Types of Mutual Funds

You've made the decision to invest in mutual funds. Now what?

For starters, you need to consider the asset allocation of your portfolio, dividing your assets among stocks, bonds and cash. Only now, you're talking about stock funds, bond funds and money market funds.

Let's start with the stock funds. Here is a list of common types:

  • Strategy funds invest in either growth stocks, value stocks or a blend of both.
  • Funds may invest according to size or market capitalization. These are usually combined with a strategy. For example, large cap value funds invest in stocks with a market capitalization greater than $10 billion and price-to-earnings and price-to-book ratios less than the industry average for that stock.
  • Some international funds invest exclusively outside of the U.S. and some allow for investments within the U.S. There are also country-specific funds as well as emerging market funds, which invest in up and coming new economies like Russia and China.
  • You have mutual funds that invest in the market indexes themselves. This is often referred to as passive investing.
  • Lastly, there are those that invest in specific industries or sectors of the economy. A popular sector these days is energy, due to rising oil prices.

The average stock fund holds 140 companies within its portfolio, so diversification is not an issue. As a result, it makes little sense to own more than a few funds in the stock portion of the portfolio. Given the U.S. accounts for approximately 50 percent of the world's market capitalization, it follows that 50 percent of the holdings are invested in U.S. funds. The remainder should be invested in international funds or international index funds. The choice is yours.

Now we'll take a look at the four types of bond fund:

  • The first and possibly most attractive bond fund invests in tax-exempt bonds issued by municipalities and state governments. Because they aren't taxable, their yields can be lower than other bonds and still receive an equal amount of after-tax income.
  • There are bond funds that invest exclusively in the debt obligations of U.S. corporations. The risk with this type of bond is the financial health of the companies in question, which is all the more reason to hire professional investment management for this portion of your portfolio. Let the pros do most of the heavy lifting. That's what they're paid for.
  • Residential real estate has done quite well in the last few years. As a result, more and more funds have been created investing in large pools of residential mortgages. Commonly referred to as mortgage-backed securities, it's an excellent way to produce fixed income in the real estate market without being hands on.
  • The last type of bond fund is those issued by the U.S. government and backed by the assets of the U.S. treasury. This is generally considered to be the most risk-free of the four.

You need to be aware of two other points when looking at bond funds: the duration of the maturity and the credit quality. Bonds are usually classified as short-term, intermediate-term or long-term. Short-term is anything less than three and a half years. Intermediate-term is between three and half and six years, while long-term are maturities greater than six years. As for credit quality, those with AAA or AA ratings are the highest. Anything from BBB to AA is considered medium quality and those less than BBB are low quality and to be avoided under most circumstances.

Lastly, we'll have a brief look at money market funds. These are used to park money that you're not using to invest in either stock or bond funds. Generally they invest in short-term corporate and government debt. While the interest paid on this type of fund is often higher than most savings accounts, you'll want to keep in mind inflation risk when investing in these funds.

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