Equity and Bond Mutual Funds
Mutual funds have been a staple of many an individual investment portfolio since the mid-1970s and fall into two main categories: equity funds and bond funds. Equity funds hold stocks. They may hold other investments such as cash, but the primary holding will be equities. Bond funds, also known as fixed income funds, hold bonds in the form U.S. Treasuries, state, municipal, and corporate issue.
Mutual funds are offered as part of almost every employer-sponsored retirement program. Knowing which types of funds to choose for your particular needs is one of the keys to successful mutual fund investing. For example, if you're between the ages of 28 and 32, is it better to own an aggressive growth fund or a bond fund? If you're over the age of 65, is it better to own an emerging markets fund or a municipal bond fund?
Types of Equity Mutual Funds
Equity funds are divided into two main categories: value and growth. Value funds seek to buy stocks that are trading for less than their intrinsic worth. Value stocks are sometimes referred to as "beaten down". They are trading for less than they're worth due to a bad quarterly earnings report, a missed product launch, the departure of a CEO, or any other reason that would cause investors to sell the stock out of panic.
Value funds present investors with an opportunity to buy low and sell high. Those who have the patience and time to wait for a stock to rebound are best-suited to value funds. A value stock doesn't always recapture it's past highs, especially if the drop in price was due to a real rather than a perceived problem. But value stocks often pay dividends that can increase the yield earned each year.
Growth funds invest in companies that show the promise of future growth. New and smaller companies are often the primary holdings of a growth fund. Growth stocks typically don't pay dividends, so the increase in value must come from an increase in share price. Aggressive growth funds are usually best for younger investors who have a longer time horizon. The risk with growth stocks in growth funds is that they won't grow at all, or the rate of growth will be terribly slow. The idea of owning several types of growth stocks in one fund is to offset some of the slower growers with those that are able to grow more quickly.
Types of Bond Mutual Funds
There are four primary types of bond funds: U.S. government, corporate, high-yield, and municipal. Each provides a different level of safety, risk, and potential for return.
U.S. government bond funds invest in U.S. Treasuries and are divided into short-, intermediate- and long-term. These funds are the safest available, as the bonds are backed by the full faith and credit of the United States federal government. The rates earned fluctuate with interest rates, so there is some risk. But investing in U.S. Treasury bond funds is widely understood to be one of the best investments for those over the age of 65. Provided the fund earns at least the rate of inflation, elderly and retired investors can be sure their money is safe.
Corporate bond funds primarily hold the highly rated debt of well-known companies that present very little risk of default. Corporate bond funds are somewhat riskier than U.S. government bond funds, but they also typically pay a higher yield. For middle-aged investors who want the safety of bonds combined with higher earnings, corporate bond funds can often be a good choice. However, it's important to make sure that the top holdings of the fund are rated between AAA and A, depending on the credit rating agency used. These ratings provide valuable insight into the risk an investor is taking.
High-yield bond funds are the riskiest of all. They hold bonds of companies that are usually in deep financial trouble and present the greatest possibility of default. Because the risks are higher, the yields are higher. However, because the risk of loss is so great, high-yield bond funds are only appropriate for those investors who can withstand both the fluctuations and the risk of loss.
Finally, municipal bond funds are best for high-net worth individuals and those in high tax brackets. Municipal bonds are almost always tax-free for those who reside in the state in which the fund is sold. While the funds pay a lower rate than taxable funds, the difference can be enough to offset any risk.
Mutual Fund Expenses and Load vs No-Load Mutual Funds
All mutual funds have expenses associated with them. Some funds, however, charge lower fees than others. For example, an index fund that tracks the S&P 500 has a very low expense ratio because there is little to manage. The fund manager needs to rebalance the fund when stocks are added to or taken out of the S&P 500 but his or her active participation in managing the fund is minimal. On the other hand, a specialty fund like one that invests in emerging market biotech companies would more than likely have a very active manager who buys and sells stocks within the fund regularly in order to protect profits and keep returns as high as possible. The expenses on this type of fund would be much higher.
"Load" refers to a sales charge that is charged when the fund is either purchased or sold. A "no-load" fund is one that does not charge a fee. A no-load fund would still charge management and expense fees, however. If at all possible, always choose a no-load fund over a load fund. A front-loaded fund, even one that has an exceptional track record, can often be replaced with a similar no-load version.
Holding a Variety of Mutual Funds
One mistake investors often make when investing in mutual funds in believing they are diversified if they hold several different funds. But holding several funds in the same category, or funds that hold similar assets, is not diversification.
When investing in mutual funds as part of an employer-sponsored retirement savings plan, make sure the funds are suitable to both your level of risk tolerance and your investing time horizon. One of the main drawbacks with employer-sponsored funds is that there is very little help or advice about choosing funds. They often have generic names such as "equity fund", "bond fund", or even "socially responsible fund". While you may want to invest in an equity fund, make sure the majority of the equities are what you want. If you have the option, choose a more specific fund such as "small cap equity fund". Regardless of which fund you choose, make sure you read the fund's prospectus and carefully look through the list of actual holding comprising the fund.
While we've covered the basics of mutual fund investing here, there is much more to maximizing the success of your fund investment strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Mutual Fund Guidance
- Mutual Funds Investment Guide — The complete guide to mutual fund investing.
- Balanced, Index, and Specialty Funds — Comparing balanced, index, and specialy funds.
- Exchange Traded Funds — Explore how EFTs compare to traditional funds.
- Money Market Funds — Explore how money market funds work.
- Best Mutual Funds — Factors affecting mutual fund rates, and how to find the best ones.
- Mutual Funds FAQ — Frequently asked questions about mutual fund investing.