| Types of Funds |
|
Mutual and exchange traded funds fall into a variety of categories. Each type of fund has different features and a unique risk/reward mix. Generally speaking, the higher the reward or potential return, the greater the risk. It is important as an investor that you understand your risk tolerance before deciding which type of fund to invest in.
Stock Funds
Stock funds have been the most popular collective investment scheme, with about half of all mutual funds being stock funds. Historically, over the long run, stock funds have outperformed their bond or money market counterparts, but in the short term their value can rise and fall substantially. Stock funds differentiate themselves by the types of securities they invest in. For example:
- Growth funds focus on smaller companies that have the potential for large capital gains.
- Income funds focus on larger companies that pay regular dividends.
- Sector funds focus on companies in a particular sector such as technology or financial services.
- Foreign funds buy securities of companies that trade on foreign exchanges such as the Chinese stock exchange.
- Index funds attempt to match the performance of a particular market index, by holding all or a "representative sample" of the securities in the index.
- Index funds are not actively managed and most rely on a computer model for investment decisions, which leads to lower management fees and expenses. The majority of exchange traded funds such as the Spiders (SPDR) and the Diamonds (DIA) track market indices like the S&P 500 and the Dow, respectively.
Money Market Funds
Money market funds are designed to be the lowest risk investment when compared to all other funds. The most important thing in a money market fund is preservation of principal, and the tradeoff for an investor is usually to accept a lower rate of return. Money market funds try to keep their net asset value (NAV) at a stable $1.00 per share. It is possible for the NAV to fall below $1.00, say to $0.99 or $0.98, but it is extremely rare, and when it happens, it is called "breaking the buck". In September 2008, the Reserve Primary Fund, a large money market mutual fund, broke the buck when its shares fell to a value of $0.97. This was caused by writing off debt issued by Lehman Brothers who had filed for bankruptcy.
To prevent NAV's from dropping below $1.00, rule 2a-7 of the Investment Company Act of 1940 restricts investments made by money market mutual funds by quality, maturity and diversity. Funds are restricted to buying debt in the two highest rating categories and it has to mature under 13 months. They also have to maintain a weighted average portfolio maturity of 90 days, and cannot hold more than 5% of any one particular issuer, with some exceptions. As a result, money funds buy short term debt such as U.S. Treasury bills and commercial paper. There also are tax-free money funds that buy short term paper from highly rated municipal issuers.
Bond Funds
Bond funds generally produce higher returns than their money fund counterparts due to their ability to invest in debt with longer maturities and lower quality. They pursue strategies that will produce higher yields and thus more risk to the investor. The two most important risks to be aware of when investing in bond funds are the following:
Credit Risk
- Represents the probability that the issuers of the debt owned by the fund may fail to pay interest or principal. Increased credit risk lowers bond prices, and thus the NAV of the fund.
Interest Rate Risk
- Represents the fact that the value of the bond portfolio will fluctuate with the level of interest rates. As interest rates rise, the NAV of the fund will go down. Funds that invest in longer dated securities have a greater sensitivity to interest rates than those funds that invest in shorted dated securities. The fund's duration is the most commonly used measure of interest rate risk.
Balanced Funds
Balanced funds buy a mix of stocks and bonds and provides investors with both income and capital appreciation, while avoiding excessive risk. The manager has the freedom to adjust the proportion of stocks in the portfolio depending on stock market returns and the perceived risk. This enables the fund to manage through a downturn in the stock market. Investors that buy into balanced funds are those who usually do not have the minimum investment necessary to invest in more than one fund.
Commodity Funds
Commodity funds invest in commodities and commodity futures and options. Commodity funds are primarily used as a way to diversify holdings beyond stocks and bonds. Commodities are an excellent hedge for inflation which erodes the value of both stocks and bonds. Commodity funds may track an index such as the Dow Jones-AIG Commodity Index or individual commodities such as Gold.
Fund of Funds
A fund of funds (FoF) is a mutual fund that invests in other underlying mutual funds (i.e., it is a fund comprised of other funds). A fund of funds typically charges a management fee which is smaller than that of a normal fund because the investor is only paying for asset allocation services. Fund of Funds can be either actively or passively managed. They are designed for the investor who wants diversification, but does not want to develop his or her own asset allocation model.
Hedge Funds
Hedge funds are pooled investment vehicles that are not to be confused with mutual funds. They face much looser regulations from the Securities and Exhange Commission (SEC) as opposed to mutual funds. Hedge funds are not limited in the assets they can invest in and also make use of leverage (using borrowed money to buy more of an asset) in their investments. Hedge funds claim to produce higher returns than either mutual or exchange traded funds and as a result charge higher fees. A common fee structure is "2 and 20", where the fund has an annual charge of 2% of assets under management as well as a charge of 20% on the profits.
| 401k Advice That Everyone Could Use< Prev | Next >Mutual Fund & ETF Structure |
|---|
|
|
Recommended Reading
