Mutual funds refer to a special type of financial vehicle consisting of a pool of money collected from several investors. Investors and traders can invest in securities, such as stocks, bonds, and money market instruments among other assets, using a mutual fund. Professional money managers operate mutual funds. They allocate the funds’ assets, attempting to produce income or capital gains on behalf of the fund’s investors. They lay out the investment objectives upfront in its prospectus and structure the mutual fund’s portfolio accordingly.
Investors can conduct their own research and select from a list of managers with a variety of management goals and styles. The variety of mutual funds is what allows investors to gain exposure, not only to bonds and stocks, but also to foreign assets, real estate, and commodities. They also have to take into consideration other factors such as expectation, investor profile, and risk tolerance to appropriately choose their mutual funds.
There are nine major types of Mutual Funds that investors should know of.
Fund of funds
Which Mutual Fund Fits You Best?
An equity Fund or a stock fund refers to a type of mutual fund that primarily invests in stocks. It can be either passively or actively. A criterion of an equity mutual fund is that it invests more than sixty percent of its total assets in the equity shares of different organizations.
What assets does Equity Funds invest in?
Equity Funds consist of the shares of different companies from different industries. There are equity funds based on specific market capitalization, such as Large-cap funds, Mid Cap funds, Small Cap Funds, and Multi-Cap Funds.
Equity Funds are far riskier than a fixed-income fund as stocks generally are riskier than bonds. However, the higher the risk, the higher the reward.
Capital Appreciation: Almost all companies in this competitive market tend to reinvest their profits towards growth, increasing product developments, and market share in the process. This in turn causes stock prices to rise.
Diversification: Equity funds require small initial investments but have widespread diversification. Buying stocks of different companies from different sectors of the economy at different times would protect against losses incurred by any single stock in the portfolio.
Liquidity: Equity funds are a highly liquid investment. This is because stocks trade across all major exchanges on a daily basis.
No Control: Investors have little to no control over his/her investments. Fund managers take all the decisions on their behalf.
Higher Costs: Investing in equity funds involves a substantial fee. This is because they are managed professionally.
Not suited for the short term: The returns from equity funds are very volatile in the short term
Examples of Equity Funds: Vanguard Total Stock Market Index Fund(VTSMX), Fidelity® 500 Index Fund(FXAIX) and Fidelity® Growth Company Fund (FDGRX)
Fixed Income Fund:
Fixed income Funds also called bond funds, are a type of mutual fund that owns fixed income securities. These include corporate bonds. Municipal bonds and US treasuries to name a few. There are 5 major types of fixed income funds.
Treasury Inflation-Protected Securities (TIPS)
Investment Grade Corporate Fixed Income Funds
Municipal Fixed Income Funds
High-Yield Fixed Income Funds
International Fixed Income Funds
What assets does a Fixed Income Fund invest in?
Fixed income funds usually consist primarily of bonds, issued by the US Treasury, municipal bonds, highly rated investment-grade corporate bonds, and Junk bonds with low credit ratings.
The securities held in fixed income funds are still subject to risk, despite it being a conservative investment. They can experience interest rate risk, credit risk, and inflation risk just to name a few.
No Fees Involved: There are no hidden fees, fees for management, or transaction fee associated with fixed income funds.
Risk Mitigation: Since fixed-income funds have a pool of investments behind them, they can prevent the risk of a single loan default.
Higher Rates: Fixed income funds offer higher rates in comparison with fixed annuities, bonds, or other industries. They don’t change through the course of the investment because of fixed rates.
Inflationary Risk: A rise in the inflation rates can easily eat into the profits which fixed-income funds generate
Interests Rate Risk: Fixed income funds suffer from interest rate risk. This means that the value of the fund decreases as interest rates increase.
Examples of Fixed Income Funds: SPDR Blackstone / GSO Senior Loan ETF (SRLN), Vanguard Mortgage-Backed Securities ETF (VMBS) and JPMorgan Ultra-Short Income ETF (JPST).
Money Market Funds:
Money market funds are a type of mutual fund that focus on investing only in near term, highly liquid instruments. These include cash, high credit rating debt-based securities, and cash equivalent securities. However, all of these must-have a short-term maturity of fewer than 13 months.
What assets does a Money market fund invest in?
Money market funds usually consist of risk-free, short term debt instruments like government treasury bills, non-treasury assets, government securities, bonds, and notes.
The higher risk money market funds invest in a commercial paper such as foreign currency CDs. These holdings lose in valuation when interest rates drop or when market conditions are volatile. However, they produce more income as well. Investors should note that the FDIC does not insure against any loss for money market funds.
Liquidity is not an Issue: Money market funds mostly trade in securities or entities which have a fairly high demand such as treasury bills. Investors can thus easily buy and sell them as they tend to be more liquid.
