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For new investors looking at mutual funds, it is important to know that not all of these funds are exposed to the same markets or the same asset types. Typically, a mutual fund will fall into one of three categories – Bond funds, Money Market funds, or Stock funds. In order to increase diversification exposure, many investors will split their resources and buy into a portion of all three. Here, we look at the characteristics of each of these Mutual Fund types.
The most volatile of these funds is the Stock fund, which is sometimes called an Equity fund. In these cases, the value of the fund might fluctuate sharply in small periods of time. On the positive side, stocks perform better on a historical basis when compared to other asset classes. This is generally due to the expectation that companies will later command a greater market share and improve on revenues and profit outlooks. These factors tend to create increases in stock value for shareholders.
When gauging potential stock performance, it is important to consider the changing economic conditions which might affect corporate earnings, or risks such as upcoming lawsuits or possible restrictions in future product releases. Stock funds have sub-divisions as well, which feature different types of assets:
- Income Funds: Focus on stocks with high dividend yields
- Index Funds: Attempt to match the performance of a major stock index (such as the Dow or S&P 500)
- Sector Funds: Specialize in industry sectors (such as technology, finance or healthcare)
- Growth Funds: Attempt to create substantial capital appreciation (but are less likely to pay dividends regularly)
Bond funds will generally buy government or corporate debt, and are sometimes referred to as Fixed Income funds. This is because Bond funds look to provide consistent investment income with regular dividend payments. These funds are included in many investment portfolios because they tend to perform well when stock markets are losing value. This helps to provide balance and risk protection for investors.
Bond funds are organized by sector (just like Stock Funds), and can vary in terms of potential risk. Low risk funds invest in stable assets like US Treasury Bonds, while riskier funds invest in very high-yield bonds or those associated with corporations with low credit ratings. Risk for bond funds can come from these areas:
- Instances where bond issuers (either a government or a company) is unable to repay its debts
- The bond is paid off prematurely, preventing a bond fund manager from re-investing profits in a higher return asset
- Interest rates rise, bringing value declines to the purchased bonds
Money Market Funds
Money Market funds are typically associated with lower risk, relative to many other fund types and asset classes. These funds have legal requirements which limit their investments to selected high quality investments over short time periods. These assets are issued by the federal government, local municipalities, or stable US companies. In exchange for this security, historical returns tend to be lower (when compared to stock or bond funds), and these lower rates of return make these funds vulnerable to value declines in periods of high inflation.
Choosing Your Mutual Fund
When choosing your mutual fund investments, it is important to keep all of these factors in mind. Different fund types will perform better in certain economic environments and the total level of risk associated with each fund type will differ from investor to investor.