The 3 Types of Mutual Funds
How equity, fixed income, money market funds are different
Many investors diversify their portfolio by including a mix of mutual funds. Mutual funds are generally placed into one of four primary categories: equity, fixed income, money market, or hybrid (balanced).
Equity funds are stocks or equivalents, while fixed income mutual funds are government treasuries or corporate bonds. Money market funds are short-term investments in high-quality debt instruments (such as corporate AAA bonds) from government, banks or corporations.
Stock funds, also called equity funds (investing in publicly traded as opposed to privately-owned companies), are the most volatile of the three, with their value sometimes rising and falling sharply over a short period.
But historically, stocks have performed better over the long term than other types of investments. That’s because stocks are traded on the expectation that a company’s future results will include expanded market share, greater revenue, and higher profits.
Generally, stocks fluctuate because of investors’ assessment of economic conditions and their likely impact on corporate earnings. Socially responsible investors also factor in other risks to earnings such as exposure to fines, lawsuits from polluting the economy or discriminating against particular employees.
Not all stock funds are the same. Some common funds include:
- Growth funds, which offer the potential for large capital appreciation but may not pay a regular dividend
- Income funds that invest in stocks that pay regular dividends
- Index funds, which try to mirror the performance of a particular market index, such as the S&P 500 Composite Stock Price Index
- Sector funds, which usually specialize in a particular industry segment, such as finance, healthcare or technology
Fixed Income Funds
Bond funds, also known as fixed income, invest in corporate and government debt with the purpose of providing income through dividend payments. Bond funds are often included in a portfolio to boost an investor’s 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 can be categorized. They can range in risk from low, such as a U.S.-backed Treasury bond, to very risky in the form of high-yield or junk bonds, which have a lower credit rating than investment-grade corporate bonds.
Though usually safer than stock funds, bond funds face their own risks:
- The possibility that the issuer of the bonds, such as companies or municipalities, 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.
- The possibility that a bond will be paid off early. When that happens to bond funds there is the chance the manager may not be able to reinvest the proceeds in something else that pays as high a return.
Money Market Funds
Money market funds have relatively low risks, compared with other mutual funds and most other investments. By law, they are limited to investing only in specific 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)—which represents the value of one share in a fund—at a constant $1 per share. But the NAV may fall below $1 if the fund's investments perform poorly.
Historically, the returns for money market funds have been lower than for either bond or stock funds, leaving them vulnerable to rising inflation. In other words, if a money market fund paid a guaranteed rate of 3%, but over the investment period, inflation rose by 4%, the value of the investor’s money would have been eroded by 1%.
During the global financial crisis, one of the bigger concerns was potential shortfalls in money market funds. Those concerns have vanished with the recovery of the global economy. However, investor sentiment is a major player in the money market, and politics tends to influence sentiment in this market.
There is a fourth type of mutual fund—the hybrid. As the name implies, this type is a combination of different types of funds that can be tailored to match an investor's situation and needs.
The Fourth Type—Hybrid Funds
This type of fund invests in both equity and bonds. This not only gives the fund the appeal of decreased risk but generally they give relatively decent returns for beginning investors or investors in need of a tailored approach.
The attractiveness of a hybrid fund is in the diversification of the portfolio, and the ability of the funds to allocate assets in different manners throughout the investor's ownership of the fund.
Hybrid funds take on the risks of the funds that are compiled within the portfolio of the fund. If there is a higher mix of bonds than equity in the fund than there will be a more bond specific risk in the fund, and vice versa.
Both equity and bond funds can specialize in either domestic (US) or international holdings. Global diversification can be as, if not more, important than diversification between equity, fixed income and money markets.
One Last Thought
There is one more fund type to be aware of. It is not a fund on its own, but rather an option you can use, a group (or basket) of securities that trade on an exchange—the exchange-traded fund (ETF). ETFs are a growing segment of investment options for the average investor; these are exchange-traded versions of all the types of funds and investments.