Understanding Investment Types lists the different types of investments, mutual funds being one of them. This article goes a little bit deeper into mutual funds.

Introduction

A mutual fund is essentially a group of investments. For example, a stock mutual fund invests in a group of stocks, while presenting a single view of the entire group to the investor, so that the investor doesn't have to deal with each stock individually. From the investors' point of view, they can treat the mutual fund as though it was just another stock (buy/sell shares of the mutual fund).

Just as there are different types of investment vehicles (stocks, bonds, CDs, real estate, etc.), there are corresponding types of mutual funds. Here are a few well-known types of mutual funds:

• Stock funds — these invest in multiple stocks.
• Bond funds — invest in bonds, both government securities and those issued by companies.
• Industry-specific funds — these invest in companies in specific industry sectors.
• Money market funds — these invest in short term CDs and bonds.
• Mixed funds — these invest in different types of investments.

How do Mutual Funds Work?

Every mutual fund has a manager, who is responsible for defining the purpose and investment strategy of the fund. For example:

• Should the fund be focused on generating income, or should it focus on capital growth, reinvesting any income that the fund might generate?
• Should the fund passively invest (e.g., buy and hold stocks), or should it aggressively buy and sell entities as the market changes, to maximize gains?
• Should the fund focus on maximizing value in the short or medium term, or should it focus on long-term growth at the expense of possible short-term losses?
• and many more.

These decisions dictate which individual entities does the fund consist of (e.g., in the case of a stock fund, which stocks), the proportion of the investment that should go into each of the selected entities, and so on.

A mutual fund presents itself as a single investable entity with its own ticker symbol and price (called NAV — Net Asset Value). Just as a stock has a price (per share of the stock), the fund's NAV acts as the per-share price of the mutual fund. A fund's price is a synthetic value, computed using the actual market value of the underlying entities. As the market values of the underlying entities go up and down, so will the fund's NAV.

Unique Aspects of Mutual Funds

Because different mutual funds are created with different purposes, they also have characteristics that are unique. Here are some:

Single Entity: As we already saw above, irrespective of the number of underlying investments that it invests in, a fund presents itself as a single investment, with its own price (its NAV).

Open and Close Periods: Unlike a stock that is always available for people to invest in (as long as the underlying company is listed on a stock exchange), a mutual fund's manager might decide to open the fund for investments only during certain times. For example, the fund manager might decide that the fund size (total value of investments) is becoming too large to manage efficiently and therefore pause new investments. A fund might go through several open and close periods.

Specialization: A fund might specialize in specific areas/aspects. Examples:

• Income vs growth funds: A fund might be focused on providing regular income, and thus might invest in dividend-paying investments. Conversely, a fund might focus on long term growth sacrificing any short term gains, and thus invest in volatile stocks of aggressively growing companies.
• Sector-specific funds: As we saw above, a fund might invest only in stocks, or only in bonds, and so on. And, even amongst stock funds, a fund might focus on, say, technology stocks, health-care stocks, or stocks of real estate companies.
• Cash-holding funds: Called money market funds, these are special income-producing funds that invest exclusively in short-term low-risk income-producing entities, such as CDs and short-term bonds. Money market funds have a fixed NAV value. Since they cannot provide returns by an increasing NAV value, money market funds provide an annual income (called yield).
• Size-based funds: Some funds invest only in companies with large market capitalizations, while some others only in medium or small companies.
• Blue chip vs emerging market funds: Some funds invest only in large, established companies, while some others focus on companies in riskier but more promising emerging markets.
• Passive vs active funds: Passive funds simply buy and hold investments, and rarely, sell any investments. They're called passive because they're said to be 'passively tracking the market'. Index funds are a kind of passive fund that simply invest in the stocks that constitute a stock index (such as S&P 500, Dow Jones Industrial Average, etc.). Thus, an index fund's performance simply tracks the index's performace. Active funds buy, sell, hold or even change the mix of investments, all with an eye towards maximizing the gains from the fund.
• Ethical funds: Funds that avoid investing in companies with questionable practices fall into this category. Example: funds that invest only in companies that are environment-friendly.
• Target funds: It is a common practice to invest in higher-risk but aggressively growing stocks when young, and to switch to safe (though perhaps slow-growing) entities (such as CDs, bonds, etc.) as we age. Target funds mimic this behavior: given a target date (example: 30 years from now), a target fund will gradually vary the proportion of its investments over the fund's lifetime from high-growth high-risk entities, through medium-growth medium-risk entities, to low-risk entities. The objective is to grow the fund quickly in its earlier years and to taper off into steady low-risk investments that protect any gains achieved.
• Fund of funds: Since a fund presents itself as a single investment vehicle, it shouldn't come as a surprise that there are funds that invest in multiple other funds, providing a level of abstraction over the underlying funds themselves.

