This article explains the basics of mutual funds by breaking down what they invest in.
You already know that mutual funds are a good way to save for retirement. Not only do they limit risk by spreading your money around – known as “diversification” in investing parlance -- they give you the comfort of knowing a professional money manager is keeping tabs on your savings.
But with so many different funds available, picking the right ones for you can be daunting. What's the difference between growth and value, mid-cap and small cap, fixed-income and equity? This primer will break down the different types of mutual funds.
Let's start with the basics. Generally, there are two types of funds, those that invest in stocks -- called "equity" funds -- and those that invest in bonds, known as "fixed-income" funds. You may have also heard of "blended" funds, which do just that -- invest in a little of both.
Equity Funds
The large majority of mutual funds fall into this category. They can generally be classified by their investment style (growth vs. value) and the size of the companies they invest in (known as the "market cap").
Growth vs. Value -- What's the difference?
With growth funds, managers are trying to find companies that have a history -- or perhaps the potential -- of strong growth in factors such as profits, (called earnings), sales and cash flow. If those indicators continue to grow, so should the stock's price.
In value funds, managers try to find companies that have strong financials already, but which have fallen out of favor with most investors. Maybe there's a clothing company that's shown reliable sales and consistent profits, but whose stock price has dipped because popular celebrities are wearing a competitor's designs. That might be a "value" opportunity, since the stock's price should eventually rise to reflect the underlying health of the company.
Size Matters
Now that you know growth from value, all you have to do is add in the size of the companies a mutual fund invests in -- its market cap -- to understand how that fund works. For instance, a small-cap growth fund is going to invest in smaller, and perhaps younger, companies whose financial indicators have had healthy growth. A large-cap value fund, on the other hand, will look for big, solid companies that are doing well financially, but aren't popular with the market.
Index Funds – Investing on Autopilot
If you're comfortable matching the performance of the overall market -- whether it goes up or down -- an index fund might be for you. These funds invest in all the stocks that make up benchmarks such as the Wilshire 5000 or the S&P 500, so their returns are in line with the broader market. Since the U.S. stock market has returned an average of 10% per year over the last 100 years, index funds can be a good, long-term investment with a reasonable return.
Fixed-income Funds
Unlike equity funds, fixed-income funds invest in bonds, which are a form of debt. Companies and governments sell bonds to raise money for their own operating or investing needs. For instance, the U.S. Treasury’s 10-year bond is an ongoing program that perpetually raises cash for government coffers.
In general, because they’re backed by a promise to be repaid, bonds are viewed as more conservative than stocks. Since bonds typically pay out interest, they also generate income for investors. But their returns are usually smaller than what you’ll get with stocks. Fixed-income mutual funds invest in a wide array and style of bonds, whether issued by companies (corporate bonds) or countries (government bonds).
Blended Funds – A Little of Both
Blended funds, which hold both stocks and bonds, aim for a higher return than straight fixed-income, but still aren't as aggressive as pure equity funds.
It's your choice
Now that you know what funds are made of, you’re that much closer to choosing the right fund for you. Next, we’ll look at figuring out your own investing profile to match you and your mutual funds together.
