A Mutual Fund
is a company that combines the investment
funds of many people with similar investment goals and invests the
funds for these people in a wide variety of securities. The individual
receives shares of stock in the mutual fund and through the mutual
fund are able to enjoy much wider investment diversity than they
could otherwise receive. Each shareholder, in effect, owns a part
of a diversified portfolio that has been acquired with the pooled
money. As the securities held by the fund move up or down in price,
the market value of the mutual fund shares moves accordingly. When
dividend and interest payments are received by the fund, they are
passed on to the mutual fund shareholders and distributed on the
basis of prorated ownership.
The above is a simple non technical
chart of Mutual Fund categories by risk and reward. It should help
you understand some basics of risk and reward. This is not an exact
science, this chart is not intended to be 100% accurate. At the
top of the pyramid an individual can expect the greatest returns
but because of the risk associated with these funds an individual
will also experience the greatest risk of loss. Consequently, with
the funds at the bottom of the pyramid an individual can expect
low returns with the lowest risk of loss of investment. Volatility
is the key. If an individual knew exactly when to invest in these
funds and exactly when to sell these funds he or she would be able
to maximize his or her return.
Before moving up the pyramid and
taking on more risk you should "cover your basics first".
That's why treasury instruments and insured deposits are shown first.
Bonds are included next since, historically, they are less volatile
than stock- meaning their returns do not fluctuate as greatly. Basic
stock index funds are usually next in line followed by more aggressive
positions until you reach the top and are involved in speculative
Money Market Funds
As a general guide, you should put
part of your money in the safer areas first before investing in
more risky investments. If you are young and the more money you
make, and if you have few or no dependents, theoretically you can
take on more risk. You have more time to recoup your losses. Consequently,
as you get older you should reduce your risk exposure because there
is less time to make up losses. However, you should never make an
investment unless you clearly know what you are investing in.
Money market funds are not FDIC insured.
They invest in short term government, municipal or corporate bonds
with less than 12 months to maturity and try to maintain a $1.00
per share value. Some funds may use derivatives in an attempt to
increase return. You should read the prospectus carefully to determine
what the fund managers can and have been doing. It is possible to
lose money by investing in money market funds.
Short Term Government, Municipal and Corporate Bond Funds
Theses bond funds usually have maturities
no longer than 3 years. Normally, the longer the period, the greater
the risk and the greater the opportunity for a higher yield. Ratings
by the various financial rating services also come into play. The
higher the rating, the lower the risk, everything else being equal.
Government and municipal securities generally have higher ratings
than corporate securities and usually yield less. Managers in almost
all bond funds continually buy and sell bonds, so the fund itself
has no maturity date. Because they are bond funds, investments in
these funds could drop in value if interest rates in the economy
were to rise.
Medium Term Government, Municipal and Corporate Bond Funds
These bond funds usually have an
average maturity around 10 years though there is no set time period.
They are more volatile than the shorter term bonds and tend to yield
more. Long Term Government, Municipal and Corporate Bond Funds:
These bond funds typically have an average maturity around 20
years though there is no set time period. They tend to drop more
in value when interest rates go up and increase more when interest
rates go down.
GNMA Funds- Government National Mortgage Association
GNMA's comprise a pool of residential
mortgages and are backed by the U.S. Government. However, the GNMA
guarantee is limited to only a mortgage default (non payment of
monthly premium) and has nothing to do with the possibility that
the principal may go up or down as interest rates in the economy
change. An interesting characteristic of GNMA's is that they do
not necessarily move in the same direction as government, municipal
or corporate bonds. The reason for this, as economic interest
rates go down, people with mortgages will usually refinance
at the lower rates. As they refinance, more money is brought back
into the pool and then loaned out at a lower interest rate making
the return lower and the GNMA fund value drop.When economic rates
rise, the value of principal may drop since you hold a portfolio
of lower yielding mortgages. If economic rates stay flat, GNMA funds
will tend to earn more than comparable bond funds. But if rates
move up or down very much, the total return on GNMA funds may be
less than other bond funds.
Asset Allocation Fund
Asset allocation funds tend to reduce
risk by using a combination stocks, bonds and cash. The use of three
non related securities is an attempt to reduce risk. Cash and bonds
have historically lower volatility than stocks. More bonds are used
when stocks are not doing well and more stocks are used when the
market is growing well. Larger cash positions are used when neither
bonds or stocks are doing do well. Different mutual funds use different
ratios even given the same economic conditions.
