Considering different types of mutual funds

As you prepare to invest in mutual funds, you need to decide which type of funds best suits your goals and tastes. Basically, you have the following four types of mutual funds to consider:

• Stocks funds, which invest in stocks
• Bond funds (also considered income funds), which invest in bonds
• Balanced funds, also called hybrid funds, which invest in both stocks and bonds
• Money market funds, which invest in short-term investments

Each of these groups presents a wide variety of funds with different characteristics from which to choose. To help you further refine your search to match fund investments to your goals, the following lists offer a general look at some different types of funds available.
Stock funds include:

• Aggressive growth funds: Managers of these funds are forever on the lookout for undiscovered, unheralded companies, including small and undervalued companies. The goal is to get in when the stock is cheap and realize substantial gains as it soars skyward. That dream doesn’t always come true. But if you’re willing to accept above average risk, you may reap above-average gains.
• Growth funds: These funds are among the mainstays of long-term investing. They own stocks in mostly large- or medium-sized companies whose significant earnings are expected to increase at a faster rate than that of the rest of the market. These growth funds do not typically pay dividends. Several types are available, including large-, medium-, and small-company growth funds.
• Value funds: Managers of these funds seek out stocks that are underpriced — selling cheaply, relative to the stock’s true value. The fund’s manager believes that the market will recognize the stock’s true price in the future. Stock price appreciation is long term. These funds don’t typically turn in outstanding performance when the stock market is zooming along, but tend to hold their value a good deal more than growth funds when stock prices slide. That’s why value funds are generally believed to be good hedges to more growth-oriented mutual funds. These funds come in large-, medium-, and small company versions.
• Equity income funds: These funds were developed to balance investors’ desires for current income with some potential for capital appreciation. These fund managers invest mostly in stocks — often blue chip stocks — that pay dividends. They usually make some investments in utility companies, which are also likely to pay dividends.
• Growth and income funds: These funds seek both capital appreciation and current income. Growth and income are considered equal investment objectives.
• International and global funds: These two funds may sound like the same type of mutual fund, but they’re not. International funds invest in a portfolio of only non-U.S. stocks (international securities). Global funds, also called world funds, can also invest in the U.S. stock markets. In fact, during the 1990s, many global funds handed in remarkable performances not because of their international stock-picking prowess, but because they concentrated the bulk of their assets in U.S. stocks. This is a prime example of the importance of understanding how fund managers are investing your money. I talk more about how to make this determination in the next section.
• Sector funds: The managers of these funds concentrate their investments in one sector of the economy, such as financial services, real estate, or technology. Although these types of funds may be a good choice after you’ve already built a portfolio that matches your investment plan, they have greater risk than almost any other type of fund because these funds concentrate their investments in one sector or industry. If you’re uncomfortable with the potential for significant losses, make sure that a sector fund only accounts for a small percentage of your portfolio — say, less than 10%. Remember, however, that if you invest in a balanced portfolio, your other investments should hold their own if only one industry is impacted.
• Emerging market funds: The managers of these funds seek out the stocks of underdeveloped countries and economies in Asia, Eastern Europe, and Latin America. Finding undiscovered winners can prove advantageous, but an emerging market fund — also known as an emerging country fund — isn’t a recommended mainstay for new investors because of the potential for loss. When these countries and economies suffer economic decline, they can create significant investor losses.
• Single-country funds: As their name implies, the managers of these funds look for the stock winners of one country. Unless you have close relatives running a country somewhere and have firsthand knowledge about that land’s economic prospects, you’re wise to steer clear of these funds. The reason is simple: They have unmitigated risk from concentration in one area. For example, when Japan’s economy declined in 1998, it sent mutual funds that invested exclusively in that country’s companies tumbling by more than 50%.
• Index funds: The managers of these funds invest in stocks that mirror the investments tracked by an index such as the Standard & Poors 500. Some of the advantages of investing in index funds include low operating expenses, diversification, and potential tax savings. More than 150 funds, including growth companies, track a variety of different indexes. Although they don’t necessarily rely on the performance of any one company or industry to buoy their performance, they do invest in equities that represent a market — such as the U.S. stock market. If and when that market dips, as the U.S. market did by 20% in 1987, index funds can be hit pretty hard.

Bond funds are less risky than stock funds, but also less rewarding. You can choose from the following types of bond funds:

• Corporate
• Municipal
• U.S. Treasury bonds
• International bond funds
• Mortgage bond funds

Balanced funds are another investment option. These funds are a mix of stocks and bonds that are also called blended or hybrid funds. Generally, managers invest in about 60% stocks and 40% bonds. Balanced funds are appealing to investors because even in bear markets, their bond holdings still allow them to pay dividends. (A bear market is generally defined as a market in which stock prices drop 20% or more from their previous high.)
Money market funds are arguably the least volatile type of mutual fund. Fund managers invest in things such as short term bank CDs, U.S. Treasury bills, and short-term corporate debt issued by established and stable companies. This type of mutual fund is ideal for people who may need to use the money to buy something in the short term like a down payment on a home. These funds are also a convenient place to pool money for future investment decisions.