Understanding Mutual Fund Categories

What Is a Mutual Fund?

Mutual funds combine money from many investors to purchase a variety of investments. Professional administrators determine which investments to purchase and sell for the fund. A professional fund manager manages this combination of investments, and its assets and objectives are detailed in the fund's prospectus.

These funds contain much of the retirement funds of middle-income Americans, but this wasn't always the case. In 1980, under 6% of U.S. households had money in mutual funds.By 2023, about 52% of American households were invested in them, and these households held shares for a massive majority, 88%, of all mutual fund assets. Investment Company Institute. "2023 Fact Book."When setting aside their money in mutual funds, these households can access a diverse range of investments, which can help reduce their risk compared to investing in a single stock or bond. Investors earn returns based on the fund's performance minus any fees or expenses levied. Mutual funds are often the investment vehicle of choice for middle America, providing a broad swath of middle-income workers with professionally managed portfolios of equities, bonds, and other asset classes.

Understanding Mutual Funds

A mutual fund possesses a portfolio of investments funded by all the investors who have purchased shares in the fund. So, when an individual acquires shares in a mutual fund, they obtain part-ownership of all the underlying assets the fund owns. The fund's performance depends on how its collective assets are doing. When these assets increase in value, so does the value of the fund's shares. Conversely, when the assets decrease in value, so does the value of the shares.

The mutual fund manager oversees the portfolio, determining how to divide money across sectors, industries, companies, etc., based on the strategy of the fund. About half of the mutual funds held by American households are in index equity funds, which have portfolios that comprise and balance the assets of indexes to mirror the S&P 500 or the Dow Jones Industrial Average (DJIA).

How Are Earnings Calculated for Mutual Funds?

Investors typically generate returns from a mutual fund in three ways:

• Dividend/interest income: Mutual funds distribute the dividends on equities and interest on assets held in its portfolio. Funds often offer investors the choice of either receiving a check for distributions or reinvesting proceeds for additional shares in the mutual fund.

• Portfolio distributions: If the fund sells securities that have increased in price, the fund realizes a capital gain, which most funds also pass on to investors in a distribution.

• Capital gains: When the fund's shares increase in price, you can sell your mutual fund shares for a profit in the market.

When investigating the returns of a mutual fund, you'll typically come upon a figure for the "total return," or the net change in value (either up or down) over a specific period. This includes any interest, dividends, or capital gains the fund has generated along with the change in its market value during a given period. In most cases, total returns are given for one, five, and 10-year periods, as well as from the day the fund opened or inception date.

Types of Mutual Funds

There are many varieties among the more than 7,000 mutual funds in the U.S., with most in four main categories: stock, money market, bond, and target-date funds.

Stock accounts

As the name implies, this fund invests principally in equity or securities. Within this classification are assorted subcategories. Some equity funds are named for the scale of the companies they invest in: firms with small-, mid-, or large-sized capitalization. Others are named by their investment approach: aggressive growth, income-oriented, and value. Equity funds are also categorized by whether they invest in U.S. securities or foreign equities. To comprehend how these strategies and quantities of assets can combine, you can use an equity style box like the example below.

Value funds invest in equities their managers see as undervalued while aiming at long-term appreciation when the market recognizes the stocks' true worth. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book ratios, and dividend yields. Meanwhile, growth funds look to companies with stable earnings, sales, and cash flow growth. These companies typically have high P/E ratios and do not pay dividends. A compromise between stringent value and development investment is a "blend." These funds invest in a blend of growth and value equities to produce a risk-to-reward profile somewhere in the middle.

Bond assets

A mutual fund that generates a consistent and minimum return is part of the fixed-income category. These mutual funds focus on investments that pay a set rate of return, such as government bonds, corporate bonds, and other debt instruments. The bonds should generate interest income that's passed on to the shareholders.

There are also actively managed funds seeking relatively undervalued bonds to sell them at a profit. These mutual funds will likely pay higher returns but aren't without risk. For example, a fund specializing in high-yield subprime bonds is much riskier than a fund that invests in government securities. Because there are many different categories of bonds, bond funds can vary dramatically dependent on when and when they invest, and all bond funds are subject to risks related to changes in interest rates.

