Types of funds

Most investment companies are funds, including mutual (open-end) funds, closed-end funds, and exchange-traded funds (ETFs). A fund’s “type” is based on its investment objective and the kinds of securities it holds. Some types are easy to recognize, while others are easiest to learn through memorization.

These are the primary types to know:

• Growth funds
• Growth and income funds
• Balanced funds
• Income funds
• Specialized funds
• Sector funds
• Index funds
• Asset allocation funds
• International/global funds

Growth funds

A growth fund seeks capital appreciation (buy low, sell high). It typically invests in growth-focused common stocks. It may also hold convertible preferred stock and bonds because the ability to convert into common stock creates potential for capital gains.

Sidenote

Capitalization

Funds are sometimes classified by the size of the companies they invest in. Market capitalization is a common way to measure company size. It’s calculated by multiplying a company’s outstanding common shares by the current market price per share. For example, a small-cap growth fund invests exclusively in smaller companies.

While knowing every market-cap category isn’t heavily tested on the exam, here are the five primary ones:

Mega-cap

• $200 billion or more

Large cap

• Between $10 billion - $200 billion

Mid-cap

• Between $2 billion - $10 billion

Small-cap

• Between $250 million - $2 billion

Micro-cap

• Less than $250 million

In general, smaller companies tend to have both higher risk and higher growth potential. When a small company performs well in a strong economy, its stock can grow significantly. On the other hand, smaller companies are often the first to fail when a recession occurs.

Definitions

Recession

General economic decline over six straight months (two quarters)

Keep this relationship in mind for test questions. Mega- and large-cap funds hold larger, more established companies. They still carry risk, but they’re typically less aggressive and less volatile than small- or micro-cap growth funds.

Aggressive growth funds are still growth funds, but they take on more risk. They invest in common stock with higher return potential, often including small- and micro-cap stocks and companies in volatile or emerging industries.

Real world examples

• Fidelity Blue Chip Growth Fund (ticker: FBGRX)
• Clearbridge Aggressive Growth Fund (ticker: SHRAX)

Growth and income funds

Growth and income funds seek capital appreciation, but they also aim to generate income. They do this by investing in income-producing common and preferred stocks. Virtually all preferred stocks have a fixed dividend rate, but only larger, well-established companies (e.g., Walmart, Coca-Cola, Procter & Gamble) commonly pay dividends on their common stock.

Dividend-paying stocks are generally less risky than growth-focused common stocks. To pay consistent dividends, a company usually needs consistent profits. Many growth stock issuers are unprofitable or have volatile revenues, so they’re less likely to pay steady dividends. Because of that, a fund that allocates part of its portfolio to dividend-paying stocks is typically more conservative (less risky) than a pure growth fund.

Definitions

Conservative

Low risk

Aggressive

High risk

Real world example

• Vanguard Growth and Income Fund (ticker: VQNPX)

Balanced funds

Balanced funds are similar to growth and income funds, but they aim for a relatively even mix of:

• growth-focused common stock, and
• income-producing securities, including debt securities

A key distinction:

• Balanced funds invest in stocks and bonds.
• Growth and income funds invest only in stocks.

Don’t mix these two up.

Real world example

• Schwab Balanced Fund (ticker: SWOBX)

Income funds

Income funds invest only in income-producing securities. They’re generally more conservative and less risky than growth-focused funds, largely because common stocks can be highly volatile as business conditions and the overall economy change. If a company has a poor year or the economy enters a recession, common stock investors can experience significant losses.

Income funds commonly hold bonds, preferred stocks, and dividend-paying common stocks.

• Bond issuers are legally required to pay interest, and bond prices typically experience major swings mainly when high levels of interest rate or inflation risk exist.
• Preferred stock dividends aren’t legal obligations, but issuers usually skip them only when facing serious financial trouble.
• As noted earlier, the largest and most established companies are the most likely to pay dividends on common stock.

For these reasons, investors can often reduce the chance of significant losses by holding a diversified portfolio of income-producing investments (though this isn’t always true).

Different types of income funds include corporate bond funds, municipal bond funds, and US Government bond funds, which invest in the securities of those issuer types. There are also high yield bond funds, which invest in riskier “junk” bonds with sizeable yields. Conversely, conservative bond funds invest in investment-grade bonds with lower levels of risk and yield. International bond funds invest in bonds from foreign companies and governments.

Investors can also find Ginnie Mae, Fannie Mae, and Freddie Mac funds, which invest in mortgage-backed securities issued by these federal agencies. Fannie Mae and Freddie Mac purchase mortgages from financial institutions, while Ginnie Mae doesn’t purchase mortgages at all - instead, it guarantees qualifying mortgage-backed securities issued by approved private lenders. Investors receive income from interest and principal mortgage payments. Although subject to prepayment and extension risk, Ginnie Mae, Fannie Mae, and Freddie Mac funds are suitable for risk-averse investors seeking conservative investments due to the government backing of agency securities.

