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 As you probably know, mutual funds
have become extremely popular over the last 20 years. What was once
just another obscure financial instrument is now a part of our daily
lives. More than 80 million people, or one half of the households in
America, invest in mutual funds. That means that, in the United States
alone, trillions of dollars are invested in mutual funds.
Originally, mutual funds were heralded
as a way for the little guy to get a piece of the market. Instead of
spending all your free time buried in the financial pages of the Wall
Street Journal, all you had to do was buy a mutual fund and you'd be
set on your way to financial freedom. As you might have guessed, it's
not that easy. Mutual funds are an excellent idea in theory, but, in
reality, they haven't always delivered.
The Definition
A
mutual fund is nothing more than a collection of stocks and/or bonds.
You can think of a mutual fund as a company that brings together a
group of people and invests their money in stocks, bonds, and other
securities. Each investor owns shares, which represent a portion of the
holdings of the fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3)
If fund holdings increase in price but are not sold by the fund
manager, the fund's shares increase in price. You can then sell your
mutual fund shares for a profit.
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.
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).
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.
Index Funds
The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA).
An investor in an index fund figures that most managers can't beat the
market. An index fund merely replicates the market return and benefits
investors in the form of low fees.
Conclusion
So, in todays article we have learned about mutual funds and their different types.Their are many advantages as well as disadvantages of mutual funds.You can classify funds based on asset class, investing strategy, region, etc.Mutual funds are easy to buy and sell. You can either buy them directly from the fund company or through a third party. But still mutual funds are believed to be very deceptive so be cautious while buying them!
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