We’ve already learned about the characteristics of mutual funds, closed-end funds, and exchange-traded funds (ETFs). Now we’ll focus on common fund types. A fund’s type is usually based on its investment objective and the kinds of securities it holds. Some types are easy to tell apart, while others can look similar, so it helps to compare them side by side.
A growth fund seeks capital appreciation - in other words, it aims to increase the value of its holdings over time (buying securities at lower prices and selling at higher prices). Growth funds most often invest in common stock because common stock has the greatest potential for capital gains. They may also include convertible preferred stock and convertible bonds, since the ability to convert into common stock can create capital appreciation potential.
Aggressive growth funds are growth funds that take on more risk in pursuit of higher returns. They typically invest in common stock with higher return potential, including stock of small-cap companies and companies in volatile or emerging industries.
Growth and income funds, sometimes called blend funds, seek capital appreciation but also invest in income-producing stocks. These holdings can include preferred stock and dividend-paying common stock.
Stocks that provide dividend income are generally less risky than growth-focused common stocks. To pay consistent dividends, a company usually needs consistent profits. As a result, growth and income funds are typically more conservative than pure growth funds.
Balanced funds are similar to growth and income funds, but they aim for a fairly even mix between:
Balanced funds invest in both bonds and stock, while growth and income funds invest in stock only. Don’t mix these up.
Income funds invest only in income-producing securities, such as bonds, preferred stock, and dividend-paying common stock. Capital appreciation (growth) is not the primary goal. Instead, these funds aim to provide consistent interest and dividend income. Income funds are generally more conservative and less risky than growth funds.
Why are growth funds usually riskier than income funds? The main reason is price volatility in the stock market. Stock prices can move sharply based on business performance and overall economic conditions. If a company has a poor year or the economy enters a recession, common stockholders can experience significant losses.
Income investments include bonds, preferred stock, and dividend-paying common stock:
In general, income-producing investments can help investors reduce volatility and limit large losses.
Different types of income funds include corporate bond funds, municipal bond funds, and US Government bond funds, which invest in those types of issuers. There are also high yield bond funds, which invest in riskier “junk” bonds with high yields. Conversely, there are conservative bond funds that 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. If you recall, these agencies purchase mortgages from banks to make it easier for Americans to purchase real estate. Investors receive income originating from interest paid on mortgages. 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.
Asset allocation funds invest across asset classes based on a chosen allocation. For example, an asset allocation fund might hold a 60% stock / 40% bond mix.
Some asset allocation funds keep a constant mix, such as Fidelity’s Asset Manager 70% Fund, which invests 70% of portfolio assets in stocks, with the remaining 30% invested 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 known as target date funds, are designed to adjust over an investor’s lifetime. They typically start out more aggressive (with a heavier allocation to growth stocks) and become more conservative over time by shifting assets into fixed-income securities. This reflects a common suitability principle: as an investor gets older, they generally should take 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 right now with roughly 90% of the assets invested in stocks, but the allocation will shift more to bonds and other fixed income securities as time passes.
Money market funds are a type of income fund, but they generally pay small amounts of income. Money market securities are fixed income securities with one year or less to maturity, so money market funds are typically low risk and low yield.
Many investors use money market funds similarly to bank savings accounts. When an investor holds cash in an investment account, it’s often placed in a money market fund. Priced at a consistent $1.00 per share, money market funds typically make monthly dividend payments. The investor can reinvest the proceeds to buy more $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.
Specialized funds aren’t defined by growth or income objectives. Instead, they concentrate on securities from a specific industry or region. Examples include Japan funds, biotechnology funds, and Latin American funds. Risk and return can vary widely depending on the region or industry.
Funds that focus on a specific industry are sometimes called sector funds.
Index funds aim to match the return of 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, often used as a proxy for “the market.” The S&P 500 is a list of 500 large companies that are traded in the United States. Investors use indexes to gauge broad market trends. When the S&P 500 is up, it’s commonly interpreted as the overall market moving upward.
Indexes come in many forms:
When investors buy an index fund, they’re choosing a fund that isn’t trying to pick the “best” securities. Instead, it’s trying to match the index’s performance. This approach is called passive investing, and it has becoming very popular in the market.
In this section, we covered the most common fund types you’ll see in practice and on the Series 65 exam, especially in suitability questions. You’ll see these fund types again in later sections.
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