One of the most important investment vehicles for personal finance remains the mutual fund. Through mutual funds, individuals can take advantage of the diversification possible with a much larger body of money, which makes it popular as a personal investment and as a way to save for retirement. A mutual fund is essentially a company that invests in stocks and/or bonds using the money of people who invest in the mutual fund itself. Then, the entire pool of investors shares in the profit based on the proportion that they contributed to the whole investment. While mutual funds are a simple concept on the surface, a wide range of different mutual funds exists, and it is important to understand how they are different when choosing which one to invest in.
The following are the most popular types of mutual funds and their distinguishing features:
One of the most common types of mutual fund in existence, equity funds invest in stock. These funds are aimed at quick growth, so they take on higher risk than some of the other options. As a result, people stand to lose money by investing in an equity fund. Typically, an equity fund specializes in a specific type of investment, such as value stocks, large-cap stocks, growth stocks, or income funds. Of course, some equity funds invest in a wide range of different types of stock.
Money market funds
A money market fund carries lower risk than most of the other types of mutual funds on this list because they focus on short-term, fixed-income securities. These securities include government bonds, certificates of depots, bankers’ acceptances, and treasury bills. Because these sorts of investments are safer than stocks, their rate of return is also significantly lower than with other options. However, the chance of an investor losing money is extremely low.
The investors in index funds pay close attention to the performance of a specific index, often the Standard & Poor/TSX Composite Index. The investments are tied to these indexes, therefore the value of the fund goes up or down as the index goes rises and falls. Because there is not much research involved and the investment decisions are based on the performance of the index, these types of funds boast lower costs than those requiring more active management. Index funds are a type of passive management, meaning that the holdings are only adjusted when the components of the index change, and the whole portfolio is designed to track the benchmark index. Active management involves aggressive buying and selling in an attempt to outperform the benchmark.
As the name suggests, these instruments purchase investments with a fixed rate of return. Possible options include high-yield corporate bonds, investment-grade corporate bonds, and government bonds. The point of investing in fixed-income vehicles is that money is always flowing into the mutual fund. The risk involved with these types of funds depends on the investments that they purchase. High-yield corporate bonds have greater risk, but they also have a higher return than government bonds or investment-grade bonds.
Also called foreign funds or global funds, international funds invest outside of the investors’ home country. Classifying these types of mutual funds as risky or safe is difficult because the risks involved vary by country. In general, these funds tend to be more volatile than others, but they can also reduce overall risk in a portfolio by providing diversification. While economies are interdependent to some degree, betting on another economy can keep a portfolio afloat when the market at home is low.
These instruments try to secure higher returns while also mitigating the risk of losing money by investing in equities and fixed-income securities at the same time. Each fund has its own formula for how to split money across these different types of investments. Because fund managers don’t always get the formula correct, these funds have more risk than fixed-income funds, but they have less risk than a completely equity-based fund. Typically, balanced funds are categorized as aggressive, meaning more equities than bonds, or conservative, meaning more bonds than equities.
Mutual funds that do not fall into the larger categories mentioned previously are typically called specialty funds. Some examples of this type of vehicle include sector funds, which target a specific sector and tend to be very volatile; ethical funds, which target companies that align with certain beliefs for investment; and regional funds, which focus on a specific geographic areas and also carry high risk because of the possibility of a recession.
Fund of funds
Another type of mutual fund worth mentioning is the fund of funds, which invests in other mutual funds. These funds often operate like balanced funds and attempt to maximize diversification and optimize asset allocation. Because of the degree of work entailed in such a setup, the management expense ratio for these types of funds tends to be rather high, meaning that the operating expenses, managing fees, and taxes cut into investor gains.