Mutual Funds

According to the Securities & Exchange Commission (SEC), most mutual funds can be classified into one of three categories: stock funds (also called equity funds), bond funds (also known as fixed income funds), and money market funds. Funds are either actively managed (a portfolio manager or management team actively manages the investments of the fund to outperform industry benchmarks) or passively managed (a fund whose investment securities are not managed by a portfolio manager, but are automatically selected to match an index or part of the market). It’s important to note that fund managers don’t always invest 100 percent of the fund’s assets in the strategy that is featured on the fund’s name (e.g., LifePlan Growth Fund, Large Company Fund, etc.). This practice is known as style drift. The SEC has issued rules that require 80 percent of fund assets to be invested in the area that is suggested by its fund name, but fund managers have up to 20 percent to “play with.” For example, a fund manager might allocate 20 percent of his or her large company fund into fast-growing small company stocks to compensate for lagging returns in the 80 percent of the fund that focuses on large company stocks.

Stock Funds

Stock funds were the most commonly held type of mutual fund in 2022, according to the Investment Company Institute (ICI). They were owned by 88 percent of U.S. mutual fund–owning households. Despite the fact that a stock’s value can fluctuate significantly (as a result of corporate scandals, product recalls, recessions, falling or rising demand for products or services, etc.), stock funds typically perform better over the long term than treasury securities and government and corporate bonds do. During the 20th century, the stock market returned an average of 10.4 percent a year, but as an example of its volatility, the market had an investment return of 18.17 percent in the 1990s, but only a return of 1.07 percent in the 2000s. In 2011, the average investment return was 2.07 percent, in 2017, 21.94 percent; and 2022, 1.38 percent. The five-year average was 7.51 percent from 2018–2022. There are many types of stock funds:

• Equity income funds contains stocks that pay regular dividends. Also known as dividend income funds.
• Growth funds invest in the stocks of companies that do not pay a regular dividend, but that analysts believe will have better than average earnings and growth in share price. Many of these funds include the stocks of high technology companies, which typically do not pay dividends but have higher growth potential than more established companies.
• International funds focus on stocks of companies that are headquartered outside the United States (although they may include the stocks of U.S. companies with global businesses). Specialized international funds include regional funds, which focus on a specific region such as Europe or South America, country funds, which focus on a particular country (Germany, Japan, Brazil, etc.), and emerging markets funds, which feature the stocks of companies in geographic regions that have undeveloped capital markets and exhibit high growth rates and high rates of inflation. Investing in emerging markets can be very volatile, and may also involve currency, political, and liquidity risk.
• Large-cap, mid-cap, and small-cap funds focus on companies of a particular size with the strategy that, at different times, a small company may perform better than a large or mid-size one, or vice versa. An example of a mid-cap fund is the Institutional Mid-Cap Equity Growth Fund, which holds shares in companies such as Hilton Worldwide Holdings, Southwest Airlines, Dominos’s Pizza, and Dollar General.
• Sector funds invest in a specific area of the marketplace, such as the stocks of companies in the energy, information technology, healthcare, or hospitality industries. They are not as diversified as funds that invest across a variety of sectors, but they are a good way for investors to get in on hot trends (such as green power) without having to conduct extensive research on specific companies.
• Socially responsible funds invest using ethical, political, social, or religious guidelines. Some funds eliminate entire industries (e.g., firearms, alcohol), while others review companies on a case-by-case basis for socially responsible practices.
• Stock index funds are passively managed funds that attempt to replicate the performance of a particular stock market index (e.g., Dow Jones Industrial Average, Standard & Poor's 500 Stock Index, Nasdaq Composite Index) by investing in the stocks that are part of this index.
• Value funds invest in stocks that analysts have targeted as underpriced in the secondary market.

Money Market Funds

Money market funds were held by 59 percent of U.S. mutual fund–owning households in 2022. They are typically less volatile than other types of mutual funds. By law, money market funds can only invest in short-term debt such as money market securities (e.g. treasury bills, certificates of deposit, and commercial paper, which are very short-term corporate debt instruments that are issued by the U.S. government, U.S. corporations, and state and local governments). Money market funds try to keep their net asset value at a steady $1.00 per share, but because the funds invested in money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation or other government agencies, investors can lose money by investing in this type of fund.

Bond Funds

A bond is a short-or long-term debt instrument that offers the promise to investors of payment of a specified amount of interest and return of the original investment on a stated maturity date. Basically, investors in bond funds are loaning a government or company money to use to complete a major project (such as building a new highway) in exchange for a return on their investment. Bond funds typically involve higher risk than money market funds because they often pursue investment strategies that aim to produce higher yields. The safest bond funds are those that invest in bonds issued by the U.S. government or state or local governments. In 2022, bond funds were held by 40 percent of U.S. mutual fund–owning households. There are many types of bonds, including:

• Corporate bond funds feature bonds that are issued by a corporation such as AT&T or Ford.
• High-yield bond funds which come in both municipal and corporate varieties, invest in bonds that are rated low by the rating services. The interest rate (and the potential earnings for investors) are higher than for corporate or Treasury bonds, but the risks of default are also higher than for other bonds. Also known as junk bonds.
• Municipal bond funds include bonds that are issued by a municipality (such as New York City or Cook County).
• Short-term or intermediate-term bond funds feature short-term duration bonds that are issued by a wide range of companies and governments.
• Single-industry funds focus on a particular market niche such as biotechnology, gold, oil, or health care companies.
• Treasury bond funds feature bonds that are issued by the U.S. government. These are considered safe investments because they are backed by the taxing authority of the U.S. government, and the interest on Treasury bonds is not subject to state income tax.

Other Types of Funds

• Alternative mutual funds use nontraditional investments and trading strategies to accomplish the fund’s objectives. Strategies might include hedging and leveraging through derivatives and short selling, and investments may be made in nontraditional areas such as commodities, global real estate, and leveraged loans.
• Fund of funds are mutual funds that invest in other mutual funds for the purpose of achieving optimal diversification. They feature a combination of stocks and bonds.
• Hybrid funds invest in a combination of fixed-income and equity securities. This mix can change over time or remain fixed.
• Lifestyle funds are advertised as maintaining a predetermined risk level in terms of their investment strategies. Fund names include such words as “aggressive” or “conservative” to provide investors with an idea of the fund’s investment strategy.
• Target date funds have been created to meet a specific group of investors’ investment goals (most commonly retirement or college) by a target date. These funds typically include the target date in the name of the fund, such as Target Date 2030 (for a group of investors that have children that will begin college in 2030). Also known as life cycle funds.