An Overview of the Different Types of Mutual Fund
Mutual funds can be characterized by investment objective, types of securities, and by geographic coverage.
Money Market Mutual Funds
Money market funds are all no-load funds, and pay dividends daily, though they may only be credited monthly. Their income generally reflects short-term interest rates, because by law, their investments are restricted to certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments. According to SEC Rule 2A-7, a 1997 addition to the Investment Company Act of 1940, money market funds shall limit their portfolio investments to those United States dollar-denominated securities that the fund's board of directors determines to present minimal credit risks.
Net asset value (NAV) is maintained at about $1.00 per share, which is possible because these funds pay out all their income as dividends. But the NAV may fall below $1.00 if the fund's investments perform poorly. Most of them have check-writing privileges, though there may be a minimum amount for the check. Taxable funds buy higher yielding short-term corporate or federal issues. Tax-free funds buy municipal debt.
Money market funds have low risks, but unlike money market bank accounts, money market mutual funds are neither insured nor guaranteed by the FDIC. Historically the returns for money market funds have been lower than for either bond or stock funds. That's why inflation risk — the risk that inflation will outpace and erode investment returns over time — is a risk with these funds. Capital losses have been rare, but are possible.
Index funds buy stocks or other assets that compose a particular index, such as the S&P 500, and the percentage of each asset purchased is usually proportional to the weight of that asset in the index so that the fund accurately tracks the index. Index funds are considered a good investment because few funds beat the indexes, and fees are minimal since trading, and its cost, is restricted to tracking the index.
Bond funds are based on bonds, but they have no maturity date and no guarantee of repayment of principal. Bond funds benefit investors because the initial investment is less than the minimum $5,000 or more for bonds, and, like other funds, it allows easier and greater diversification by having a collection of different bond types, such as investment-grade corporate, junk, government, sector, international, gold and precious metals, and other categories; and different bond maturities.
In some funds, management is free to change categories as the changing markets warrant.
Taxable funds buy corporate and federal bonds.
Tax-free funds buy municipal bonds. No federal tax, and no state or local tax if investor lives in the municipality.
Although bond funds are generally safer than stock funds, they do have risks:
- Credit risk is the risk that issuers whose bonds owned by a fund may fail to pay their debts. Such risk is inversely related to the credit rating of the issuer. Thus, there is virtually no credit risk with U.S. Treasuries, little risk with investment-grade bonds, and great risk with junk bonds.
- Interest-rate risk arises from the possibility that interest rates will rise, thereby decreasing the value of bonds in the secondary market. Such risk can even reduce the value of Treasury bonds. The longer the bond term, the greater the risk. However, since interest rates don't vary that much, this risk is relatively small compared to the price swings of stocks.
- Prepayment risk increases as interest rates decline, increasing the likelihood that the bond issuer will call the bond in early to issue new bonds at the lower prevailing interest rate. Although, like interest rate risk, this risk is minor, it will lessen a fund's future income, unless the company is willing to buy bonds with a higher credit risk.
Although a stock fund's short-term value is volatile, because prices depend not only on the economy, but also on the underlying business, stocks usually outperform other types of investments over the long term.
Different kinds of stocks are chosen for their risk and potential profit:
- Income funds invest in stocks that pay regular dividends.
- Index funds buys stocks in a particular index, with the proportion of each stock proportional to the weight of that stock in the index.
- Blue-chip funds provide income and relative safety compared to small-cap stocks.
- Growth funds have a greater chance of significant appreciation, because they are based on small-cap, undervalued, or out-of-favor companies.
- Value funds are based on companies that some believe are undervalued, and thus, have a greater appreciation potential and greater safety.
- Cyclical funds invest in stocks that rise and fall with the economic cycles. Some businesses are heavily dependent on discretionary spending, such as airlines and hotels. When the economy is strong, these businesses do better as more people spend money for luxury items, thus, their stocks rise; when the economy is weak, people cut back on spending that isn't necessary, thus lessening the earnings of these businesses, and reducing their stock prices.
- Sector funds invest in a particular industry, such as the medical field or technology. The increased potential for returns is proportional to the increased risk that results from limited diversification in a volatile investment.
There are actually 4 different kinds of international funds.
Global funds invest both in the United States and in other countries, but most investments are usually in U.S. companies.
Overseas funds invest only in other countries.
Regional Funds — Country Funds
Regional funds invest in a specific region of the world, such as Asia, Europe, or Latin America.
Country funds invest in a specific country.
Regional and country funds can profit from fast-growing economies, such as India or China, but there is a currency exchange risk and political risk. If the dollar increases in value, the value and profit of a foreign investment will decrease, and vice versa. Political turmoil will decrease the value of any investment in that country by increasing risk and reducing demand for its equities.
Special Funds — Tax-Free Funds, Sector Funds, Green Funds
Tax-free funds invest in the bonds of state and municipalities, which are generally tax-free for residents. The rate of return is generally lower than taxable returns, and it is best for high-income people who live in high-tax states, such as California and New York. However, investment opportunities are limited.
Sector funds invest in a particular sector of the economy, such as health care or technology. Lack of diversification in other sectors can yield higher profits, but at a greater risk of losses. Precious metal funds invest in mines and bullion, which is generally more stable than the typical sector fund.
Green funds invest in environmentally friendly companies. These funds are not tracked as a sector fund, nor do they generally do as well as other funds, because returns are not the only consideration.
