Many investors diversify their portfolios by using a mix of mutual funds. These funds are often placed into one of four categories: equity, fixed income, money market, or hybrid (balanced).
Equity funds are stocks or their equivalents. Fixed income funds are government treasuries or corporate bonds. Money market funds are short-term investments in high-quality debt instruments from the government, banks, or corporations, such as corporate AAA bonds.
1. Equity Funds
Stock funds are also called "equity funds." They're the most volatile, and their value can rise and fall sharply over a short time. These funds invest in publicly traded rather than privately owned companies.
Over the long term, stocks often perform better than other types of investments. They are traded with the expectation that a company’s future results will include greater market share, greater revenue, and higher profits.
Stocks tend to move up and down due to investors’ assessment of economic conditions and their likely impact on corporate earnings. Some investors also factor other risks into earnings, such as exposure to fines or lawsuits due to discriminating against certain workers.
Not all stock funds are the same. Some common funds include growth funds, which offer the chance for large capital appreciation but might not pay a regular dividend. They include income funds that invest in stocks that pay regular dividends.
Index funds try to mirror the performance of a particular market index, such as the S&P 500 Composite Stock Price Index. Sector funds are included. They often focus on a certain industry segment such as finance, healthcare, or technology.
2. Fixed Income Funds
Bond funds are also known as fixed income funds. They invest in corporate and government debt with the goal of providing income through dividend payments. Bond funds are often included in a portfolio to boost the total return by providing steady income when stock funds lose value.
Just as stock funds can be organized by sector, so, too, can bond funds. They can range in risk from low, such as U.S.-backed Treasury bonds, to very risky. High-yield or "junk" bonds are thought to be highly risky. They have a lower credit rating than investment-grade corporate bonds.
Bond funds face their own risks, even though they're often safer than stock funds. The issuer of the bonds may fail to pay back their debts. There may be a chance that interest rates will rise, which can cause the value of the bonds to decline. There is an inverse relationship between bond value and interest rates when rates fall.
There's a chance that a bond will be paid off early. The manager may not be able to reinvest the proceeds in a way that pays as high a return if this happens.
3. Money Market Funds
Money market funds have lower risks compared with other mutual funds and most other investments. They are limited by law to investing only in certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments.
Money market funds try to keep their net asset value (NAV) at a constant $1 per share, which represents the value of one share in a fund. However, the NAV may fall below $1 if the fund's investments perform poorly.
The returns for money market funds are often lower than those for bond or stock funds. They're vulnerable to rising inflation. Your money would be cut by 1% if a money market fund were to pay a guaranteed rate of 3%, but inflation were to rise by 4% over the investment period.
One of the bigger concerns during the global financial crisis was potential shortfalls in money market funds. These concerns vanished with the recovery of the global economy, but investor sentiment remains a major player in the money market.
4. Hybrid Funds
The fourth type of fund, the hybrid, combines different types of funds. They can be set up to match an investor's needs. This type of fund invests in both equity and bonds. Not only does that give the funds the appeal of less risk, but they often give decent returns for new investors as well. They could work well for you if you need a tailored approach.
The bonus of a hybrid fund is in the diversification of the portfolio. It allows you to allocate assets in different ways for as long as you own the fund.
Hybrid funds take on the risks of the funds in the portfolio. The fund will have a more bond-specific risk if there is a higher mix of bonds than equity, and vice versa.
Both equity and bond funds can focus on either U.S. or international holdings. Global diversification can be vital to diversification between equity, fixed income, and money markets.
An exchange-traded fund (ETF) is not a fund on its own but rather an option that you can use. It's a group, or "basket," of securities that trade on an exchange. ETFs are a growing segment of options for the average investor. They are often funds with lower fees, and they often track an index, such as the S&P 500, the Russell 2000, or even certain sectors of the economy, such as technology. ETFs offer many investment choices that you may want to think about.
Frequently Asked Questions (FAQs)
Which type of mutual fund is best for a Roth IRA?
The best mutual funds for your Roth IRA will vary widely based on your stage in life. When you're young, you typically want more equity and fewer fixed-income investments. As you approach retirement, that weighting flips, and you usually emphasize stable, fixed-income investments over volatile stocks. There are also target-date funds that automatically rebalance toward conservative investments as the target date approaches.
What types of commissions can you expect with mutual funds?
Some mutual funds charge sales commissions for trading fund shares. These commissions are also known as the "sales loads," and they are expressed as a percentage of the transaction value. Class A mutual fund shares charge a "front-end load" as you buy them. Class B mutual fund shares charge a "back-end load" as you sell them. When possible, you may want to look for "no-load" funds that don't charge any sales commission. Sales loads are different from expense fees, which all funds charge in order to pay the fund managers.
Which mutual fund type charges the highest fees?
Actively managed mutual funds typically come with the highest fees. Passive funds that track indexes like the S&P 500 are cheap to maintain, and investors can share in those savings. Active fund managers spend more time and effort trying to find the best investments, so you'll pay more for that service. These fees are different from sales commissions, which do not necessarily correspond to whether a fund is active or passive.
What type of mutual fund has the investment objective of capital appreciation?
Investment objectives generally fluctuate between capital appreciation and capital preservation. Capital appreciation funds seek investments that will gain value over time. Capital preservation funds seek investments that offer the highest level of downside protection. Most funds balance these two goals, but the more equity a fund holds—especially in growth stocks—the more it is likely to emphasize capital appreciation over preservation.