The world of mutual funds is a complex one. With so many different types of mutual funds available, knowing what to look for and how to start investing can be a little overwhelming.
Before you start investing in mutual funds, whether it be through a robo-advisor or a DIY investor, it’s good to ensure that you are well aware of the different types of funds, their purpose, and role, as well as how they might suit your specific need.
A great way to make sure a mutual fund’s investments align with your investment strategy is to look at the fund’s prospectus. You will be able to see the type of investments made, the asset allocation funds, and the extent of involvement by the investment manager.
No matter the mutual fund company you choose or whether you go with exchange-traded funds (ETFs), stock funds focused on capital gains, or even global funds, make sure you know what you’re in for.
Here we will look at some of the major types of mutual funds you need to know about so you can invest in one that is aligned with your investment objectives.
Money market funds
A money market fund is a mutual fund designed for keeping your money liquid, like a checking account. It invests in bonds guaranteed by the US government (which means it will pay you if any of these bonds goes bad). It sells short-term debt instruments like government bonds (also known as municipal funds), treasury bills and notes, and certificates of deposit.
It also buys other securities, including mortgage-backed securities and commercial paper (loans to companies from ordinary people who want their money back).
Money market funds are among the most important financial products on the market. They are a crucial part of the financial system and form part of the investment goals for many due to their lower level of risk.
Pros
- It technically ‘can’t go broke’ as it’s based on government debt instruments.
- The interest rate on short-term government debt is higher than the interest rate on other kinds of investments.
- It’s a pretty safe investment compared to stocks and bonds.
- Generally charge low or no fees and can be very efficient.
- Provide a convenient place to invest money when you’re short on time.
Cons
- Offer investors very little interest.
- Mutual fund managers have limited power to buy and sell MMFs at a profit.
- Even if you have a long-term view, its long-term returns will depend on the short-term performance of stocks.
- Patterns you’ve studied in its performance can be unreliable.
Fixed income funds
Fixed income funds are attractive because they minimize risk. The idea is that the money you put in will be working for you, not buying an asset that could fall apart at any time. Fixed income securities pay a fixed rate of return, usually through interest income. That means the FIMFs are more like a commitment than an investment.
Fixed income funds are also useful if you have a large investment portfolio and need to stay within a certain range of risk. But, unfortunately, fixed-income funds’ choices are also limited; there aren’t many of them, and they don’t offer many of the exotic investments that can make up for lousy returns.
But the benefit of stability and security is something that some investors might prefer, giving a leg up for FIMFs (fixed income mutual funds).
Pros
- FIMFs provide more certainty as to when you sell the fund, you know that your return will be fixed at whatever rate is printed on the coupon attached to the bond.
- Regardless of the market going up or down, you can count on it for stable returns.
- FIMFs are highly liquid.
Cons
- The interest rate on most government bonds has fallen since the early 1980s. That means the value of their investments has been going down, lowering FIMFs value.
- They generally offer lower returns.
- Only suitable for cautious investors, not those seeking growth.
Equity funds
An equity mutual fund is a mutual fund that invests primarily in stock. It can be a simple index fund (which tracks the performance of broad stock indexes) or a more specialized fund, usually focused on one type of stock (such as growth, value, or large-cap stocks).
You can construct your portfolio using different types of equity funds and then rebalance it periodically as required to keep it diversified among many different kinds of investments; this is called portfolio rebalancing.
Equity mutual funds are a great option for most investors. These funds are an excellent way to grow your money as long as you don’t mind the extra risk that comes with it, especially with growth funds or those focused on emerging small-cap and mid-cap companies.
Pros
- It enables investors to invest in different kinds of stocks without owning shares in all of them.
- This allows investors to achieve diversification.
- Allows better asset allocation as people spread their money among different stocks at different growth rates.
Cons
- They can be riskier than other funds because they are exposed to market risk, giving them more volatility than others. If the stock market goes down, these funds could lose money and should be avoided by people with a low tolerance for risk.
- Their results are not very predictable due to the internal management of the fund and its relations with other financial institutions. The long-term results depend on several variables beyond an investor’s control.
- The equity funds are also a volatile investment, both in terms of absolute performance and relative to the market.
Bond funds
Bond funds are mutual funds that invest in the debt (and often the default) of countries, companies, and other entities. These include corporate bonds. As an investor, you’re paid a fixed amount each year for your initial investment, and then no more unless there’s a drop in value.
Investors generally think of bond funds as relatively low-risk investments; this makes sense because they are supposed to be backed by the assets of the company or country whose debt they hold.
