Mutual Fund Categories

On 09/09/2010, in Mutual Funds, by Jordan Wilson
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Today we will define a few common fund investment styles.

Later, we will review the risk-return profiles and investment uses for each category.

I have previously written about some of the asset classes listed below, so please refer to my earlier posts for greater detail on a specific style.

Money Market

Money market instruments are short-term debt (i.e. less than 1 year to maturity) instruments. Investments are considered extremely safe due to the nature of the fund investments.

Interest income is paid to investors.

While the returns are not high, they are better than what one would receive from savings accounts. And as the fund aggregates money from many individual investors, it can obtain higher returns on treasury bills and other short-term debt than a small investor could achieve on his own.

Money market funds may be available in foreign currencies. This may create foreign exchange gains or losses as compared with the investor’s domestic currency. In some cases, this can greatly enhance investor returns or possibly create losses.

Always take care when investing in money market funds – or any asset – that are not in your own currency.

Fixed Income Funds

You may also see these termed “bond funds”.

These funds invest in government and corporate debt. Some include preferred shares as well.

Within the fixed income style, there are many sub-categories.

Quality of Issuer

Some funds focus only on high quality debt issuers.

Others create funds that specialize in high risk issuers in the expectation of receiving higher returns. This latter group of non-investment grade fixed income instruments is known as “high yield” or “junk bonds”.

The quality of the issuer is based on ratings assigned by one of the bond rating agencies.

For example, bonds with ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.

Terms to Maturity

Some funds concentrate on specific terms to maturity. Perhaps only investing in bonds with maturities between 5 and 10 years. Or maybe only in bonds with over 20 years life remaining.

Fixed income funds attempt to generate a steady cash flow of interest (and possibly dividend) income to investors.

Although the objective is interest income, there may be capital gains or losses as well.

As interest rates fall, the market value of existing bonds will increase. This can create a capital gain if the bond is sold prior to maturity. Should interest rates rise, bond prices will fall, causing a capital loss if the bond is sold.

Because of the underlying investments, fixed income funds should generate greater interest income than in money market funds.

However, in times of rising interest rates, money market funds may outperform fixed income funds as the fixed income funds experience capital losses.

Balanced Funds

Balanced funds try to provide a balance between security, income, and capital appreciation.

The funds invest in a mix of money market, fixed income, and equity instruments to achieve this objective. As a result, the fund generates both dividend and interest income as well as capital gains or losses.

The asset mixture is defined in the fund’s stated objectives.

Combination of asset classes may be fixed (e.g. 5% money market, 35% fixed income, 60% equities) or have a range of maximum and minimum investment levels for each of the three classes (e.g. 0-10% money market, 20-50% fixed income, 40-70% equities).

Do not confuse balanced funds with asset allocation funds.

Asset Allocation Funds

Although similar in nature, there is usually greater flexibility in an asset allocation fund. This allows the portfolio manager the ability to take advantage of changes in the business cycle to maximize investments in an asset class.

For example, as the economy heats up, stocks will begin to rise and fixed income assets should fall in value. An asset allocation portfolio manager has the flexibility to shift the bulk of the portfolio assets into equities and out of under-performing asset classes like bonds.

Balanced funds have less or no leeway in altering the asset mix.

Because of the extra work involved by the asset allocation managers, it is normal for asset allocation funds to have higher fees than similar balanced funds.

Target-Date Funds

Like balanced or asset allocation funds, target-date funds invest in multiple asset classes.

However, target-date funds automatically reset the portfolio asset mix based on the stated investment time horizon.

With a long maturity, investments are skewed towards riskier assets. As the maturity date gets closer, assets shift into less risky investments.

This is much like Life-Cycle funds (also known as “Aged-Based” funds).

We will consider these funds further when we look at investor profiles and strategies.

Equity Funds

The largest class of funds are equity funds. They also have the most sub-categories.

In general, equity funds strive for long-term capital appreciation. Some may also generate dividend and interest income, but those are normally secondary considerations.