Money market funds are also a type of income fund, but they generally pay small amounts of income. As a reminder, money markets are fixed income securities with one year or less to maturity. Many investors use money market funds similarly to bank savings accounts. When an investor holds cash in a brokerage account, it’s typically invested in a money market fund.

Money market funds are:

• priced at a consistent $1.00 per share
• likely to make monthly dividend payments

Investors can reinvest dividends to buy additional $1.00 shares or take the payment as cash. These funds are very liquid (easy to sell), provide a small amount of income, and are suitable for investors with short-term time horizons.

Real world examples

• JP Morgan Corporate Bond Fund (ticker: CBRAX)
• American High-Income Municipal Bond Fund (ticker: AMHIX)
• Dreyfus US Treasury Long-Term Fund (ticker: DRGBX)
• PGIM High Yield Fund (ticker: PBHAX)
• Fidelity Conservative Income Bond Fund (ticker: FCNVX)
• Vanguard GNMA Fund (ticker: VFIIX)
• T. Rowe Price Cash Reserves Fund (ticker: TSCXX)

Specialized funds

Specialized funds aren’t defined by “growth” or “income.” Instead, they invest only in securities from a specific industry or region, so their risk and return potential can vary widely. Funds that focus on a particular industry are sometimes called sector funds.

Real world examples

• RMB Japan Fund (ticker: RMBPX)
• Columbia Seligman Technology and Information Fund (ticker: SLMCX)
• Schwab Health Care Fund (ticker: SWHFX)
• T. Rowe Price European Stock Fund (ticker: PRESX)

Index funds

Index funds aim to give investors the same return as a specific index.

An index is a list of securities designed to track and average the values of the securities on that list. A well-known example is the S&P 500, which is often used as a shorthand for “the market.” The S&P 500 is a list of 500 large company stocks traded in the United States. Investors use indexes to gauge broad market trends. When the S&P 500 is up, it’s often taken as a sign that the overall market is moving upward.

Indexes come in many forms:

• small- and large-cap indexes (tracking smaller vs. larger companies)
• bond indexes (tracking bonds from various issuer types)
• specialized indexes (tracking specific industries or regions)

Investment management is often described in two broad styles:

• Active management: selecting what the manager believes are the best investments within a market. For example, the manager of the Fidelity Large-Cap Stock Fund (ticker: FLCSX) identifies and invests in what they consider the best large-cap stocks.
• Passive management: tracking an index as closely as possible. For example, the manager of the Fidelity 500 Index Fund (ticker: FXAIX) invests in the same stocks in the S&P 500. With index funds, there’s no “picking and choosing” - the portfolio is built to mirror the index.

Passive management through vehicles like index funds is becoming very popular in the market, and passive strategies have grown to represent a majority of the US mutual fund and ETF market. We’ll discuss more about this investing style later in this unit.

Real world examples

• iShares Total U.S. Stock Market Index Fund (ticker: BASMX)
• Shelton NASDAQ-100 Index Fund (ticker: NASDX)
• Northern Bond Index Fund (ticker: NOBOX)

Asset allocation funds

Asset allocation funds invest across asset classes (such as stocks and bonds) according to a stated strategy.

Some asset allocation funds keep a constant mix, like Fidelity’s Asset Manager 70% Fund, which invests 70% of portfolio assets in stocks and the remaining 30% in long- and short-term debt securities.

Other asset allocation funds change their mix based on expected market performance or fund requirements. Life cycle funds, also called target date funds, use a changing allocation designed to align with an investor’s timeline. They typically start out more aggressive (heavier in growth stocks). Over time, they become more conservative by shifting assets into safer fixed-income securities. The idea is straightforward: as an investor gets older, they generally take on less risk.

A common example is the Vanguard Target Retirement 2050 Fund, which was created for investors targeting retirement around the year 2050. The fund is aggressive today, with roughly 90% of assets in stocks, but it will shift more toward bonds and other fixed income securities over time.

Real world examples:

• Spectrum Conservative Allocation Fund (ticker: PRSIX)
• Franklin LifeSmart 2050 Retirement Target Fund (ticker: FLSOX)

International/global funds

As the names suggest, international and global funds invest outside the United States.

• International funds invest only in securities issued outside the US.
• Global funds invest worldwide, including US-based securities.

These funds can add diversification and may help hedge against domestic risks.

Real world examples:

• Causeway International Value Fund (ticker: CIVIX)
• Kopernik Global All-Cap Fund (ticker: KGGAX)