With the different types of mutual funds to choose from there’s a good chance you’ll come across one that you didn’t know about. It just might be a perfect fit for your portfolio…or not. You’ll never know unless you understand the basic types of mutual funds available.
Mutual funds are broken down and categorized by the fund’s investment objectives. The name usually gives it away, but you can find this detailed in the fund’s prospectus. You should be reading the prospectus anyway before investing in a fund.
Nowadays, there is some semblance of structure to fund names. It’s like taxonomy in biology (only easier and less Latin), where the fund type or category is built into the name. You’ll find this mostly with index funds. When you see Large Cap Dividend Fund you know the asset class and investment style. It’s boring but it works.
It also makes it easier to build a portfolio when the fund names fit the categories in most asset allocation models. Plus, it’s a lot easier to find and compare funds when you use a mutual fund screener.
But not all fund companies follow this structure. In the early days of mutual funds, the fund companies did a terrible job naming their funds. Most names told you nothing about the funds investment objectives. So you had to dig into the fund prospectus to find out. The Fidelity Magellan Fund is the perfect example. It was a rock star fund back in the 90’s, yet its name tells you nothing about how it invested your money (based on the name, you’d think your money was going a trip with a slim chance of returning).
As long as you understand the different types of fund categories – you’ll know how a fund invests your money, the risks involved, and how it fits in your portfolio. Most of the funds you run across will fall into at least one of the categories below.
Mutual Fund Types
To start, there are two types of mutual funds – index funds and actively managed mutual funds. Both can be divided into four main categories: money market funds, equity funds, bond funds, or some combination known as a hybrid fund. In addition, there are alternative or specialty funds that fall into multiple categories. From there, each can be divided further into subcategories based on the funds investment objectives.
Money Market Funds
Money market funds fit the cash portion of a portfolio. It’s a highly liquid fund that invests in short-term treasuries, CDs, and other short-term bonds. These are low risk funds that offer a low return that is slightly higher than a savings account.
Stock or Equity Funds
Value funds focus on stocks that are undervalued in price. The active value fund managers will choose stocks based on their value investing strategy. Index based value funds will overweight stocks based on specific ratios like book value, p/e ratio, and price/sales.
Growth stock funds put an emphasis on capital appreciation over income from dividend paying stocks and based on a growth investing strategy. These funds invest in stocks of faster growing companies. Growth index funds will overweight stocks based on momentum, revenue growth, and growth in earnings to price. In return, these funds have higher risk, higher volatility, and higher capital gains.
Aggressive Growth Funds
Aggressive growth funds have a single goal of the highest capital appreciation possible. These are growth funds turned up to eleven and are very high risk, high reward investments.
Blend funds invest in a combination of growth and value stocks.
Market Cap Based Funds
Some of the more popular stock funds are broken down by a company’s market cap. By breaking stocks down by market cap, you can invest in a basket of companies in similar points in the business growth cycle. This allows you to take more or less risk depending on which market cap fund you choose.
- Small Cap Funds – invest in companies with a market cap of $2 billion or less.
- Mid Cap Funds – invest in companies with a market cap from $2 billion to $10 billion.
- Large Cap Funds – invest in companies with a market cap over $10 billion.
Stock dividend funds put an emphasis on income through dividend paying stocks over capital appreciation. These funds typically have lower risk, lower volatility, and less capital gains than other equity funds and can be combined with a number of other types of mutual funds to tweak the investment objective and adjust the risks and returns.
Defensive stock funds focus on companies involved with selling consumer staples. These are everyday things you would buy regardless of where the economy is headed – things like food, soap, or toothpaste.
Cyclical stock funds invest in stocks of companies that sell consumer discretionary items. These are things like cars, restaurants, hotels, vacations, and furniture. All the stuff you’d buy with extra spending money. These funds tend to move in the same direction as the economy.
International equity or foreign equity funds invest in non-U.S. stocks. These funds can take on a variety of combinations with other fund categories like market cap, region, sector, etc. Each combination has unique risks and rewards.
Emerging Markets Funds
Emerging market equity funds specifically focus on investing in stocks from the faster growing developing countries. These funds typically have higher risks with higher returns.
Global equity funds aren’t limited by country or region and will invest in stocks from everywhere around the world.
Fixed Income or Bond Funds
Duration/Term Based Funds
Many bond funds are built around a duration or timeline. These funds will invest in bonds with maturities that match that timeline. So a short-term bond fund will buy short-term bonds and so forth.
- Ultra Short Term Funds – invests in bonds with a maturity of three months to one year.
- Short Term Funds – invests in bonds with a maturity of one year to three years.
- Intermediate Term Funds – invests in bonds with a maturity of three to six years.
- Long Term Funds – invests in bonds with a maturity of more than six years.
High Yield/Junk Funds
High yield bond funds or junk bond funds invest in corporate bonds that are below investment grade. These bonds pay a higher yields to offset the lower credit rating, but bring along higher risks.
Tax Exempt Funds
Tax exempt bond funds invest in municipal bonds to take advantage of the tax-free income. Municipal bonds are exempt from federal taxes. Some are even exempt from state and local taxes. These funds are best used in a taxable account.
Bank Loan Funds
Bank loan funds invest in loans that banks make to companies. These loans have floating rates that are tied to interest rate changes. That means less volatility for the fund but it comes with a higher credit risk.
International bond funds invest in non-U.S. corporate and government bonds. There are a wide array of possibilities from investing in high quality bonds from developed countries to low quality debt in specific regions.
Emerging Markets Funds
Emerging markets bond funds focus on investing in debt from faster growing developing countries. These funds usually have higher yields but come with higher volatility and risks.
A global bond funds is exactly what the name implies. It invests in bonds from anywhere around the world. Unlike international bond funds, a global fund will include U.S. based bonds too.
Balanced funds invest in a combination of stocks and bonds with the goal of reduced risk and preservation of capital. Most balance funds stick to a specific mix of stocks to bonds, like 60/40. That’s would be 60% of the fund invested in stocks and 40% in bonds. The prospectus will tell you exactly how the fund is divided up.
Tax Advantaged Funds
A tax advantaged mutual fund is also known as tax managed funds or tax efficient funds. The fund will invest in stocks and/or bonds with a goal of a high after tax return based on a tax efficient investment strategy.
Target Date Funds
A target date fund is a fund of funds. Also known as a life cycle or age based fund, it uses several funds to build an asset allocation with a specific time frame or target date in mind. The funds allocation changes as you grow closer to the target date. Most target date funds are promoted towards retirement and college savings.
Closed End Funds
Closed end funds are actively managed mutual funds with a fixed number shares. These funds then trade on the exchanges like regular stocks and present similar opportunities as well. For instance, an investor might look for closed end funds trading below its NAV or net asset value. Find out more about how closed end funds work.
Sector funds invest in stocks of companies that make up a specific section of the economy. For instance, a utility fund would invest in utility companies or a technology fund would invest in tech companies.
Commodity funds don’t invest in real commodities, rather it invests in companies that produce commodities. An oil mutual fund would invest in stocks of oil companies. A gold mutual fund would invest in gold miner stocks.
Regional funds focus on invests in specific geographic areas. These are usually broken down by continent, country or state. Often times you’ll see regional funds combined with another fund type like California Tax Exempt Bond Funds or Brazil Growth Fund.
Socially Responsible Funds
Socially responsible funds add an ethical approach to investing. There are several areas these funds invest in. One fund might avoid sin stocks like alcohol, tobacco, and gambling companies. Another might focus on environmentally friendly companies.