Mutual funds have existed since the 1920's but their popularity and growth over the past 10-15 years have exploded. Today mutual funds are a top investment vehicle for both young and seasoned investors. There are currently over 8,000 funds to choose from and the list grows everyday. Buying into a fund is the easy part. Determining which fund is best suited for your financial goals takes a bit more work. In a nutshell, a mutual fund is an investment company which pools the money of many individuals who have similar investment goals thereby increasing diversification and reducing overall risks. By doing so, companies gain economies of scale which lowers the cost of investment research, portfolio management and buy and sell transactions. Mutual funds may be open-end or closed-end funds. The term "mutual funds" is used most often to mean open-end funds. - Open-End Fund
An open-end fund is a fund in which there are unlimited shares available to the investing public. When you want to put money into the fund, you can buy shares from your favorite broker or directly from the fund house. These shares are bought at the fund's Net Asset Value (NAV), or simply its total asset value minus liabilities divided by the number of outstanding shares. It is generally calculated daily.
- Closed-End Fund
A closed-end fund is similar to an open-end fund in most ways. However, it differs in that a limited number of shares are made available to the public when the fund is created. These shares trade on exchanges just like shares of stock. While the fund's price may be related to its NAV, it may often trade at a different value.
Different Types of Funds
There are thousands of different mutual funds designed to meet different goals and objectives. Most funds fall into three main categories: money market funds, bond funds and stock funds. Each category can be further subdivided. Stock Funds These funds invest primarily in common stocks of corporations to provide growth in value. They bring the stock market to the investor who does not have the time or ability to pick stocks or construct a portfolio. - Growth funds invest primarily in stocks of corporations that show potential for growth. They often forego paying dividends to their customers because growth companies reinvest their earnings instead of paying them out. Many invest in larger stocks and industries that have strong positions in their markets, stable earnings and good growth prospects.
- Aggressive funds invest in riskier, generally smaller cap stocks, that the manager believes will offer higher than normal returns in the future. These stocks will often have high price to earnings ratios and not pay dividends.
- Growth and Income Funds invest in larger, blue chip companies, which are well established in their industries. These companies offer some dividends as well as the potential of stock appreciation. They are more diversified than other types of funds.
Bond Funds
These funds invest primarily in bonds to provide income with safety of principal. They bring the world of bond investing to the small investor. Most bond funds are conservative focusing on payment of dividends. Investors can choose among several types: - Municipal bond funds invest in debts issued by state and local governments. Dividends are free from federal taxes
- Government bond funds invest in debts of the U.S. Government and its agencies. These funds include mortgage backed securities as well as bills, notes and bonds of the U.S. Treasury
- Corporate bond funds invest in debts issued by companies
- Junk bond funds (or high-yield funds)buy bonds with ratings that are quite a bit lower than high-quality corporate and government bonds. These funds have an added degree of volatility and risk of default.
| Money Market Funds
These funds invest in the short-term debt obligations of corporations, federal, and state governments and their subsidiaries. They bring these investments to the small investor for an initial investment as low as $500. Money market funds invest in Treasury bills, commercial paper, banker's acceptances, negotiable certificates of deposit, repurchase agreements and short-term debts of the U.S. Government. A fund's prospectus will list each investment and how much of it the fund owns. The returns on money market funds depend on the yields of their individual holdings. Money market instrument yields can fluctuate greatly. This causes the yields of money funds to fluctuate as well. Investors who hold money market funds can track the funds' yield changes in the financial pages of most major newspapers. Other Fund Types - Hybrid Funds do not specialize in a particular security. These funds are structured to meet an objective such as rapid growth, matching a market index, or investing in one area of the economy. They use combinations of securities to meet their goals.
- Income funds are structured to provide regular income dividends to their investors. Preservation of capital is a key concern. These funds invest in "income securities", including preferred stock, bonds, and money market instruments. Such securities yield relatively stable current income. They focus on paying dividends while de-emphasizing the growth in value of their portfolios, and are popular with those who want stable income.
- Index funds are for the investor wishing to keep his or her mutual fund's performance in line with "the market". These funds are made up of the securities that comprise major market indexes. The advantage of index funds is that they are always in line with their market index. Their downside is that they cannot outperform the market. Some funds divide their holdings evenly among the various stocks. Some use dollar weighting so that bigger companies comprise a larger share.
- Balanced funds seek to balance growth and income in one portfolio. To do this, they invest in common stock, preferred stock, bonds and cash equivalents. Hypothetically, these funds have a "balanced" ratio of these asset types. Managers of balanced funds can, however, shift this ratio one way or the other to take advantages of high interest rates or stock market growth. Balanced funds generally have low volatility and are popular with investors seeking current income with growth potential.
- International Funds invest in foreign markets. These funds may invest in large cap or small cap stocks or specific industries. Funds exist for regions of the world such as Southeast Asia, Europe or Latin America. They also exist for many individual countries. The details are discussed in their investment objective statements.
- Sector funds (specialized funds) usually limit their holdings (or at least 25% of its money) to one industry. They may choose industries like health care, high tech, or pharmaceuticals. They exist on the belief that certain industries will outperform the market as a whole. On the other hand, a downturn in an industry may affect all the companies in the portfolio.
- Socially responsible funds seek to combine social and ethical beliefs with investing. Many of them avoid investing in companies whose products and/or business practices they consider harmful. They may avoid investing in tobacco companies, the alcohol industry, weapons industries, companies that violate environmental protection laws, and companies with poor records of employee treatment.
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