Pros
- They have a consistent standard way to evaluate their investments. All bond funds are assigned a rating based on the quality of their bonds plus a risk-free rate, which is the rate at which the fund can be redeemed but only if it has enough assets to meet its obligations.
- You can see how your money is performing at a glance.
- They are ideal for people who want to keep their savings in one place and are not looking to diversify.
Cons
- Bond funds don’t fluctuate much, which means they will often lose money in a down market, even though the performance of other investments has been poor.
- When you buy a bond fund, you are not buying stock. You are buying certificates that promise to make periodic payments of interest and principal at regular intervals but whose value can only be determined by guessing what interest rates will be at that time.
- The value of the certificates is not based on anything real—it is based entirely on your hopes for future interest rates.
Balanced funds
A balanced fund is a kind of financial insurance policy: if you pay a small monthly premium, you will get a regular flow of income in return. It does this by investing equally between equity instruments and fixed-income investments.
They are popular with investors because they allow you to have more money invested in stocks without taking all the risk of owning them yourself. For example, let’s say you have an investment in target-date funds for your retirement plans. You can also balance it out with this fund to minimize the risk and have steady dividends/interest income coming in.
If your investment goes up and down, it will usually bounce back to its original level after a few years. A balanced fund also protects you from the risk of losing money. But balanced funds aren’t as safe as bank accounts or savings accounts with FDIC coverage.
Pros
- They promise to earn a certain return, usually matched or slightly better than the market.
- You can avoid paying brokerage commissions, or if you want to diversify your investments across different industries or anything else that might make it hard to find the best stock for your particular purposes.
- You can also tweak the asset classes accordingly to your strategy as you get a fixed percentage of each of two assets: say stocks and bonds. The more volatile one is, the higher your return will be if it goes up. The less volatile one is, the lower your return will be if it goes down.
Cons
- Most stock markets move up and down at very different speeds. A balanced fund that tries to match an index that holds a lot of stocks with a lot of bonds will do very badly if stocks go up while the fund holds lots of bonds.
- The returns you gain from balanced funds entirely depend on the asset distribution.
Index funds
Index funds, a type of mutual fund, are popular because they track an index such as the S&P/TSX or Dow Jones Industrial Average. They are often cheaper than actively managed funds because the portfolio manager does not have to research or make as many investment decisions.
Pros
- Their returns are uncorrelated with the market and therefore don’t fluctuate up and down with it.
- You can invest in indexes that are baskets of stocks like the S&P/TSX Composite Index, and rest assured that your returns don’t tank.
- Index funds usually don’t have high management fees. But they do have lower performance fees than active funds.
- Index funds don’t have sales charges either, so you’re likely to get a higher return on your money.
Cons
- Index funds are not as diversified as actively managed mutual funds.
- It requires more supervision and time spent for proper asset allocation.
- Less diversification opportunity than other investment types.
Specialty funds
A specialty fund is a mutual fund that invests in a particular field or sector funds. The field can be, for example, the securities of companies in a particular industry, the bonds issued by governments, or the stocks of companies that have their headquarters in a certain country—for example, investing in international funds catering to an emerging market, healthcare sector or even real estate.
The point of specialty funds is that they don’t try to beat the market as if it were made up of all investors. They aim to make money only for their investors. If you decide to invest in a specialty fund, your money will probably be invested in whatever stocks or bonds are considered best by experts in that field.
As a specialty fund does not have just one kind of stock, if the economy gets better or worse, if oil prices rise or fall, if interest rates go up or down, it must always be on guard for changes in each of those industries or sub-industries.
Pros
- Achieves diversification at low cost.
- You can add it to your portfolio to balance risks depending on your existing asset allocation.
- Specialty funds invest in individual companies that are known to be good investments.
- The mutual fund managers have the expertise and sound knowledge in the markets and know which companies stocks to buy and sell.
Cons
- Not all specialists are equal and have the same level of expertise.
- Some specialist funds—the ones that specialize in owning certain companies—are better than others. They may provide historically higher returns.
- To understand which kind is best, you need to know more about how the market works than you do now.
FAQs
What type of mutual funds are most safe?
Liquid funds are often considered the safest for investors as you can withdraw or liquidate your investment at any time. An example is money market funds.
Which mutual fund is best for beginners?
Index funds are great for beginners to start with as they use the benchmark of existing indexes like the S&P 500. You don’t have to be an expert to start.
Can I withdraw from mutual funds at any time?
Most mutual funds offer liquidity, so you should be able to liquidate your investments and withdraw at any time. The net asset value (NAV) is valued at the end of every day, so you can use this to guide your decision.