Safe Haven: Money market funds have less risk compared to stock and bonds. It also generates single-digit returns for investors, which can still be an attractive prospect for them in down market conditions
Expenses are Substantial: Depending on the money market fund chosen, fees can have a negative impact on profits.
Losing Purchasing Power: Investors can lose purchasing power depending on inflation. For instance, this could happen if the inflation rate is at 4% and an investor generates a return of 3%.
Examples of money market funds: New York Tax-Free Money Fund (NYTXX), JP Morgan Prime Money Market Fund, Vanguard Federal Money Market Fund.
Index Fund or Index tracker is a type of Exchange Traded Fund or mutual fund. They follow certain pre-set rules which track a specified group of underlying investments.
What assets does an Index Fund invest in?
Managers of an Index Fund usually buy stocks that correspond with any major market index, such as the Dow Jones Industrial Average and the S&P 500.
Index funds are ideal for cost-sensitive in investors, as there are fewer expenses that eat up the returns.
Expense ratios: Index Funds have lower expense ratios as compared to other actively managed funds who also struggle to keep up with their benchmark overall returns.
Lack of flexibility
The human element is missing
Gains are limited
Examples: Russell 2000, Nasdaq Composite and Dow Jones Industrial Average (DJIA)
Balanced Funds, also known as asset allocation funds invest in a variety of asset classes. There are two types of such funds designed accordingly to cater to the objectives of investors. While some funds follow a strategy for dynamic allocation percentages to satisfy the objective of investors, other funds have a fixed, specific allocation strategy.
What Assets Does a Balanced Fund invest in?
They usually invest in a hybrid asset class. This contains stocks. money market instruments, bonds, and alternative instruments.
Balanced Bonds have bond stability that does not make it susceptible to the price swings that affect equities. Additionally, share prices debt security almost always move in the opposite direction to stocks.
Expense Ratios are low
Volatility is Significantly lower
Comparatively Low risk
Low expense ratio
Asset Allocations are pre-set
Not suitable for use ins strategies for tax shielding
Stodgy but secure returns
Examples: Vanguard Balanced Index Fund (VBINX)
A sector fund refers to an investment fund that focuses solely on a single industry or sector. They are usually available in the form of ETFs or mutual funds. Investors can invest in sector funds through both passive and active management funds. The former usually follow indexes that are sector-specific.
What assets do Sector Funds Invest in?
Sector Funds normally invest in companies operating in the chosen sector of the fund. Some common sectors include the technology sector, the health sector as well as the financial sector.
Because Sector funds focus on one area of the economy, the degree of volatility is considerably more. They also have no diversification.
It has a higher possibility of larger gains
A collapse of a particular sector may negatively impact the sector bond if it invests in the same sector.
Examples: S&P 500 Energy Index, the S&P 500 Healthcare Index and S&P 500 Consumers Staples Index
The “Income” in Income funds comes from its capabilities to provide steady current income. It is a type of mutual fund whose primary objective is to produce a steady flow of cash for investors, despite fund holdings appreciating in value.
What assets does an Income Fund invest in?
Income Funds invest more in high-quality corporate debt and government debts. To provide streams of interest, they hold these bonds till they mature.
Income Funds are ideal for retirees or conservative investors. However, they are not suitable for tax conscience investors because of the regular income generation.
Produces income even during bearish markets
Varied Monthly Income
Example: Rowe Price Equity Income Fund
An International fund, also known as a foreign fund is a fund that invests in companies that are based outside of the country of residence of the investor. They provide a higher potential for return by allowing investors to broaden their investment horizons.
What assets does an International Fund invest in?
For investors based out of the U.S, international funds consist of the frontier, emerging, or developed market investments. These are available in a range of asset classes.
The potential returns and risks depend on the country of the bonds. For instance, emerging markets with growing but volatile economies may offer significant gains but come with high risks. Alternatively, markets from developed countries have the least risk.
Scope for better market returns by capitalizing on multiple economies together
Can produce significant gains from emerging markets
Requires Constant vigilance to keep an eye on the social, political, and economic aspects of foreign countries.
Currency risk is present as currency volatility has a direct impact on the returns.
Example: Vanguard Emerging Markets Select Stock Fund
Fund of Funds
A Fund of Funds refers to a pooled investment fund that invests in other funds. Also known as a multi-manager investment, the portfolio of these funds consist of other different underlying portfolios that belong to other funds.
What assets does a Fund of Funds invest in?
A Fund of funds normally invests in hedge funds or mutual funds. Some Fund of funds can only invest in funds managed by its management company while others invest across the market.
Fund of Funds always tries to achieve minimal risk through diversification.
Helps in diversification
Allows investors with limited capital to take part
Fees may be high
There is difficulty in finding funds and qualified managers.
Overlap in holdings can take place
Example: Barclay Fund of Funds Index
With so many types of mutual funds available, investors might get confused when choosing a particular mutual fund. Ultimately, the decision depends on the investor’s goals and preferences, and the knowledge of the risks and advantages associated with each option.