Contents
Mutual Fund Basics
Why Invest in Mutual Funds?
Mutual Fund Returns
Types of Mutual Funds
Mutual Fund Investment Holdings
Funds vs. ETFs, Stocks, and Bonds
How to Plan a Mutual Fund Portfolio
How to Research Mutual Funds
How to Buy Mutual Funds
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Mutual Fund Investment Holdings
Whether they’re actively managed or index-based, closed- or open-end, load or no-load, most mutual funds are classified (and usually named) based on the type of investments the fund owns, such as stocks, bonds, or other securities. The five most common classifications of funds based on investment holdings are stock funds, bond funds, balanced funds, REIT funds, and money market funds.
Stock Funds
Stock funds, or equity funds, invest in the stocks of publicly traded companies. These funds are further classified by market capitalization (market cap), investment style, sector, and geographic location. Some funds combine several classifications into one fund.
Market Cap
A company’s market cap is equal to the number of shares the company has issued to the public multiplied by the current value of a single share. Typical market cap ranges (and the name given to each) are:
- Mega-cap: $200 billion or more
- Large-cap: $10–200 billion
- Mid-cap: $2–10 billion
- Small-cap: $100 million–$2 billion
- Micro-cap: Under $100 million
Stock funds often focus on buying companies whose market caps fall within the same range. Examples include the Fidelity Small-Cap Stock Fund® and the Vanguard Mid-Cap Index Fund®. Funds choose to focus on a specific market cap range because each range tends to have a predictable level of risk and, therefore, reward—the smaller the market cap, the greater the risk and reward.
Investment Style
In the world of stock mutual funds, the term “style” refers to whether a fund invests in growth stocks or value stocks.
- Growth stocks: Stocks of rapidly growing businesses that rarely issue dividend payments to shareholders. Funds that invest solely in growth stocks are termed growth funds.
- Value stocks: Stocks of established, slower-growing businesses that usually do issue dividends. Funds that invest solely in value stocks are called value funds.
Some funds invest in a mix of growth and value stocks. These are called blend funds.
Sector
The term “sector” refers to the specific industry a company is in, such as energy, financial services, utilities, or health care. Sector funds invest solely in companies that do business in a particular industry. Fidelity Investments (www.fidelity.com) is the leading issuer of sector funds, with several dozen Fidelity Select® sector funds that specialize in everything from aerospace to gold to multimedia.
Geographic Location
Some stock funds limit their investments to businesses based in particular geographic regions, such as Latin America, Asia, Europe, or even specific countries. Investors buy these funds when they believe the stocks of businesses in a particular region are poised to boom due to political, economic, or other factors. For instance, with the rise of China as a global economic power, many fund companies have begun issuing funds that buy only Chinese stocks, such as the popular Matthews China Fund®.
Bond Funds
Bond funds own bonds issued by corporations, governments (local, state, or federal), and other institutions. Bond funds break down into a variety of subcategories based on term, issuer, tax status, and region. As with stock funds, many bond mutual funds combine one or more of these subcategories. The relative risk of bonds depends on a variety of financial factors, such as the issuer’s likelihood of default (cessation of interest payments), expressed as a bond rating. Ratings range from AAA (best) to D (worst).
Term
Every bond has a term that begins with its date of issue and ends with its maturity date—the specific date on which the company or government that issued the bond redeems, or recalls, the bond and stops paying interest on it. Longer-term bonds tend to have higher interest rates (the amount of interest the bond pays) than shorter-term bonds. Bond mutual funds are classified by three categories of terms:
- Short-term bond funds: Hold bonds with maturity dates from 0–3 years
- Intermediate-term bond funds: Hold bonds with maturity dates from 3–10 years
- Long-term bond funds: Hold bonds with maturity dates longer than 10 years
Bond mutual fund investors often buy one of each of these funds in order to spread out their risk while also receiving a fair amount of interest income.
Issuer
A bond’s issuer is the company or government that issues the bond. Bonds typically are sold to the public not by the issuer itself but by brokers.
- Government bonds: Bonds issued by federal or state governments, whether U.S. or foreign
- Municipal bonds: Bonds issued by local municipalities or institutions, such as large towns and cities
- Corporate bonds: Bonds issued by private or publicly traded companies
Fund companies offer bond funds based on these three classifications, often in conjunction with another category, such as term. For instance, a long-term government bond fund would own bonds issued by federal or state governments with terms of 10 years or more.
Tax Status
All bonds are either taxable or tax-exempt.
- Taxable bonds: Require owners to pay taxes on interest income that the bond pays. Taxable bonds have higher interest rates than tax-exempt bonds.
- Tax-exempt bonds: Allow owners not to pay federal, state, and/or local income tax on interest income that the bond pays. Holders of bonds issued by state or local government are often exempt from state or local (city) tax on the interest from those bonds. Some bonds, called triple-tax-free bonds, are exempt from federal, state, and local and thus allow owners to pay no tax at all.
Tax-exempt bond funds have considerably lower interest rates than taxable bonds, but for a good reason—tax-exempt funds are designed to appeal to investors in high tax brackets and/or in high-tax states, since these investors are often willing to accept a lower interest rate in exchange for the benefit of not having to pay certain income taxes.
Geographic Location
International bond funds, or foreign bond funds, buy bonds issued by governments or corporations in specific regions other than the United States. Investors often favor foreign bond funds that focus on regions or countries with stable political and economic climates, such as Europe or Japan. However, bond funds that focus on emerging markets, such as Brazil or Russia, may offer the prospect of higher returns—but with significant risk.
Balanced Funds
Balanced funds invest in a mix of mostly stocks and bonds. Investors buy balanced funds when looking for a convenient way to build a balanced portfolio with just one fund. Fund companies offer two main types of balanced funds, each of which offers a slightly different approach:
Lifecycle Funds
Lifecycle funds adjust their holdings to suit your financial needs as you approach a major life event, such as retirement or the beginning of a child’s college education. As the event nears, the fund sells the riskier stock investments that it owned to help grow your money and buys safer, more conservative investments to preserve your money for the major life event. Lifecycle funds are usually named with a specific target date, such as the Fidelity Freedom Funds®, which are available in five-year increments all the way out to 2050. Investors who plan to retire in 2035 might therefore look into the Fidelity Freedom 2035 Fund®.
Asset Allocation Funds
Asset allocation funds aim to help investors establish a diversified portfolio without the target-date constraints of lifecycle funds. This flexibility allows asset allocation funds to respond immediately to changes in the marketplace, such as stock market downturns, by switching the fund’s asset allocation accordingly. For instance, if stocks suddenly fall out of favor after years of solid gains, the fund might shift its allocation to favor bonds.
REIT Funds
REIT funds invest in different types of real estate investment trusts (REITs), corporations that own and manage a portfolio of real estate investments. Some REIT funds invest in the overall real estate market, while others invest in specific types of properties, such as apartment complexes, shopping centers, or office buildings in the United States and/or abroad. Investors may buy REIT funds:
- To diversify their investment portfolios beyond just stocks and bonds
- As an alternative to owning actual real estate, which is less convenient and liquid than REIT mutual funds
Money Market Funds
Money market funds invest in short-term debt instruments that pay interest. Fund companies often recommend these funds to clients as an alternative to savings accounts, since money market funds:
- Are nearly as risk-free as savings accounts
- Offer higher interest rates than savings accounts
Money invested in money market funds can earn interest, but the principal almost never fluctuates in value, which makes these funds a great place to “park” money in anticipation of making other investments. Money market funds are not a great place to keep money long-term if you intend to grow your principal.
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