Equity funds may be aggregated in a variety of ways.

Market Capitalization

They may focus on stocks of companies that have certain levels of market capitalization. Large cap or small cap equity funds are common variations.

Type of Company

They may focus on expected return characteristics of companies.

For example, you will see value and growth equity funds.

Some funds focus on companies that pay high dividends. Others on companies that pay no dividends.

Geographics

You will also see funds that are developed based on the geographic location of the underlying companies. These equity funds may be designated domestic, international, and global.

Domestic equity funds are those that contain stocks listed on stock exchanges in the same country as the investor.

International equity funds are those whose companies are listed on stock exchanges outside the investor’s country of domicile. International funds may also be called “foreign” funds.

Global equity funds may contain shares of companies from anywhere in the world.

For example, consider the Credit Suisse Equity Fund Swiss Blue Chips. It invests mainly in large cap companies located in Switzerland.

As a Swiss investor, this would be domestic fund. To an Canadian investor, it would be an international fund.

In contrast, the Credit Suisse Equity Fund Global Value invests in a wider range of equities. Its scope includes “undervalued companies which are listed worldwide on regulated and accessible markets.”

Because it has shares of companies from both within and outside Switzerland, it is a global fund to a Swiss investor. And to a Canadian investor as well.

Sector

Within the broader categories, you may see smaller fund compositions.

For example, funds may be created based on industry or business sector.

For example, Fidelity has equity funds that cover such sectors as: Consumer Staples, Consumer Discretionary, Energy, Industrials, Telecommunications, Financial Services, Health Care, Materials, Natural Resources, Precious Metals, Technology, Utilities.

Countries or Regions

Funds also exist that narrow the geographic segments into regions and countries.

T. Rowe Price has a Global Stock fund. But they also provide more geographically focussed equity funds including: Africa & Middle East, Emerging European & Mediterranean, Emerging Markets, European, Japan, Latin America, New Asia.

Speciality Funds

Speciality funds are those that do not fit into one of the above boxes.

That said, some people include sector and regional funds as specialty funds.

Real Estate

In this category, you usually find investments in real estate companies or assets.

Some funds invest in operating companies that manage hotels, develop properties, etc.

Precious Metals

You may also see funds that invest in precious metals.

This can be achieved by investing in companies involved in precious metals. But it also may include direct investments in the assets.

For example, DynamicGold & Precious Metals I invests about 80% of its capital into shares of mining and related companies. But it also invests a portion of its assets directly into “gold, silver, platinum and palladium in the form of bullion, coins and storage receipts.”

Collectibles

Some funds allow you to invest in other exotic assets such as collectibles.

The Fine Art Fund  invests in fine art; paintings and other art from around the world.

Similarly, The Wine Investment Fund invests in vintage wine.

There are many funds that specialize in tiny market segments.

I would caution investors to be very careful with these unique types of funds. Usually the management fees are extremely high, the ability to liquidate one’s investment may be limited, and the investment time frame required may be substantial.

While collectible funds may be useful for diversification purposes, I would not recommend their purchase for most investors.

Socially Responsible

I would also include the so-called Socially Responsible funds in this category. Sometimes these are referred to as Ethical funds.

These funds invest in specific areas or exclude specific investments from their options in an attempt to be socially responsible.

For example, Pax World Investments has a Global Women’s Equity Fund. Its investment strategy is “to invest in companies around the globe that are leaders in promoting gender equality in the workplace and beyond.”

Or consider the American Trust Allegiance Fund. Investments in shares of “companies involved in the alcohol, gambling, tobacco, or health care industries are avoided.”

Personally, I am not a fan of these funds. It is difficult enough to invest without restricting your investment options. I have also found that investors pay a premium in fees for these funds. As a result, I do not use them myself. But that is just my own view and many people do invest in these funds.

That is an overview of common fund categories. Over time, I will discuss these in more detail as we look at constructing diversified portfolios.

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