Asset Allocation Funds
Asset allocation funds give complete liberty to the investment advisor as to how the fund can be allocated among assets, such as money market funds, stocks, bonds, options, and tangible assets, such as precious metals or real estate. This gives the advisor the greatest freedom to respond to market conditions, and to develop a strategy for maximum profits.
Designed to build a retirement income, target-date mutual funds (also, life-cycle funds) are funds of funds—including stock, bond, real estate, and international funds—where the mix of funds becomes more conservative as the target date approaches. Some funds include international and real estate funds to provide diversification from stocks and bonds. The most popular target date currently is 2015-2029. Greater than 90% of these funds are in retirement accounts.
More than 80% of the money in target-date funds is managed by 3 mutual-fund giants: Fidelity Investments, Vanguard Group, Inc., and T. Rowe Price Group, Inc.
Some example asset mixes: Vanguard funds start with a 90% stock and 10% bonds mix; at the target date, the mix becomes 50%- 50%. Barclays LifePath funds start with the same mix but end up with 35% stocks and 65% bonds at the target date. Details of any fund can be found in its prospectus.
Expense ratios range from 0.21% of assets for Vanguard Target Retirement 2035 Fund to 1.25% or more, for other funds. Note that these expenses are to manage the target-date fund itself, and do not include the expense ratios of the underlying stock and bond funds.
The name quant comes from the root word of quantitative, which describes the primary method that quant funds used to generate profits: letting computers determine what stocks to buy and sell, and when, based on quantitative measures of desirable stock characteristics, such as price-to-earnings, price-to-book, price-to-sales, and other ratios. Computers are also programmed to look at fundamental values, risk potential, and momentum. Because computers—not managers—select the trades based on specific algorithms, emotion is not a factor, and expense ratios are typically less than 1%. Minimum investments are usually $2,500 or $3,000. Some examples of quant funds are the Schwab Core Equity (SWANX), and INTECH Risk-Managed Stock (JRMSX) funds.
These funds, recently created as a new type, are being marketed as a way to earn what they are calling "absolute returns"—a marketing term, not a guarantee. The name probably stems from the fact that absolute numbers are always positive. Their goal is to produce positive returns every year, regardless of the financial markets, by using many of the techniques employed by hedge funds—investing in foreign currency and commodities in addition to buying stocks and bonds, and using options, swaps, arbitrage, and selling short, which are strategies for making money when the financial markets are declining. The drawback to this approach is that while these funds may do better in bear markets, and may, indeed, produce positive returns every year, they probably won't perform as well as other funds in a bull market because their use of opposing strategies diminishes their returns. To illustrate, the CSFB/Tremont Hedge Fund Index has continually risen since its inception in the early 90's, but it didn't do as well as the S&P 500 in the bull market of the late 90's, but it continued to rise even as the S&P declined substantially after March, 2000. Some example absolute-return funds: Rydex Absolute Return Strategies A (RYMQX) and Rydex Absolute Return Strategies H (RYMSX). Minimum investment is typically $25,000 or more.
Earnings-momentum, sometimes called profit-momentum, funds buy stocks of companies that are growing more rapidly than the market average, and that have a good earnings forecast by Wall Street analysts, which is often supplemented with the funds' in-house research. When a company ceases to have increasing earnings, it is sold by the funds, which increases turnover of the funds' portfolio, and increases expenses and taxes for the investor. Furthermore, because fast-growing companies are frequently concentrated in particular sectors, these funds are less diversified than most, and thus have more risk. However, when the stock market is rising, these funds tend to do best of all, but when the stock market drops, these funds drop more than most. Typical examples include American Century Vista (TWCVX), which buys mid-cap growth stocks, and N/I Numeric Investors Emerging Growth (NIMCX), which emphasizes small growth companies.
Qualified Dividend-Paying Stock Funds
Dividend-paying stocks generally don't yield as much as bond funds, but they do have a greater potential for capital appreciation, and with qualified dividends, the top tax rate for the dividend income is 15% for most investors, and only 5% for people in the 2 lowest tax brackets. As an example, Goldman Sachs Growth and Income Fund is currently yielding about 1.5%, but its gains, with stock appreciation, through October 31, 2006 is 17.84%.
Because funds of other countries pay higher dividends than in the United States (S&P 500 average: less than 2%), many stock funds buy qualified foreign stocks paying 5% to 7%. Alpine Dynamic Dividend Fund, for instance, had a yield of 12.6% through October 31, and a total return of 14%.
The preferential tax treatment, which will expire in 2010 unless renewed by Congress, applies only to dividends paid by many United States and foreign companies, not to cash distributions earned through other investments of the mutual fund, such as earned interest, even if the fund holds mostly qualified dividend-paying stocks. The mutual fund will designate which earnings are qualified dividends on the Form 1099-DIV.
Qualified Dividend Holding Periods
In general, to qualify for the lower tax rates, the taxpayer must hold the dividend-paying stock for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date – the first date that the buyer will not be entitled to receive that dividend. This same condition applies to qualified dividends paid out by mutual funds—the shareholder must have owned the mutual fund shares for a 61-day period that included a payment of dividends. A similar holding period exists for preferred stock dividends attributable to a period exceeding 366 days. This holding period is at least 91 days during a 181-day period beginning 90 days before the ex-dividend date. More info: Taxation of Ordinary and Qualified Dividends
Mutual funds, other regulated investment companies, and real estate investment trusts that pass through dividend income to their shareholders must meet the holding period test for the dividend-paying stocks that they hold in order for corresponding amounts that they pay out to be reported as qualified dividends on Form 1099-DIV. Investors must then meet the test relative to the shares that they hold directly, from which they received the qualified dividends that were reported to them.