Index mutual funds

Index mutual funds are designed to replicate the performance of a specific index, such as the S&P 500 or the DJIA. This strategy requires less research from analysts and advisors, so fewer expenses are passed on to investors through fees, and these funds are designed with cost-sensitive investors in mind. They also frequently outperform actively managed mutual funds and thus potentially are the uncommon combination in life of less cost and greater performance.

Balanced finances

Balanced funds invest across various securities, whether equities, bonds, the money market, or alternative investments. The objective of these funds, known as an asset-allocation fund, is to reduce risk through diversification.

Mutual funds detail their allocation strategies, so you know ahead of time what assets you're indirectly investing in. Some funds follow a strategy for dynamic allocation percentages to meet diverse investor objectives. This may include responding to market conditions, business cycle changes, or the shifting phases of the investor's own existence. The portfolio manager is commonly given the freedom to alter the ratio of asset classes as required to maintain the fund's stated strategy.

Money market mutual funds

The money market consists of secure, risk-free, short-term debt instruments, mostly government Treasury notes. The returns on them aren't considerable. A typical return is a little more than the amount gained in a conventional checking or savings account and a little less than the average certificate of deposit (CD). Money market mutual funds are often used as a transient holding place for cash that will be used for future investments or for an emergency fund. While minimal risk, they aren't insured by the Federal Deposit Insurance Corporation (FDIC) like savings accounts or CDs.

Income assets

Income funds are intended to disburse income on a regular basis, and are often seen as the mutual funds for retirement investing. They invest primarily in government and high-quality corporate debt, holding these bonds until maturity to provide interest disbursements. While fund holdings may rise in value, the primary aim is to offer a consistent cash flow​.

International mutual funds

An international mutual fund, or foreign fund, invests only in assets located outside an investor's native country. Global funds, however, can invest anywhere worldwide. Their volatility depends on where and when the funds are invested. However, these funds can be part of a well-balanced, diversified portfolio since the returns from abroad may provide a ballast against reduced returns at home.

Regional mutual funds

Often international in scope, regional mutual funds are investment instruments that concentrate on a specific geographic region, such as a country, a continent, or a collection of countries with similar economic characteristics. These funds invest in equities, bonds, or other securities of companies that are domiciled, or generate a significant portion of their revenue, within a targeted region. Examples of regional mutual funds include Europe-focused mutual funds that invest in that continent's securities; emerging market mutual funds, which focus on investments in developing economies worldwide; and Latin America-focused mutual funds that invest in countries like Brazil, Mexico, and Argentina.

Classes of Mutual Fund Shares

If you're attempting to reduce your fees, you'll want to monitor the type of mutual fund shares you buy. Traditionally, individual investors would purchase mutual funds with A-shares through a broker.

Then, a front-end burden of up to 5% or more, plus management fees and ongoing fees for distributions (also known as 12b-1 fees), would be added on. Financial advisors selling these products may encourage clients to purchase higher-load offerings to generate commissions. With front-end funds, the investor pays for these expenses as they purchase into the fund.

To rectify these difficulties and meet fiduciary-rule standards, investment companies have designated new share classes, including "level load" C shares, which generally don't have a front-end load but bear a 12b-1 annual distribution fee of up to 1%.

Funds that charge management and other fees when investors sell their holdings are classified as Class B shares.

How To Invest in Mutual Funds

Investing in mutual funds is relatively straightforward and entails the following steps:

• Before purchasing shares, you should check with your employer if they offer additional mutual fund products since these might come with matching funds or are more beneficial tax-wise.

• Ensure you have a brokerage account with enough deposits and access to purchase mutual fund shares.

• Identify mutual funds matching your investing objectives for risk, returns, fees, and minimum investments. Many platforms offer fund screening and investigation tools.

• Determine how much you want to invest and submit your trade. If you choose, you can likely set up automatic recurring investments as desired.

• While these investments are most often for the long term, you should still check on how the fund is doing periodically, making adjustments as required.

• When it's time to end your position, submit a sell order on your platform.