There are three major types of mutual funds that parallel the major asset classes: money market mutual funds, stock mutual funds, and bond mutual funds. Within the main asset class that each of the mutual funds comprises, there are many smaller asset classes that investors should consider when selecting a mutual fund. There are also several specialty mutual funds that investors should know about: index funds, exchange-traded funds (ETFs), balanced funds, asset-allocation funds, life-cycle mutual funds, and hedge funds.

Major Types of Mutual Funds

Money market mutual funds: Money market mutual funds invest primarily in short-term, liquid financial assets, such as commercial paper and U.S. Treasury bills. The goal of these funds is to obtain a higher return (after fees and expenses) than traditional savings or checking accounts.

Stock mutual funds: Stock mutual funds invest primarily in common stocks listed on the major securities exchanges discussed in Investments 5: Stock Basics. Each type of stock mutual fund has a particular emphasis or objective, such as large-capitalization stocks, small-capitalization stocks, value stocks, growth stocks, and so on.

Bond mutual funds: Bond mutual funds invest primarily in the bonds offered by companies or institutions. Each of these bond mutual funds has a particular emphasis or objective: corporate bonds, government bonds, municipal bonds, agency bonds, and so on. Most of these funds have specific maturity objectives, which relate to the average maturity of the bonds in the fund’s portfolio. Bond mutual funds can either be taxable or tax-free, depending on the types of bonds the fund owns (see Investments 4: Bond Basics.

Specialty Mutual Funds

Index funds: Index funds are mutual funds that are designed to match the returns of a specific benchmark. Since these funds buy and sell securities infrequently (i.e., they have a low turnover), they are very tax-efficient investment vehicles. Index funds have the option of following many different benchmarks, including the S&P 500 (large-cap stocks), Russell 5000 (small-cap stocks), MSCI EAFE (international stocks), Lehman Aggregate (corporate bonds), and DJ REIT (real estate investment trusts). As of May 3, 2010, there were 822 different index funds listed in the Morningstar database. Morningstar is one of the largest and best private data providers of mutual fund information.

Exchange-traded funds (ETFs): Exchange-traded funds are similar to mutual funds in that they comprise groups of stocks; however, ETFs are different from mutual funds because ETFs are traded in an organized exchange. Because ETFs are purchased on an exchange, they incur all the transaction fees and custody costs that stocks do. They are also similar to stocks in that they are priced throughout the day rather than at the end of the day like mutual funds. ETFs can be both shorted and purchased on margin. ETFs can be structured as either unit investment trusts (UITs), whose money is invested in a portfolio where the composition is fixed for the life of the fund, or open-end mutual funds, where money is invested in a portfolio that can change over time. The UIT structure does not allow for immediate reinvestment of dividends. As of May 3, 2010, there were 931 different ETFs listed in the Morningstar database.

Balanced funds: Balanced funds are mutual funds that purchase both stocks and bonds, usually in a set ratio (e.g., 60 percent stocks and 40 percent bonds). The benefit of these funds is that the fund manager makes both the asset-allocation decisions and the stock-selection decisions for the investor.

Asset-allocation funds: Asset-allocation funds are mutual funds that rotate investments among stocks, bonds, and cash, with the goal of beating the return of a specific benchmark (after all expenses have been accounted for). These funds invest in the asset classes that the portfolio managers expect to perform the best during the coming quarter.

Life-cycle mutual funds: Life-cycle mutual funds change their allocations of stocks and bonds depending on the age of the investor. As an investor ages, life-cycle funds reduce their allocations in stocks and increase their allocations in bonds, which typically makes the fund more consistent with the goals of an older investor. These funds make asset-allocation decisions for the investor and aim to reduce transactions costs.

Hedge funds: Hedge funds are mutual funds that assume much more risk than normal mutual funds: more risk is assumed in the expectation of higher returns. Sometimes the managers of these funds take long positions, in which they buy and hold assets; sometimes the fund managers take short positions, in which they borrow assets and sell them (i.e., sell the assets short). The managers of hedge funds hope that they will later be able to buy back the assets at a lower price before they must return them to the lender.

 

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