Choosing a Mutual Fund
By: Source: AARP Bulletin Today Date Posted: January 2004
When you invest in a mutual fund, you're buying shares of a portfolio of stocks, bonds, real estate or other securities, or a combination of any of these investments. There are four basic kinds of mutual funds—stock, bond, combined stock and bond, and money market—along with numerous specialized variations. Given the thousands of mutual funds from which to choose, deciding how to invest your money can be a daunting task. Factors include how fast a return you want, what risk you're willing to take and how diverse a portfolio you need. Here are a few types of mutual funds to consider:
Money Market Funds
These are one of the safest types of mutual funds. They invest in short term (from one day to one year) debt instruments such as Treasury bills and certificates of deposit (often referred to as CDs). Their objective is to preserve the principal, while earning modest gains. Although these funds are not guaranteed or insured, the biggest risk you'll face is that the rate of inflation will surpass your fund's rate of return.
Index Funds
The goal of these passively managed mutual funds is to achieve the same return as a particular market index, such as the S&P; 500 (500 large companies from a diverse range of industries) or the Russell 2000 (2,000 smaller companies from various industries). These funds track an index by buying every stock in the index in amounts equal to the weightings within the index itself. They deliver on diversification and often beat actively managed funds.
Sector Funds
If you put your faith in a particular sector of the economy—biotechnology, banking, health care or utilities, for example—these funds may be for you. But the fickle market makes them volatile. If your chosen sector rises, you win. But if it falls, you don't. Especially with sector funds, past performance is no guarantee of future returns.
Growth Funds
With big gains in bull markets and big drops in bear markets, these volatile funds focus on companies experiencing significant earnings or revenue growth, rather than companies that pay dividends.
Income Funds
These conservative funds are popular with people who are looking for a steady cash flow without much risk. They invest in government and corporate securities that pay dividends with fixed rates of return.
Value Funds
Somewhat riskier than income funds but less volatile than growth funds, value funds invest in stocks that are currently viewed as undervalued. They offer dividends plus the potential for long-term growth if the stocks become popular again.
Balanced/Hybrid Funds
Investing in both stocks and bonds, these funds offer investors a single mutual fund that combines growth and income objectives. Because of this diversity, these funds won't suffer greatly from stock-market downturns, but they also won't enjoy as many gains as an all-stock fund during a bull market.
Global/International Funds
One surefire way to ensure diversification is to invest in assets from all over the world. Global, regional, emerging market and country-specific mutual funds invest in stocks or bonds throughout the world, including the United States. Remove domestic assets from the equation, and you're left with international funds (sometimes referred to as foreign funds), which can be more volatile than domestic funds. Risks include currency fluctuations and political and economic instability abroad. You also can choose to invest in a particular region, such as the Pacific Rim or Western Europe, emerging markets (developing countries with growing economies) or a particular country.
Socially Responsible Funds
These funds combine societal concerns with investment decisions. A screening process, which varies by investment company, looks at several factors such as a company's source of revenue, human rights record and business practice. Some funds exclude weapons manufacturers, companies that violate indigenous people's rights or those that test products on animals. Others invest in environmentally responsible companies, those with positive community relations programs or those with strong benefits for working parents.
Mortgage-Backed Securities Funds
These low-risk funds invest in home mortgage securities offered through government-chartered companies such as Freddie Mac (the Federal Home Loan Mortgage Corporation). These funds are either backed by the federal government or have very high credit ratings, so they are considered to be very safe. Risks include interest rate fluctuations and prepayment, when the mortgagor pays off the principal earlier than anticipated.
Fund Supermarkets
Like supermarkets, these funds allow you to buy a variety of goods from different companies with one-stop shopping. The main benefit here is simplicity: you can buy funds from different families and receive all their statements in a single report. Although there are usually no commissions or transaction fees, investors face stiff expense fees and reduced distributions.
Funds of Funds
Too many choices? Consider these meta-mutual funds, which buy shares of other mutual funds. On the plus side: diversification. On the minus side: higher expense fees and duplication—owning the same stock through several different funds.
Lifecycle Funds
Investors in for the long run may prefer "lifecycle" funds that offer high, average and low-growth funds and allow investors to switch from one type to another as they age and their risk tolerance changes. Lifecycle funds can contain any combination of stocks, bonds and cash. Targeted lifecycle funds have a specific end date—10, 20, even 30 years into the future. Initially, they focus on high risk/high gain. Toward the end of the fund's life, the mix of funds is automatically adjusted toward safer/lower gain investments.
Contrarian Funds
These funds try to make a profit by swimming against the current of the prevailing market sentiment in anticipation of a sea change. When the stock market is high, these funds invest in bonds, and when the stock market's low, they invest in stocks.
GIC Funds
Investing solely in guaranteed investment contracts (GICs), these conservative funds pay a fixed interest rate over a short period of time, usually about 5 years. They are sold by insurance companies to pensions and other types of retirement plans and are guaranteed by the insurance agency that issues them.
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