The Different Kinds of Mutual Funds Explained

Mutual funds are open-ended funds managed by fund managers that raise money from many individual investors and invest it in a group of assets to meet a set of common investment objectives. Over the recent years, mutual funds have gained increasing popularity by being a good alternative investment solution for keeping a portfolio balanced in times of financial uncertainty.

According to the type of security in which they invest in, mutual funds can be classified into four broad categories. These are:

(1) Stock Funds

Stock funds, also referred to as equity funds, are the most popular types of mutual funds. Because they solely invest in stocks, they are considered highly risky but, on the other hand, they offer a great potential for higher returns.

Stock funds are classified into several subcategories depending on (1) the types of companies in which they invest (2) their style of management and (3) their investment objectives. In particular:

One of the most commonly known classifications of mutual funds is based on the market capitalization of the companies in which they invest. According to market capitalization, cap funds are classified into Large-cap, mid-cap, and small-cap. Large cap funds invest in companies with market cap larger than $10 billion, mid cap funds invest in companies with market cap between $1 and $10 billion and small cap funds invest in companies with market cap below $1 billion. Generally, the smaller the market capitalization the riskier the investment, as the return of the fund is more volatile.

Growth funds are stock funds that invest in stocks that have a potential of long-term growth. For this reason, fund managers focus on companies that demonstrate significant earnings or revenue growth in the hope that these firms will continue to increase in value. The only consideration for investors is that growth funds are highly volatile, which makes their prices experiencing sharp fluctuations.

Value funds invest in companies that fund managers consider them to be good investment opportunities. Generally, these are companies with low P/E ratios that are not favored by investors anymore for a variety of reasons. For instance, investors may have lost their confidence to a particular firm or poor quarterly financial statement may have led investors to change their preferences. Typically, value stocks are the stocks of companies that pay high dividends. By investing in value funds, fund managers produce both current income incurred from dividends and long-term growth incurred from earnings as the stocks become popular again.

Sector funds invest in specific sectors of the market aiming to achieve growth from industries that are expected to perform well in the future. Fund managers typically invest in sector funds that include health care funds, real estate funds, financial funds or gold and precious metals funds, but in reality every sector can produce the relevant mutual funds. Generally, sector funds are highly volatile because they focus on a sole sector rather than diversifying the portfolio assets across a wide variety of sectors and industries.

(2) Bond Funds

Bond funds generally generate current income with minimal risk. Investors can choose among bond funds that invest in short, mid-term or long-term maturities, among government, corporate, mortgage-backed or high-yield bond funds, or among funds that invest in domestic or global securities. Typically, bonds funds are managed with extensive trading aiming to earn higher total returns.

(3) Blended Funds

Blended funds are a combination of stocks and bonds that aim to maximize returns by combining common stocks with fixed-income securities including government bonds, or preferred stocks.

(4) Money Market Funds

Money market funds invest in low-risk securities aiming to earn interest and provide investors with safety principal and liquidity. Generally, money market funds invest in short-term securities such as T-bills, bank CDs, and commercial paper and their NAV is constant at $1. Investors do not use money market funds for long-term investing, but as an opportunity to invest in short-term cash-equivalent assets.