There are many different types of mutual funds on the market. How do you know which one to choose? This post explores some of the different types of mutual funds available.
An equity fund concentrated mainly on the purchase of stocks. As there is such a variety of companies to invest in, one equity fund can be completely different from the next. Equity funds are mainly divided defined along two lines, the size of the companies it invests in, and the growth category their investments fall into. Each of these is divided into three sub-sections.
The sizes of the companies invested in are either Small Cap, Mid Cap, and Large Cap.
Small-Cap companies have market capitalisations ranging from $300 million to $2 billion.
Mid Cap companies have market capitalisations ranging from $2 billion to $10 billion.
Large Cap companies have market capitalisations above $10 billion.
Likewise, there are three growth categories. These are Value, Growth, and Blended.
Value Funds are focused on companies that are of high quality but have low growth prospects. They generally have low P/E ratios and pay dividends. Stocks in this category may have the potential for appreciation as they are undervalued by the market but have solid fundamentals.
Growth Funds concentrate on companies which are expected to have strong earnings growth. As such, they usually have high P/E ratios and generally don’t pay dividends. As earnings increase, so should the stock prices ensuring positive returns for the fund.
Blended Funds are exactly what they sound like, they offer a compromise and invest in both value and growth stocks.
Most equity funds combine two of the above attributes to define their investing style. For example, you may come across Small-Cap Growth Funds, Mid Cap Blended Funds, Large Cap Value Funds and any combination from the above options. Knowing what strategy a fund uses will help you to determine if it is a fit for you.
Fixed Income Funds
Fixed income funds are primarily concerned with bonds and debt. The fund generates income through bond coupons and interest payments which it passes onto shareholders. They may also actively buy and sell bonds, aiming to profit from undervalued bonds. Just like equity funds, fixed-income funds vary widely. Some funds will concentrate on low-risk governmental bonds while another may invest in high-risk junk bonds. It is important to know what sort of bonds a fund invests in before committing capital to it.
As is the case with bonds, bond funds are open to interest rate risk. Nonetheless, they offer an alternative to equity funds and should form a part of your portfolio.
Index funds are a popular choice here. They track an index like the S&P 500 or the FTSE 100 by holding all the same stocks in the same proportions. By tracking the index, they aim to closely match its performance. Index funds are passive, a fund manager does not choose when to buy and sell individual stocks. Because of their passive nature, they usually offer lower expense ratios than managed funds.
Exchange-Traded Funds (ETF’s)
ETF’s employ similar strategies to traditional mutual funds, but with one key difference. ETF’s can be actively bought and sold on the stock exchange. ETF’s can be traded during market hours, a far cry from the once-a-day valuations of the mutual funds. ETF’s have become increasingly popular over the last number of years, their liquidity and low cost make them an attractive alternative to mutual funds. As ETF’s function in the same way as stocks, they can be sold short, bought on margin and even traded as options.
Balanced funds invest in various asset classes across stocks, bonds, commodities or money market instruments. The aim is to reduce risk by diversifying across various asset classes. Balanced funds can come in one of two forms, fixed allocation and dynamic allocation.
In a fixed allocation fund, the proportion of each asset class is fixed. The fund strategy may dedicate 60% to stocks, 25% to bonds and 10% to money market securities with the remaining 5% staying in cash.
In a dynamic allocation fund, the fund manager has the scope to invest in whatever proportions he sees fit. If they feel like stocks offer the best potential for a return, they will dedicate a large portion of their resources to stocks.
Both fixed and dynamic funds can offer good returns, your choice will come down to personal preference. Some people like knowing that they will always have a certain percentage of their money invested in stocks, while others are happy to put their trust in the fund managers instincts.
Global funds spread their assets across various countries. They offer an investor exposure to different markets which may or may not be correlated with their home market. As with most investments, there are pros and cons to global exposure. There are risks involved when holding assets that are not in your home currency, along with political and country-specific risks but as we know from our post on risk, this can be positive or negative.
Money Market Funds
Money market funds invest in low-risk securities. The primary benefit of these funds is safety. Preservation of capital is paramount for someone using money market funds, as a result, the returns can be quite low. Money market funds typically invest in short term government bonds and the returns tend to be slightly higher than a typical savings account.
Speciality funds cover a range of funds that are typically focused on a narrow range of investments. They may focus on a specific country, industry or sector. Speciality funds forgo the usual benefits usually associated with mutual funds (diversification being the main one), but they offer investors a chance to target a specific area of interest. If you believe the financial sector is undervalued, a speciality fund that focuses on this sector may be right for you. Within this fund, there will be some diversification in terms of the number of companies owned, but it will be open to sector-specific risks.
Speciality funds also cover mutual funds that invest according to a specific ethos. Over the last number of years, socially responsible or ethical funds have become more prevalent. These funds typically avoid the tobacco industry, oil industry and weapons industry. They offer an ethical alternative to the socially conscious investor.