What You Should Know About Mutual Funds
The first mutual funds appeared about 70 years ago and invested only in common stocks. The stated objective of those funds was to participate in the long-term growth of the American economy. They offered the "common man" a way to acquire small pieces of ownership interest in a variety of U.S. corporations.
Types of Mutual FundsThe following are some of the major categories of mutual funds: Stock Funds, Balanced Funds, Income Funds and Tangible Asset Funds.
Before you invest in a mutual fund, it is important to understand what these different categories represent, and what they can and can not do for you over a long period of time.
Stock FundsA stock fund is composed of shares of the stock of many different companies. When you purchase shares in a stock mutual fund you become the indirect owner of a large number of companies. To achieve additional diversification, most stock funds own stocks of companies from a number of industry groups.
Funds, which instead concentrate on one or a few related industry groups, are referred to as sector funds. An example of a sector fund would be a mutual fund that only invests in companies that are involved in technology. This type of fund would not own a company like Coca-Cola, but would instead own lots of telecommunication, computer and software companies.
It is also important to know that even among stock funds, there are significant differences. A growth fund invests in companies which the fund manager feels have good potential for rapid growth of sales and earnings. An aggressive growth fund looks for stocks with unusually high growth potential, accepting the greater volatility that this approach brings. Companies whose shares are purchased by aggressive growth funds tend to reinvest their earnings into internal growth through research and development or acquisitions, and therefore most pay small dividends or none at all. If this type of company has a slow down in their earnings growth, the prices will generally fall, often dramatically.
A growth and income fund focuses on common and preferred stocks which tend to provide higher dividend income and yield than those held in strictly growth oriented funds, while still offering some potential for long term-growth.
A value fund is a stock fund that attempts to find stocks that have been overlooked by other investors, and is thus undervalued. These stocks tend to have low price-to-earnings ratios, and high book value to market-value ratios. Finally, mutual funds can be differentiated by the size of the companies they invest in. A small-cap fund invests only in companies with small market capitalization (the total number of shares multiplied by the price). A mid-cap fund invests in medium-sized companies and a large-cap fund invests only in large companies.
Besides understanding the different types of stock mutual funds, it is also important to keep in mind that stocks do tend to be volatile, and they drop in price often without warning or reason. Any money you consider investing in any stock mutual fund should be money that you do not expect to need for at least five years. A key to successful stock investing is patience-you need to be able to wait out the inevitable drops in the stock market.
Income FundsIncome funds are mutual funds whose primary objective is to pay out an income on a regular basis. A money market fund is an income fund that owns very short-term, very high-quality debt securities. The objective is to maintain a very stable price and pay out a reasonable yield.
A bond fund invests in longer debt securities than a money market fund. Bond funds can invest in either corporate or government securities or both. They generally offer higher levels of income than stock funds. Among bond funds you will find mortgage-backed funds such as GNMA funds. These types of funds own bonds that are collateralized by pools of mortgages on real estate. While the yields are higher than on other government bonds, there is also more volatility.
There are also municipal funds that invest only in tax-free municipal bonds. Although the yields are lower, the effective after-tax yield can be very attractive for people in a high income-tax bracket.
Another popular type of bond fund is the high-yield fund. This type of fund invests in lower rated corporate debt. Because these companies have lower credit ratings, they must pay a higher rate to borrow money. Although the interest rate is higher, the chance of default is also higher.
As contrasted with stock oriented mutual funds, bond funds are subject to interest rate risk. If interest rates start to rise (like they have so far this year) the price of bonds will fall. This means that if you invest in a bond fund, even a U.S. government fund, you can still see your investment drop in value if interest rates rise. Conversely, if interest rates fall, your investment should rise.