We’ve already learned about the characteristics of mutual funds, closed-end funds, and exchange-traded funds (ETFs). Now, we’ll focus on various fund types, which are largely dependent on the fund’s investment goals and the types of securities it invests in. Some will be easy to distinguish and others may require some memorization. Regardless, let’s go through the common types of funds to better understand the choices investors have when choosing funds.
A growth fund is a fund that seeks to attain capital appreciation. That’s a fancy way of saying buy securities low and sell them high. Growth funds most often invest in common stock due to their potential for capital gains, Convertible preferred stock and convertible bonds may also be included (their convertibility into common stock provides the potential for capital appreciation).
Aggressive growth funds are also growth funds, but with more risk involved. This type of fund invests in common stock that provides a higher potential for return, including stock of small-cap (smaller) companies and companies from volatile or emerging industries.
Growth and income funds, sometimes referred to as blend funds, also focus on attaining capital appreciation, but additionally invest in income-producing stocks, which includes preferred and common stock. Virtually all preferred stocks have a fixed dividend rate, but only larger and well-established companies like Walmart pay dividends on their common stock. Stocks that provide dividend income are generally less risky than growth-focused common stocks; in order to pay consistent dividends, the company must make consistent profits. Therefore, this type of fund is more conservative than pure growth funds.
Balanced funds are similar to growth and income, but balanced funds seek a fairly even distribution between growth-focused common stock and income-producing securities, which include bonds. Balanced funds invest in bonds and stock, whereas growth and income funds only invest in stock. Don’t get the two mixed up!
Income funds only invest in income-producing securities, which include bonds, preferred stock, and common stocks that pay regular dividends. Capital appreciation (growth) is not a focus for these funds as they aim to only provide their investors with consistent interest and dividend income. Income funds are generally more conservative and less risky than growth funds.
Why are growth funds riskier than income funds? It’s due to price volatility in the stock market. The stock market is unpredictable and prices can move in a variety of directions depending on business activity and general economic conditions. If a company has a rough year or the economy is going through a recession, it’s not uncommon for investors to lose significant amounts of money on their common stock.
Income investments include bonds, preferred stock, and common stock. Bond issuers are legally required to pay interest, and bondholders generally don’t see significant fluctuations in their bond values unless interest rates change considerably. Although dividend payments from preferred stock are not legal obligations, issuers rarely miss their dividend payments unless the company is facing significant financial troubles.
Larger, well-established companies with a long track record of profits frequently pay cash dividends to their common stockholders. Even in tough economic environments, these investments tend to maintain most of their value. Generally speaking, investors can largely avoid volatility and significant losses with income-producing investments.
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 that 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 do exactly what their name suggests; they invest in specific asset classes depending on various factors. For example, an asset allocation may currently hold a 60% stock, 40% bond mix. Some asset allocation funds maintain a constant asset mix, like the 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.
Some asset allocation funds shift their structures around due to expected market performance or because of fund requirements. Life cycle funds, also known as target date funds, have changing allocations and are meant to “follow along” an investor’s lifetime. They start out more aggressive when originally issued, investing primarily in growth stocks. As time passes, the fund becomes more conservative by shifting more assets into safer fixed-income securities. This enforces good investment practices; the older an investor is, the less risk they should expose themselves to. A good 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 also an income fund, but generally pay small amounts of income. Money markets are fixed income securities with one year or less to maturity. Money market funds are low risk and low yield.
Many investors utilize money market funds similarly to their bank savings accounts. When an investor has cash in their investment accounts, it is typically invested in a money market fund. Priced at a consistent $1.00 per share, money market funds typically make monthly dividend payments to their investors. The investor can reinvest to proceeds and buy more $1.00 shares, or can take the payment as cash.
These funds are very liquid (easy to sell), provide a small amount of income, and are suitable for investors who have short-term time horizons.
Specialized funds are not specific to growth or income investments. These are funds that only invest in securities from a specific industry or region. Some examples include Japan funds, biotechnology funds, and Latin American funds. Specialized funds can range in risk and potential return depending on the region or industry. Funds that invest in specific industries are sometimes referred to as sector funds.
Index funds aim to provide their investors with the exact return of a specific index. An index is simply a list of securities that tracks and averages all of the values of the securities on that list. You’ve probably heard of the S&P 500, which is the most popular index in finance and is commonly referred to as “the market.” The S&P 500 is a list of 500 large companies that are traded in the United States. Investors commonly use indexes to determine general trends in the market. When the S&P 500 is up, it is assumed that the general market is moving upward.
Indexes come in all shapes and sizes; indexes like the S&P 500 cover the general stock market. There are small and large cap indexes, which track stocks of smaller and larger companies, respectively. Also, there are a variety of bond indexes that track the bond values of a variety of issuers. Additionally, there are specialized indexes that track investments from specific industries and regions.
By investing in an index fund, investors are handing their money to a fund that is no longer looking for the best investments in the market, but instead is trying to match the exact return of the index. Known as “passive” investing, this style of investing is becoming very popular in the market.
In this section, we discussed the most common funds in finance, which are important to know for the Series 65 exam (especially for suitability purposes). You’ll learn more about these funds in future sections.
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