In this article, I will discuss the different types of mutual funds, and will provide examples for each mutual fund classification as well. This will help you decide on which mutual funds to invest in, regardless of your investment time horizon and goals as a hands-off investor. Note that all of the examples provided are rated three stars or above on Morningstar, and should give you a good starting point to begin evaluating mutual funds.
Mutual funds are actively managed investment vehicles that pool money from investors to buy a basket of securities, which is then priced and sold to the public on a daily basis. The most common types of mutual funds invest in equity (stocks), fixed-income securities (bonds and money market funds), or a balanced/hybrid mix with both equity and fixed-income securities.
If I were to invest in a mutual fund, the first thing I'd do is investigate what type of mutual fund it is. The fund you choose will depend on your investment goals, whether it be purely stock price capital appreciation, income from dividend stocks, interest from bond and debt instruments, or something in between. Although every mutual fund is designed to minimize risk and maximize returns, some funds carry a higher amount of risk and potential rewards, while others offer the opposite.
Morningstar is a great resource for researching and evaluating mutual funds. It classifies mutual funds in the following way:
Much of what is discussed in this article will therefore cover these different classifications of mutual funds. Although Morningstar and other mutual fund research-oriented websites should give you a good idea on what a particular mutual fund is trying to achieve, reading through a fund's "Prospectus" or going through its website will clarify the fund's objectives. Also note that for the examples below, you can see the portfolio allocation of a mutual fund by clicking on the "Portfolio" tab on Morningstar.
Equity (stock) funds primarily invest in companies within publicly traded stock markets. Growth, value, and blend funds (as later discussed) are divided up into either small, medium, or large-cap funds, depending on the market capitalization (number of shares outstanding * current stock price) of the investments within the fund.
The classifications for these funds are listed below:
With this in mind, below are the different types of equity (stock) mutual funds, with examples:
Growth funds invest in small, mid, or large-cap companies that are expected to have high growth potential, with the goal of capital appreciation and little to none in dividends. Generally, the firm's goal or promise to investors is that they will beat the market (S&P 500 Index). However, history has shown that nearly 92% of large-cap mutual funds have failed to do so over the 15-year period. Regardless, if a growth fund piques your interest, it may be worth investing in.
Examples of growth mutual funds:
Income funds invest in more established companies (i.e. blue-chip companies) that regularly payout dividends. Steady capital appreciation is generally expected as well, but investors do not invest in an income fund and expect high stock price growth. Income funds also have relatively lower downside risk than growth funds due to their holdings in well-established and financially solid companies.
Examples of income mutual funds (all large-cap):
Value funds invest in companies the fund deems intrinsically undervalued, so as to profit from the capital appreciation of the stock. These are similar to growth funds, but are usually less risky with less return potential. These funds can be attractive to long-term investors who believe in the firm's ability to invest in undervalued stocks, which may contribute to possibly beating the market as well.
Examples of value mutual funds:
Sector funds (aka specialty funds) invest in particular sectors (aka industries) within the economy, such as healthcare, consumer staples, technology, etc. Obviously, this will provide strong exposure to an industry but the performance is heavily reliant on how the sector performs. These funds can also invest in particular objectives defined by the mutual fund. For example, environmental, social, and corporate governance (ESG) funds invest only in companies that have a positive societal impact and are sustainable. In short, these funds could be great investments if you have specific knowledge on an industry or if you believe in pro-environmental/sustainable companies.
Examples of sector mutual funds:
Index (mutual) funds invest in an assortment of companies in an attempt to mirror the performance of a particular index, such as the S&P 500 Index. Typically, index funds have lower fees and expenses than other mutual fund types due to the minimal research and active management required.
Exchange traded funds (ETFs) mirror indices as well, and usually have no trouble doing so while maintaining a minimal (and possibly lower) expense ratio. Therefore, I'd look into ETFs before looking into mutual funds that track a market index.
Examples of index mutual funds:
International funds invest in companies outside the U.S., such as those in the emerging and/or developed markets in hopes of capital appreciation. This fund can be great for diversification and for building a portfolio hedge if U.S. equities were to fall. Most international stock funds do invest in U.S. equity as well, so be sure to look into the asset allocation of the fund if you want a heavier weighting in non-U.S. equity.
Examples of international mutual funds:
Fixed income funds primarily invest in corporate and government debt to provide exposure to the fixed income market and returns through interest and/or dividend payments. Fixed income funds are separate from the equity markets, so they can continue to provide steady income when stock funds lose value. If you're older, a higher portfolio allocation to fixed income is preferred to preserve the capital you've built up over your life.