Balanced funds are similar to asset
allocation however they use stocks and bonds only. They tend to
use 60% in stocks and 40% in bonds and usually do not change much
even when the economics change. Stocks and bonds together tend to
lower volatility (risk). They also tend to have lower returns than
pure stock funds.
Equity Income Funds
Equity Income funds normally use
stocks that generate consistent income through dividends. The fund
also appreciates if the stock market increases and lose value when
the stock market falls.
Utility funds invest in Utility company
stocks and are similar to equity income funds due to their income
Convertible Securities Funds
Convertible securities are bonds
that can be converted into stock in the company under certain conditions.
The bonds normally have a yield less than standard bonds due to
the convertibility. The value also is dependent on the movement
of the underlying stock.
S&P 500 Index Funds
Funds that invest in a representative
portion of the stocks in the S & P 500. It represents a broad
selection of stocks in the marketplace.
High Yield Bond Funds
High Yield Bond Funds Bonds are rated
from AAA down to D. Bonds rated BBB and above are called "investment
grade". Bonds rated below BBB are usually called "junk
bonds" and tend to pay a higher yield because of their lower
rating. High yield securities inherently have a high degree of market
risk. There are credit risks associated with the underlying issuers
of high yield securities in addition to the lack of liquidity associated
with these types of securities that may impair their value.
International Bond Funds
International Bonds may earn higher
returns than U.S. bonds. They Have a higher risk than U.S. Bonds
due to currency fluctuations. If the dollar appreciates returns
can drop appreciably.
Blue Chip and Large Capitalization Stock Funds
These funds represent the bigger
and more historically successful companies. These companies represent
continued growth based on past performance. Many have also shown
a history of paying dividends. The risk is identified as higher
than the 500 index overall since the selection represents just one
section of the marketplace - not a broad coverage.
Medium Capitalization Stock Funds
Companies in these funds are not
quite as large as those listed in the large capitalization stock
funds above and may provide some greater element for growth. These
companies are considered middle of the road providing a little of
both- reasonable growth with acceptable risk.
Zero Coupon Bond Funds
Zero Coupon bonds can be government,
corporate or municipal bonds. These are unique bonds in that they
do not provide a cash flow. The bonds are bought at a discount and
the face value is paid out at maturity. For example, a $10,000 face
amount bond can be bought today for $6000 with a maturity
in 10 years. At the end of ten years, the bond can be cashed in
for $10,000. During the 10 years the bond is earning interest, unless
the bond is tax exempt, the bearer of the bond is subject to income
taxes on the interest each year.
Value Stock Funds
Value stock funds represent companies
that are considered under valued. These may be companies that have
poor histories but may be on the brink of recovery. Their
statistical ratios are less than other companies that are currently
Small Capitalization/Aggressive Growth Stock Funds
These represent smaller companies
that historically have been shown to grow faster and have higher
appreciation than larger companies with greater volatility. They
tend to pay little, if any, dividends because they put earnings
back into the business.
Real Estate Funds
These funds invest in the stock of
companies primarily devoted to real estate activity either through
building, financing and other real estate related services. It is
one of the few ways of investing in real estate while allowing almost
complete liquidity. One reason an investor would include this investment
category is that this industry's movements are not directly correlated
with the movements of the stock or bond markets. It allows growth
independent of those markets. These funds may be subject to a higher
degree of market risk than funds whose investments are more diversified.
Global funds purchase stocks of foreign
countries as well as the United States. Therefore the risks and
returns are based on the proportion invested in the various countries-
but are not solely tied to non U.S. stocks. There is currency risk
related to any investments in stocks in foreign countries.
International Stock Funds
These are mutual funds that can invest in
companies located anywhere outside of its investors' country of residence. Some
funds will pick stocks of any country- some will focus on the Pacific
Basin, Latin America, Europe, etc.
Emerging Foreign Markets
These funds invest in stock markets
of emerging countries. It is a very difficult area to be an expert
in. The stock markets in foreign countries are not required to adhere
to the same reporting standards as required under the Securities
Exchange Commission. Managers buying stocks in these countries must
do extra work in analyzing the companies they are interested in.
Single Country Funds
These funds invest in one country
only and risk is tied to only their performance. These funds may
be subject to a higher degree of market risk than funds whose investments
are more diversified.
Sector funds focus the majority of
its investments in only one area- health, technology, computers.
Sector funds must have at least 25% of their portfolios in the area
selected. These funds may be subject to a higher degree of
market risk than funds whose investments are more diversified.
Gold and Precious Metals Funds
These funds are always at the top
of a pyramid and should only be used when you can afford a high
risk. There is a lot of volatility in this area.