companies are less volatile than the small
cap companies, but more volatile (and with greater potential for
growth) than the large cap companies.
- Large cap stock funds
- These funds buy shares of big companies. Think IBM. The stock prices for these companies tend to be relatively stable, and the companies may pay a decent dividend.
- International Funds
-
Goal: Invest in stocks or bonds of companies located outside the
investor's home country. There are many variations here. As a rule of
thumb, a fund labeled "international" will buy only foreign
securities. A "global" fund will likely spread its investments across
domestic and foreign securities. A "regional" fund will concentrate on
markets in one part of the world. And you might see "emerging" funds,
which focus on developing countries and the securities listed on
exchanges in those countries.
In the discussion above, we pretty much assumed that the funds would be investing in securities issued by U.S. companies. Of course any of the strategies and goals mentioned above might be pursued in any market. A risk in these funds that's absent from domestic investments is currency risk. The exchange rate of the domestic currency to the foreign currency will fluctuate at the same time as the investment, which can easily increase -- or reverse -- substantial gains abroad.
- Fund of Funds
- Goal: achieve diversification. A fund of funds, as the name suggests, is a mutual fund that holds shares of other mutual funds (stock funds, bond funds, maybe both). This is one way of achieving a high level of diversification. However, the expense ratio tends to be high since the fund must pay for itself as well as the expenses charged by the holdings. Further, because many mutual funds have similar holdings, buying shares in many different funds doesn't always result in diversification of holdings.
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