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Mutual funds offer a simple way to diversify your portfolio -- albeit at a cost
The theory behind mutual funds is simple: by pooling your money together with that of a lot of other investors, you have a lot more power to invest. And a professional manager can put the funds across enough investments to reduce the risk of being wiped out by any single bad bet.
The fund is essentially a corporation whose sole business is to collect and invest money. You join the pool by buying shares in the fund.
Your money is then invested by a team of professionals, who research stocks, bonds, or other assets and then place the money as wisely as they can.
The managers charge an annual fee -- generally 0.5 percent to 2.5 percent of assets -- plus other expenses. That puts a drag on your total return, of course. But in exchange, you get professional management and instant diversification, two factors that have helped propel the number of funds into the thousands.
There are several flavors of mutual funds. Funds that impose a sales charge -- taking a cut of any new money that comes into the fund, or a cut of withdrawals -- are called load funds; those that do not have sales charges are called no-load funds.
Funds can also be divided into open- and closed-end funds. Open-end funds will sell shares to anyone who cares to buy; essentially, they are willing to invest any new money that the public wishes to pump into the fund. Their share price is determined by the value of the underlying investments, and is calculated anew each evening after the close of the U.S. markets. Closed-end funds, on the other hand, issue a limited number of shares that then trade on the stock exchange like stocks. The price of such shares can fluctuate above or below the actual value of the underlying shares held within the portfolio.
Funds also can be broken down by their investment strategy. Here's a quick overview of some of the principal types. There are more to come in later Money 101 lessons:
Index funds
When people talk about the long-term performance of stocks, they're usually talking about the Dow Jones industrial average, the Standard and Poor's 500-stock index or some other broad market index.
Funds based on the S&P 500, by definition, will never outperform the market (or not by very much anyway). But because they are so cheap to run -- you'll typically pay just $2 a year in expenses for every $1,000 invested compared to $14 a year for the average stock fund -- they outperform the vast majority of actively managed funds over time.
Growth funds
These invest in the stock of companies whose profits are growing at a rapid pace. Such stocks typically rise more quickly than the overall market -- and fall faster if they don't live up to investors' expectations.
Value funds
Value-oriented fund managers buy companies that appear to be cheap, relative to their earnings. In many cases, these are mature companies that send some of their earnings back to their shareholders in the form of dividends.
Funds that specifically target such income-producing investments are often called equity-income or growth-and-income funds.
Sector funds
Sector and specialty funds concentrate their assets in a particular sector, such as technology or financials. There's nothing wrong with that approach, as long as you remember that a hot performing sector one year could crash the following year.
Others
Since there is a lot of overlap in the stocks held in each of these fund types, you'll need to branch out to get any kind of meaningful diversification. That's where more aggressive funds, like aggressive growth funds, capital appreciation funds, small-cap funds, midcap funds and emerging growth funds, fit in.
Typically, these funds, which tend to be more volatile than large-cap funds, pursue one or more of the following strategies:
Invest in smaller companies, where earnings aren't as reliable as at bigger firms but where the potential for gains (and losses) is higher.
Invest in pricey, high-growth stocks.
Invest in stocks that are in "hot" industries, such as technology or health-care.
Invest in just a handful of companies.
International
Funds that invest outside the U.S. come in three basic flavors. The first, international funds, typically buy stocks in larger companies from relatively stable regions like Europe and the Pacific Rim. Global funds do likewise, but they can also invest heavily in the United States. Emerging market funds invest in riskier regions, like Latin America, Eastern Europe, and Asia.
Bond funds
These tend to be segmented across the risk spectrum, with those that specialize in Treasury securities being the safest (and the lowest-yielding) and those that specialize in junk bonds being the riskiest but offering the highest yield. They also divide according to whether the bonds they hold are taxable or tax-free.
One thing to remember: When the market is headed down, funds that invest in Treasuries tend to rise in value and investors flock to the safest investments around. Likewise, when the market is going up, junk bonds funds tend to do the best, as the better things are for business, the more likely that even the riskiest bond bets will pay off.
