Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.
A mutual fund is a pool of money collected from a group of investors. Managers use the fund’s money to purchase securities like stocks, bonds, and other assets. As an investor, you can buy into a fund and essentially own a portion of whatever the fund owns. You share in the gains and losses of the fund.
Mutual funds are some of the most popular investment vehicles for amateur and professional investors alike. They are accessible, easy to buy, and come with a healthy amount of built-in diversification.
The Different Types of Mutual Funds
There are more than 10,000 mutual funds in the United States alone. Each fund is different in terms of its hunger for growth and tolerance for risk. It would be impossible for you to comb through every mutual fund, but it’s important to know the basic types. Understanding these categories will help you build an investment portfolio that meets your needs and goals.
1. Money Market Funds
Money market funds invest in fixed income, short-term debt from banks, corporations, and governments. They might hold certificates of deposits (those CDs you can buy at your bank), U.S. Treasuries, and commercial paper (unsecured promissory notes issued by companies.)
These are considered one of the safest types of investments. However, their being low-risk means that the returns from these kinds of funds are typically lower.
A money market fund is a great place to park your cash when you aren’t sure where to invest. They’re low risk and generate more income than a traditional savings account. They’re also a fairly liquid form of investment, meaning it’s easy to sell your holdings to get your money back whenever you need it.
2. Fixed-Income Funds
Fixed-income funds invest in bonds and other securities that pay a fixed rate of return. The goal is to outpace inflation (which eats into your money’s buying power) and create a steady stream of dependable income with little risk.
Basically, owning a fixed-income fund means owning debt from parties highly unlikely to default, like massive corporations and governments. As such, these funds buy high-yield corporate bonds, investment-grade corporate bonds, and government bonds.
Fixed-income funds are popular because they are considered one of the safest kinds of investments (though no investment is completely safe). That said, their safety also means they have low income potential.
If you’re nearing retirement age, fixed-income funds are great tools to preserve your nest egg. They won’t explode in growth, but they come with low risk and will earn more interest than cash sitting in a savings. Fixed-income funds are also good investment vehicles for timid investors who really want to preserve their money.
3. Index Funds
Index funds track the performance of a specific market index, like the S&P 500, the Dow Jones Industrial Average, or the NASDAQ Composite. The index fund invests in all the companies in that index, so the value of the fund raises or lowers as the index goes up and down.
Index funds are passively managed. All the fund manager has to do is match the fund’s holdings with the index. He or she doesn’t have to do any research, perform any analyses, or even make any decisions. This means the fees of index funds are significantly lower than other actively managed funds (like equity funds or specialty funds). Lower fees means more of your money gets invested back into the fund to grow.
Furthermore, actively managed funds may only invest in 25 or 50 securities, but index funds are highly diversified. Index funds often invest in hundreds of securities—possibly thousands!—in various industries and sectors. More diversification means less risk.
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4. Equity Funds
Equity funds (also known as stock funds) purchase shares in publicly traded companies. Their goal is to grow faster than fixed-income funds, money market funds, or index funds. Keep in mind, however, that aggressive growth also creates more risk.
Buying equity funds is a safer way to invest in the stock market than purchasing individual shares of a company. It also doesn’t require extensive research. Whereas stock value will rise or lower depending on the company’s value, an equity fund will more closely track the broader market.
Generally, it’s smart to invest in equity funds when you’re younger because you have the time to weather a bad year (or several). You’ll want to move your portfolio away from equity funds as you get older to preserve your savings.
There are countless varieties of equity funds, and they can be structured any way a fund manager likes according to the goals of the fund.
Funds based on company size:
These are funds that focus on a company’s market capitalization, or the market value of a publicly traded company’s outstanding shares. A fund may only invest in small-cap companies, only large-cap companies, or it may invest in a predetermined formula (i.e., 50% mid-cap and 50% large-cap companies).
Funds based on industry or sector:
These are funds that invest in a particular industry, like healthcare, manufacturing, or technology companies. If you wanted to invest in Tesla, for instance, you might invest in a fund for auto manufacturers. This would make you an investor in a hot company, but also spread out your risk.
Funds based on growth and value:
Some funds focus on companies its managers think are undervalued and will have better-than-average returns. This is a particularly aggressive type of fund. It’s also expensive because it requires active management by expert investment managers.
Funds based on location:
These are funds that invest in companies based on their location. A fund might invest in Western European companies, or companies specifically in Ireland.
Funds based on emerging markets:
These are funds that target countries with small, but growing markets. Their goal is to buy in a market when things are cheap and sell them when the market matures.
5. Balanced Funds
Balanced funds are sometimes called asset allocation funds. They mix fixed-income securities and equity securities together. The goal of this kind of fund is to get better returns than fixed-income funds without taking on as much risk as an equity fund requires.
Generally, these funds follow a formula to determine how much they invest in different kinds of securities. For instance, a conservative balanced fund may invest 80% of its funding into bonds and the remaining 20% into stocks. An aggressive balanced fund may go after more growth by investing up to 70% of its funding in stocks.
Target-date funds are a popular type of balanced fund popular with novice investors. Essentially, a target-date fund grows with you over time by rebalancing your portfolio every year. The target date is the year you intend to retire. The fund starts off aggressive by allocating more money into stocks and grows conservative over time by slowly switching to bonds.
6. Specialty Funds
Specialty funds are sometimes called alternative funds. This is a catch-all category for funds that adhere to a specific mandate. It includes hedge funds, real estate investment trusts, commodities, and managed futures.
In many cases, specialty funds aren’t open to the public. You can only invest into them if you work with a specific investment bank or manager.
Specialty funds can specialize into anything they want. Some specialty funds focus on a cause, like environmental preservation, social responsibility, or healthcare innovation. A specialty fund might only invest in companies who power themselves with renewable energy and avoid companies that rely on fossil fuels.
Some specialty funds refuse to specialize at all. They simply invest in whatever’s a good deal at the time. They might buy options one week and wade into currencies or futures or derivatives the next. It often depends on what the managers know well.
A fund-of-funds is just what it’s name implies: A fund that invests in other funds. This is the ultimate form of diversification. By investing into a single fund-of-funds, your holdings could spread across tens of thousands of securities. This makes your return less volatile, as well. You’re less likely to lose money.
A fund-of-funds can also allocate assets based on its own goals. Some are aggressive by investing in other funds that focus on stocks, while others are more conservative by investing in funds that focus on bonds.
The safety of a fund-of-funds comes at a price, however. A fund-of-funds needs to be actively managed, which costs a fee on top of the fees you pay to the other funds you invest in. Essentially, you pay double for this level of diversification.
Which Type of Mutual Fund is Right for You?
The right mutual fund for you depends on your goals and interests. Before you invest in a fund, make sure you understand how it works and that the fund’s goals match your own. Most importantly, make sure you’re comfortable with the fund’s level of risk.
And as always, don’t dump your entire savings into a single fund. Diversify your portfolio to protect yourself from catastrophe.
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