Generally, mutual funds work the same as stocks and bonds when it comes to returns and risks. Investors seeking higher returns must take on higher risk of loss on their investments. Mutual fund investors can select funds with fewer risks compared to others, but investors cannot eliminate all risks.
Investors have an option of selecting from three categories of mutual funds: equity funds (stock funds), fixed-income funds (bonds) and money market funds. Other types of mutual funds, such as asset allocation, growth or specialty funds consist of some variant of the three primary classes of mutual funds.
Types of Mutual Funds
Equity Funds: Stock funds represent the largest category of mutual funds. Usually, equity funds have a dual mission of long-term capital growth and income. The industry subdivides equity funds according to the size of the companies selected for a fund’s portfolio and the investment style of the fund’s professional managers.
Value funds invest in high-quality firms with low price/earning ratio, price-to-book ratios and pay high dividends. A growth fund focuses on strong growth of sales, earnings and cash flow.
Bond Funds: Investors looking for a consistent cash flow purchase bond funds. Sometimes called fixed-income or income funds, these funds invest primarily in government bonds and corporate bonds. Income funds have the primary objective of providing a consistent cash flow to investors.
The appreciation of bonds holdings provides a secondary benefit for fixed-income fund investors. Conservative investors and individuals close to retirement usually prefer bond funds.
The volatility of bond funds can differ, depending on the nature of the holdings. For example, a government bond fund carries less risk compared to a bond fund that invests in highly speculative corporate junk bonds. Bond funds have a high proclivity to interest rate risk– If interest rates increase the value of the fund decreases and vice-versa.
Money Market Funds: Money market funds consist mainly of Treasury bills. Investors used money markets to place money until investing the funds in other instruments. Money market funds offer principal protection and pay interest rates between rates paid on the average savings accounts and certificate of deposit.
Other Mutual Funds:
Balance funds have an investment objective of principal protection, cash flow and appreciation. Fund managers may split a fund’s assets between 60 percent growth companies and 40 percent fixed income. International or global funds invest overseas and domestically. Specialty funds buy the stock of companies in a certain sector of the economy, such as financial, transportation or defense stocks. This type of fund has a more volatile reaction to certain market dynamics because of the lack of diversification.
Regional mutual funds concentrate its holdings on a particular region, such as Asia or Latin America. Socially responsible funds have an objective of investing in the stock of companies that have certain beliefs or conscious. Index funds attempt to reproduce the performance of indexes– the most common being S&P 500 or Dow Jones Industrial.
Selecting Mutual Funds
Fund choices for mutual fund investors exceed 10,000. Prior to investing in a fund, make sure you understand your personal investment objectives. Then, research available options and choose a fund with a proven investment strategy and risk in line with your personal goals.
For example, if you seek a reliable cash flow consider bond funds. For dependable dividend distributions, select growth and income funds. To protect your capital, invest in money market funds.
You can find funds through banks, brokers, insurance agents and financial planners and the Internet. Many discount and full-service brokerage offer “no-transaction fee” funds. Start your due diligence by obtaining the prospectuses of mutual fund companies that have the investment strategy your desires. Find funds with proven management as verified by the fund’s performance.
Understanding Mutual Fund Costs
One of the biggest criticisms about mutual funds has to do with costs. Critics say the industry gets away with excessive fees because the average investor does not understand charges to their account. Mutual funds fees fit into two categories: 1) ongoing yearly charges and 2) transaction costs for buying and selling shares.
Ongoing expense: Can be calculates as an expense ratio or management expense ratio (MER). The following items make up a MER:
Fund manager – 0.5% to 1% of assets
Administrative costs – expenses for administration, including stamps, customer service, office machines
12B-1 fees – brokerage commissions and marketing expenses.
Some companies do a good job of keeping the expense ratio to a minimum. Other funds may add latte machines and other benefits to expenses. On average, expense ratios range from 0.2% for index funds to 2.5 %. Stock funds average from 1.3% to 1.5%. Global funds and specialty funds charge the highest fees.
When comparing the expense ratio for funds, consider the following line from the Security & Exchange Commission (SEC), “Higher expense funds do not, on average, perform better than lower expense funds.”
Loads: refers to fees paid to brokers and salespersons. A front-end load of five percent means that if you invest $2,000 in a mutual fund, the company subtracts $100. Therefore, your net investment in the fund totals $1,900. A back-end load (deferred sales charge) assesses a fee when you sale the fund. For example, the company may charge 6% if you sell in the first year or 0% if you sell in the sixth year. A no-load fund does not assess a fee on the sell of a fund.