Categories of Mutual Funds for Online Investors - dummies

Categories of Mutual Funds for Online Investors

By Matt Krantz

Because you find more mutual funds than stocks, it’s probably not too surprising that you also find many types of mutual funds. Mutual funds at their most basic level come in four basic flavors: those that invest in stock funds, bond funds, money market funds, and hybrid funds. But if you drill down, you find even more categories.

Stock funds

Stock funds invest in shares of publicly traded companies. These funds typically go for large gains by pursuing one of a number of strategies:

  • Growth funds are filled with shares of companies that investors generally expect to expand their earnings the fastest. Portfolio managers of actively managed growth funds are typically willing to pay higher valuations for growth stocks because they think the companies are worth it. Growth index funds buy shares of companies that have the highest valuations, often measured by the price-to-book ratio.

    If you’re young and retirement is still years off, many experts advise to invest in growth funds. The trouble, though, is that academic studies have shown growth funds, including growth index funds, tend to own the most overvalued stocks. That means they tend to have lower future returns and higher risk than value funds that own less glamorous stocks.

  • Value funds own companies that are generally out of fashion or considered to be ho-hum and mature by Wall Street. Actively managed value funds are constructed by portfolio managers trained to look for undervalued stocks, or stocks that sell for less than what they’re truly worth. Value index funds generally own stocks that have the lowest valuations.

  • Income stock funds seek to invest in companies that pay fat dividends, such as utilities and real estate investment trusts (REITs). Income stock funds aren’t looking for stock price appreciation alone.

  • International funds invest 80 percent or more of their money in companies located outside the United States. Some international funds concentrate on specific areas of the world, such as Europe or Japan. Yet others, called emerging market funds, focus on up-and-coming parts of the world.

  • Global funds invest in companies in any part of the world, including the United States.

  • Sector funds pick specific industries investors often like to invest in, such as technology, energy, and utilities.

Bond funds

Bond funds own diverse baskets of bonds, which usually have similar characteristics. Bond funds are generally seen as a way to reduce risk because they collect income from a variety of borrowers. If one borrower defaults on the loan, you own many other bonds and aren’t wiped out. You find many types of bond funds. The main ones to know about are the following:

  • Government bond funds tend to invest in debt issued by the U.S. government. These funds usually invest in Treasurys that mature in the short term, intermediate term, or long term, or a blend of each.

  • High-yield bond funds, nicknamed junk bond funds, generate higher returns by investing in debt issued by companies with shakier finances. The overall risk is reduced by spreading the investment over many companies’ debt.

  • Corporate bond funds own bonds issued by large companies. Their yields are generally higher than those paid by government bonds but less than high-yield bonds.

  • Municipal bond funds invest in debt issued by state and local governments. These bonds can be attractive because they’re usually not taxed by the federal government.

Money market funds

Money market funds are a great place to park cash you might need at short notice. They invest in very low risk short-term Treasurys issued by the federal government or IOUs from banks. Money market funds can be great places to get a decent return on cash you’ve set aside for emergencies.

Money market funds are supposed to be super-safe places to park cash. The price of a money market fund is supposed to be rock solid and always $1 a share. But like many things that were supposed to be true, but weren’t, the financial crisis that erupted in 2007 and 2008 called into question the safety of money market funds.

Hybrid funds

Hybrid funds blend aspects of all the types of funds in the preceding sections into a unique package that suits some investors. Some examples include the following:

  • Balanced funds split their portfolios into a preset mix of bonds and stocks. Investors who want to diversify their holdings between stocks and bonds can in theory just buy one of these and leave it up to the portfolio manager.

  • Target date funds are an increasingly popular type of investment where you tell the mutual fund company how old you are and it determines the right mix of investments for you. You literally don’t have to do anything. These types of funds automatically split your money into a preset blend of stocks and bonds.

    As you age and your appetite for risk declines, the funds automatically shift your portfolio to be more weighted toward bonds and away from stocks.

  • Fund of funds are mutual funds that buy other mutual funds. The idea is that these funds can assemble a collection of mutual funds so that you don’t have to.