Cost: Some funds charge the investor an annual fee for managing the fund. Typically, actively managed funds are fee-based.

Unique tax treatments: Certain mutual funds are allowed to be part of government-approved qualified investments, such as 401K and IRAs (Individual Retirement Accounts). Thus, these funds can accept pre-tax investments, or allow investments to grow tax-free (i.e., gains from these investments will not be taxed when withdrawn). Similarly, certain money market funds could also enjoy some degree of tax-exemption.

Pros and Cons of Investing in Mutual Funds

Like every kind of investment, there are advantages and disadvantages of investing in mutual funds.

Pros

Mutual funds:

• allow us to invest in multiple entities in one shot;
• offer a wide range of investment choices for people with different risk tolerances and investment objectives;
• target funds make it easy for retirement planning;
• investing in funds through qualified retirement schemes allows us to save on taxes, often substantially.

Cons

• As a fund becomes huge, it could become unmanageable for the fund managers to make changes quickly and the fund's performance might suffer as a consequence.
• Large funds' actions may have a ripple effect on the market: a stock fund buying/selling large number of shares of a stock may affect the price of the stock, which in turn could affect the NAV of other funds that also invest in that stock.
• Investors don't have control over when the fund manager chooses to buy/sell the underlying entities. More importantly, investment in a fund could result in taxable income even in a year when the investor does not sell any shares of the fund: the fund manager could decide to sell some underperforming investments and replace them with more promising ones, etc., thus resulting in a taxable event in that year.
• Similarly, investors may not have a say in which entities that a fund should (or should not) invest in. They might find that a fund is not investing in a (to them) obviously profitable company, and/or has invested in (profitable) companies with questionable ethical practices.
• Some actively managed funds charge an annual fee, irrespective of how the fund performs. This could result in a sizable loss over the years, especially if the fund is also losing money. Passive funds (such as most index funds) usually do not charge a fee for managing the fund.

Examples

Here are some web pages that provide information about specific mutual funds. Each page provides a summary of the fund, its historical performance, the underlying investments (termed 'holdings'), latest news about the underlying companies, risk scores, etc. Often, funds that are similar are also listed.

NOTE: The examples below are just that: examples. They are not recommendations of which funds to invest in!

• Blue chip fund — Fidelity Blue Chip Growth Fund is an example of a fund that invests in established companies. The term 'Growth' in the fund's name is an indication that the fund focuses on capital growth instead of short-term income.
• Index fund — Here's a fund that tracks the S&P 500 stock index: Vanguard S&P 500 Index Fund.
• Sector fund — Fidelity Select Energy Portfolio is a fund that specializes in a specific industry sector (in this case the energy sector). Its 'holdings' section lists the companies the fund invests in.
• Bond funds — Vanguard Total Bond Market Index Fund is an example of a fund that invests in corporate bonds. Similarly, PIMCO Long-Term U.S. Government Fund is a fund investing in U.S. government bonds.
• Money market fund — Schwab Value Advantage Money Fund is an example of a money market fund.
• Others — In addition to web sites for specific funds, there are ways to search and find information about mutual funds. Here are a few:
  • U.S. News Mutual Funds Page.
  • MarketWatch List of Funds.
  • Websites like Yahoo! Finance and Google Finance allow us to look up information about any fund by the fund's name or ticker symbol.

Summary

Mutual funds provide a convenient way for us to invest in different types of investment vehicles, such as government-held securities, bonds, cash entities such as CDs, the stock market, real estate, precious metals, and so on.

The huge number of choices of mutual funds also means that there's a lot of variability when it comes to a fund's dos and don'ts, risks, liquidity, tax treatments, etc. It is always a good idea to heed the advice of a qualified investment professional to select the best mutual funds for our needs.