With so many different types of mutual funds to choose from, you may be wondering how they differ from one another and which kind is best for you. This guide will help you navigate some of the most common terms you'll encounter when shopping around for mutual funds.
What are mutual funds?
Mutual funds are companies that pool together money from individual investors and invest it in professionally managed portfolios of securities like stocks, bonds, money market instruments, and other assets.
Mutual funds are one of the most popular ways to invest because of their liquidity, affordability, and diversification. Diversification means your money spreads across different types of investments, which lets investors choose an investment portfolio based on their particular goals, level of risk tolerance, and personal values. Affordability refers to the fact that some funds have low costs to begin investing, and liquidity means these investments easily convert to cash.
When you buy shares of a mutual fund, you get a portion of the fund's profits or losses. A fund's Net Asset Value (NAV) determines how much you pay for your shares. The NAV is equal to the fund's total assets, minus its total liabilities, and divided by its total number of shares. NAVs are updated every day, and you're free to redeem your shares at any time at the newly established daily price. You might incur a fee if you cash out too early, though.
In addition to the profit you can make from selling your shares, a mutual fund can also generate income from dividends or interest. These are referred to as a fund's yield, expressed as a percentage of the per-share NAV. Your mutual fund’s yield can either be paid back to you as a check or reinvested into the fund.
Every mutual fund publishes a prospectus detailing its investment objectives and strategies, as well as information on the fund's past performance, fund managers, NAV, interest rates, and yield. The prospectus is your go-to document to find out everything you need to know about a given mutual fund before you buy.
Main Types of Mutual Funds
Mutual funds are divided into different categories according to their different types of asset allocation. You can distinguish between different kinds of mutual funds based on their asset classes, their investment objectives, and the type of returns they seek.
There are four main types of mutual funds:
- Equity funds
- Fixed-income funds
- Money-market funds
- Balanced or hybrid funds
Equity funds (stocks)
Equity funds are the most common mutual funds. Equity portfolios invest in a collection of different, publicly-traded company stocks, and the NAV of the fund follows the value of the stocks it contains. These kinds of funds often have higher returns but also more potential volatility.
Equity mutual funds can further be divided into subcategories based on the size of the companies they invest in, the sector or industry that is focused on, whether the fund is value- or growth-oriented, and the geographic location of the investments.
- Company size: Large-cap funds invest in companies with a market value of ten billion dollars or greater, mid-cap funds in companies worth two to ten billion, and small-cap funds in companies worth between 300 million and two billion.
- Industry/sector: Some mutual funds focus on a particular sector or industry, like technology, energy, medicine, or transport. Many mutual funds now also offer socially and environmentally responsible funds for those who want their money to work toward those types of goals.
- Growth vs. value: Growth funds invest in well-established companies that have a proven track record. The idea is that these companies will continue to grow at a steady rate, guaranteeing a respectable return on investment. They also offer a higher yield.
Value funds, on the other hand, seek out companies that portfolio managers believe are undervalued. By getting in on the ground floor, investors hope to profit when the company's value increases.
- Geographic location: Funds can also be grouped based on geographic location. International funds focus their investments on companies outside the U.S., while global funds buy into companies both in the U.S. and abroad. Emerging market funds target countries that are developing new markets.
Fixed-income (bond) funds
Unlike equity funds (which vary in value according to the stocks they contain), fixed-income bond funds pay their investors a fixed amount over time. They do this by investing in debt-based instruments like government or corporate bonds and treasury bills. The interest accrued on these debts then goes to the investor.
Fixed-income funds offer less potential growth than equity funds but they’re also safer. They’re ideal for retirement plans or for more risk-averse investors who want to use their money in the short term.
Money market funds (short-term debt)
Money market funds are a slightly different type of fixed-income fund and are the safest kind of mutual fund. They invest in high-quality, short-term debt issued by the U.S. government, U.S. corporations, and state and local governments. These offer lower interest returns but also less risk.
Hybrid funds, as their name suggests, are a combination of equity and bonds. The ratio between each type of asset is customizable depending on the investor's objectives. For example, an asset allocation that favors equity over bonds will generate more potential growth but at slightly higher risk (and vice versa).
Hybrid funds, also known as balanced funds, can take the form of target-date funds, which automatically reallocate their assets from equity to bonds over a given amount of time. That means they generate more income early on and become safer as time progresses.
Other types of funds
Index funds are pooled investments that follow a particular market index, such as the Dow Jones Industrial Average (DJIA), the S&P 500 Index, or the Nasdaq Composite Index. A market index is a hypothetical portfolio of investments that gauges the overall financial health of a particular market segment.
Index funds are a passive type of investment, which means that a financial advisor does not actively manage them. Instead, they're built using a set of rules that decide which stocks (or bonds) are included.
Exchange-traded funds (ETFs)
ETFs are similar to index funds because they contain various assets that track a given sector or commodity. But unlike mutual funds, ETFs can be traded on the open market like stocks, and their prices fluctuate throughout the day.
Open-end vs. Closed-end funds
Mutual funds can also vary based on their structure and how they’re sold to investors.
Most mutual funds are open-ended, so there is no limit to the number of shares bought or sold. (Selling shares can also be referred to as “redeeming” shares.) The price of an open-end fund is determined by its NAV, and when an investor decides to redeem their shares, the fund repurchases them using cash on hand or by selling off investments.
Unlike an open-end fund, a closed-end mutual fund issues a fixed number of shares through an initial public offering (IPO). Once the shares are sold, the offering is closed. The shares can then be bought and traded on a stock exchange, and their price varies throughout the day according to supply and demand without necessarily tracking the fund's NAV.
The bottom line
When you consider the liquidity, affordability, and diversity of most mutual funds, it's no surprise that they're one of the most popular ways to invest. You might find the number of different choices a bit intimidating, but if you take the time to get informed and shop around, you're almost guaranteed to find the right mutual fund for your investment objectives.
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