Below are different types of fixed income funds:
Government bond funds invest in government securities and treasury bonds, which typically hold AAA ratings from credit rating agencies. This means they are very low-risk and high-grade investments that pay periodic interest payments, but receive little in capital gains. Government bond funds are ideal for risk-averse investors that may want to receive tax breaks as well.
Most U.S. government bonds in government bond mutual funds include:
Examples of government bond mutual funds:
Money market funds invest in short-term highly liquid debt securities, cash, cash equivalent securities, and U.S. Treasuries (as discussed above). These are extremely low-risk investments that earn very little interest on the principal invested. Rising inflation and negative interest rates can even negatively effect the yields these funds earn. Therefore, you do not invest in a money market fund to generate a return, but to store cash temporarily before investing elsewhere.
Examples of money market mutual funds:
Corporate bond funds invest in debt securities that are issued by firms and sold to investors. Although corporate bonds can vary in credit ratings, corporate bond funds typically invest in bonds that are rated BBB and above by credit rating agencies. Therefore, corporate bond funds are ideal for investors looking to receive a higher return (in comparison to government bond funds), while still maintaining a low risk level. Like most bonds, corporate bonds make regular interest payments until the maturity date when the principal is paid off.
Examples of corporate bond mutual funds:
Municipal bond funds invest in municipal bonds, which are issued by state and local governments to fund public projects and infrastructure. Uniquely, the interest received on most municipal bonds is tax-free at the state and federal level, so they are preferred bond investments for wealthier investors or those living in states with high taxes. In terms of risk and return, municipal bond funds fall somewhere between U.S. Treasuries and corporate bonds. According to The Motley Fool, "municipal bonds are 50 to 100 times less likely to default than corporate bonds with the same credit ratings."
Examples of municipal bond mutual funds:
High-yield bond funds invest in high-yield bonds or "junk bonds," which have low credit ratings (below BBB-) and high credit risk. For investors who are more risk-tolerant, high-yield bonds (with their high yields) can be attractive investments. These funds are also more popular when ultra-safe government bonds have a yield lower than the inflation rate. Obviously, these bonds are not for most investors, as they are much more likely to default and generally experience more price volatility.
Examples of high-yield bond mutual funds:
International bond funds invest in foreign bonds, which are bonds (usually corporate) issued by a country or company outside of the investor's country. These can be advantageous to buy if U.S. equity markets crash and/or if the U.S. dollar is depreciating in value, thereby acting as a portfolio hedge against the market. Because these funds are highly subject to currency risk, many practice "currency hedging" to mitigate the impact of currency price fluctuations.
Examples of international bond mutual funds:
Balanced funds invest in both equity and fixed-income investments (including bond and money market funds). The risk-return relationship of these funds therefore relies on what the fund is holding and the allocations towards equity and fixed income. Generally, a stock-heavy (aggressive) mutual fund will always be riskier and offer more return potential than a bond-heavy (conservative) mutual fund, which would offer the opposite. In short, these are ideal investments if you're looking for a mixture of adequate capital appreciation, interest, and safety.
Examples of balanced mutual funds:
Fund-of-funds (FOF) are funds that invest in other funds. In other words, it's a mutual fund for mutual funds. These are ideal options for investors who want to diversify greatly and those that are not familiar with the process of evaluating a mutual fund. Moreover, with fund-of-funds, you're not investing with a single fund manager, but rather with multiple fund managers. The downside to this, however, is that fund-of-funds generally have higher overall expenses ratios because of the fees and expenses charged by the fund-of-funds and the underlying funds in the fund.
Target-date funds are usually classified as fund-of-funds. They typically have a mix of different asset classes, such as stocks, bonds, and real estate, and are often designed to become more conservative as a target date approaches, such as the year you expect to retire. Put simply, this just means portfolio managers will allocate your assets so that they have less downside risk as you age, meaning a higher allocation to fixed income securities near retirement. Naturally, these are extremely long-term investments that require more active management, which may translate to higher fees and expenses as well.
Examples of target-date mutual funds:
Target-risk funds are made up of other funds and target a certain risk exposure, which the managers of the fund attempt to maintain and keep consistent overtime. This is usually conservative, moderate, or aggressive, and can be achieved by keeping a certain portion of the portfolio equity and the other portion fixed-income, much like a balanced fund. Target-risk funds can also be geared towards investors who are looking to retire by a certain year.
Examples of target-risk mutual funds:
Every investor should know what types of mutual funds are available to them. To recap, the most common types of mutual funds are equity or bonds funds, with others having a bit of both. What you decide to invest in depends on your risk tolerance, investment time horizon, the market, and whether you believe the mutual fund can achieve its objective within a reasonable time frame. Finally, although index funds and ETFs may be the smarter long-term investment choice for many, certain mutual funds can be beneficial for passive investors looking to achieve a successful hands-off approach to investing.