The world of investing is full of trading terminology. If you’re looking to invest in mutual funds, it’s important to know what kind of mutual fund best fits your needs and goals, but with so many options to choose from, it can be overwhelming. To help you out, here are some quick and easy definitions of different types of mutual funds to help you select the best type for your investments. Armed with this information, you’ll be ready to conquer investing and make wise decisions for your financial future.
Before we look at different types of mutual funds, what is a mutual fund? A mutual fund is a diversified portfolio of stock, bonds and other investments, instead of investing in one stock. You purchase stock in the fund itself, which fluctuates based on the performance of the companies and securities that the fund is invested in – rather than stock in the companies themselves.
With this in mind, here are some different types of mutual funds to consider for your investing.
Open-End Funds vs. Closed-End Funds
Open-end funds are bought and sold on demand at their NAV (net asset value), which is calculated at the end of each trading day and is based on the fund’s underlying securities. You purchase shares directly from the fund.
Closed-end funds are traded between investors in an exchange and have a fixed number of shares. Their prices are determined by supply and demand, like stocks. They are often bought and sold at a much higher or lower price than their NAV.
Both have been around for decades, but open-end funds are far more popular than closed-end. Though you may be able to purchase closed-end funds at a steep discount, that doesn’t necessarily make it a good deal if it doesn’t rise in value.
Passive Funds vs. Actively Managed Funds
Active mutual funds have a portfolio manager and analysts who are constantly evaluating and determining which investments to include or exclude from the portfolio. The success or failure of the portfolio is due to the skill of the manager. If you choose this kind of fund, be sure to select a manager with a strong track record of success. They can also have higher fund expenses, due to the larger number of transactions each year. If managed well, though, the profits can outweigh the costs.
Passive mutual funds typically track a stock index and buy or sell those indexes without much involvement from humans. There is no manager constantly evaluating each trade. These are convenient and easy with lower fund costs, but there is little to no chance of making any excess profit from this kind of fund.
In a tax-efficient fund, the goal is to lower the tax liability that shareholders face. This is done in one of three ways:
1. Buying tax-free (or lower tax) investments. An example of this would be municipal bonds.
2. Reducing the fund’s turnover. Stocks that are held for more than a year are taxed at the lower long-term capital gains rate, instead of higher short-term transaction tax rates.
3. Avoiding and/or limiting income-generating assets. These include dividend-paying stocks, since they cause tax liabilities at each dividend issuance.
Tax-efficient funds are especially helpful when paired with a tax-deferred account, so that the investor can put higher-taxed securities (like the dividend-paying stocks) into the tax-deferred account, and use the tax-efficient fund for other investments.
Load Mutual Funds vs. No-Load Mutual Funds
Load mutual funds are purchased from a broker (what is a stockbroker?) and have a sales charge or commission associated with them to pay the middleman for his work and expertise. A-shares typically have a front-end sales charge (paid in full at the time of purchase), while B-shares typically have a back-end sales charge (paid when selling the shares within a specified number of years).
No-load funds are purchased by the investor without the help of a middleman. Investors buy no-load funds at the NAV directly from a mutual fund company or through a mutual fund supermarket.
Many studies have shown that no-load funds tend to outperform load funds, returning a higher profit for investors. However, this is partly due to the fact that load funds have a higher cost associated with them, due to the sales charges. In order to compensate for that charge, load funds must produce a higher profit. Many investors choose load funds simply because they feel uncomfortable making direct investment decisions, or they already have a financial advisor or broker and prefer to have them handle everything.
Money Market Funds
These are considered some of the lowest-risk investments available. They invest in highly liquid and short-term securities. These are a safe place to invest. You won’t gain much, but you won’t worry about losing your principal either. The return is generally a little higher than what you would get in a checking or savings account at your bank. Money market funds try to keep their NAV at $1.00 per share.
Legally, these funds can only invest in specific, high-quality, short-term investments. These often include Treasury bills, government and U.S. corporations. However, because of the NAV, their greatest weakness is their susceptibility to inflation. During the 2008 financial crisis, money market funds did lose money as the share price fell below $1.00 and broke the buck. This is highly unusual, though, and not typical for this kind of fund.
Fixed Income Funds
The goal of fixed income funds is, as the name suggests, to have a consistent amount of money coming into the fund regularly. These funds buy investments in government bonds, high-yield corporate bonds and investment- grade corporate bonds. The income is primarily through the interest the fund earns. Generally, high-income corporate bonds are considered riskier than government or investment-grade corporate bonds. Because these funds produce regular income, and are popular with conservative investors and retirees. Often, fixed income funds are included in an investment portfolio to boost the return of an investor, in the situation where stock funds drop or decrease in value. They are a good addition to a portfolio, but if you are hoping to make large gains or see high returns on your investment, they won’t fulfill that need.
Equity funds (also called stock funds), aim to grow faster than a money market or fixed income fund, which of course also means that they are higher-risk. They are the most volatile and the most prone to sharp rises and falls in value. These funds invest in stocks, but you can choose from different specialised equity funds including those that focus on growth stocks, income funds, large-cap stocks, mid-cap stocks, low-cap stocks, a combination of the three or value stocks. The goal of an equity fund is long-term capital growth. Equity funds are one of the largest types of mutual funds, with a huge array of different types of funds – as many types of funds as there are types of equity. By using equity funds and blending different investment styles, different company sizes and different risk/profit likelihoods, you can construct a strong portfolio.
Balanced funds are a blended type of fund, where they invest in both equities and fixed income securities. The name comes from the fund’s goal of balancing the risk of losing money against the hope of gaining higher returns. Most balanced funds have a formula that they follow to split money between the different kinds of investments. They are a good middle ground in terms of risk between pure equities and fixed income funds. You can choose between a more aggressive balanced fund, which will have more equities and fewer fixed income bonds, or a more conservative balanced fund, which will be the reverse. Typical balanced funds are 60 percent equity, 40 percent fixed income. Overall, the aim of a balanced fund is to create a strong balance between capital gain, risk and income.
Hopefully, this has helped clarify the different types of mutual funds you will encounter as you begin your investment journey. Hiring a broker or a financial advisor is a wise decision if you feel uncertain or overwhelmed by the decisions to be made. Your financial future is important, and not something to be trifled with. However, even if you choose to hire a middleman to help you with your portfolio, be sure to educate yourself on the different terminology and types of investments. A savvy and informed investor will be equipped to make good decisions, have discussions with his advisor about potential investments and plan for his financial future.
Diversifying your portfolio to include mutual funds – and more than that, different types of mutual funds – can strengthen your overall financial standing and mitigate risk as the market rises and falls. Consider investing in mutual funds, with a mix of higher risk and lower risk options, as a way to grow and build your portfolio. With the right judgment calls and purchases, you will not regret it.