The theory behind mutual funds is simple: by pooling your money together with that of a lot of other investors, you have a lot more power to invest. And a professional manager can put the funds across enough investments to reduce the risk of being wiped out by any single bad bet.
The fund is essentially a corporation whose sole business is to collect and invest money. You join the pool by buying shares in the fund.
Your money is then invested by a team of professionals, who research stocks, bonds, or other assets and then place the money as wisely as they can.
The managers charge an annual fee -- generally 0.5 percent to 2.5 percent of assets -- plus other expenses. That puts a drag on your total return, of course. But in exchange, you get professional management and instant diversification, two factors that have helped propel the number of funds into the thousands.
There are several flavors of mutual funds. Funds that impose a sales charge -- taking a cut of any new money that comes into the fund, or a cut of withdrawals -- are called load funds; those that do not have sales charges are called no-load funds.
Funds can also be divided into open- and closed-end funds. Open-end funds will sell shares to anyone who cares to buy; essentially, they are willing to invest any new money that the public wishes to pump into the fund. Their share price is determined by the value of the underlying investments, and is calculated anew each evening after the close of the U.S. markets. Closed-end funds, on the other hand, issue a limited number of shares that then trade on the stock exchange like stocks. The price of such shares can fluctuate above or below the actual value of the underlying shares held within the portfolio.
Funds also can be broken down by their investment strategy. Here's a quick overview of some of the principal types. There are more to come in later Money 101 lessons:
Index funds
When people talk about the long-term performance of stocks, they're usually talking about the Dow Jones industrial average, the Standard and Poor's 500-stock index or some other broad market index.
Funds based on the S&P 500, by definition, will never outperform the market (or not by very much anyway). But because they are so cheap to run -- you'll typically pay just $2 a year in expenses for every $1,000 invested compared to $14 a year for the average stock fund -- they outperform the vast majority of actively managed funds over time.
Growth funds
These invest in the stock of companies whose profits are growing at a rapid pace. Such stocks typically rise more quickly than the overall market -- and fall faster if they don't live up to investors' expectations.
Value funds
Value-oriented fund managers buy companies that appear to be cheap, relative to their earnings. In many cases, these are mature companies that send some of their earnings back to their shareholders in the form of dividends.
Funds that specifically target such income-producing investments are often called equity-income or growth-and-income funds.
Sector funds
Sector and specialty funds concentrate their assets in a particular sector, such as technology or financials. There's nothing wrong with that approach, as long as you remember that a hot performing sector one year could crash the following year.
Others
Since there is a lot of overlap in the stocks held in each of these fund types, you'll need to branch out to get any kind of meaningful diversification. That's where more aggressive funds, like aggressive growth funds, capital appreciation funds, small-cap funds, midcap funds and emerging growth funds, fit in.
Typically, these funds, which tend to be more volatile than large-cap funds, pursue one or more of the following strategies:
Invest in smaller companies, where earnings aren't as reliable as at bigger firms but where the potential for gains (and losses) is higher.
Invest in pricey, high-growth stocks.
Invest in stocks that are in "hot" industries, such as technology or health-care.
Invest in just a handful of companies.
International
Funds that invest outside the U.S. come in three basic flavors. The first, international funds, typically buy stocks in larger companies from relatively stable regions like Europe and the Pacific Rim. Global funds do likewise, but they can also invest heavily in the United States. Emerging market funds invest in riskier regions, like Latin America, Eastern Europe, and Asia.
Bond funds
These tend to be segmented across the risk spectrum, with those that specialize in Treasury securities being the safest (and the lowest-yielding) and those that specialize in junk bonds being the riskiest but offering the highest yield. They also divide according to whether the bonds they hold are taxable or tax-free.
One thing to remember: When the market is headed down, funds that invest in Treasuries tend to rise in value and investors flock to the safest investments around. Likewise, when the market is going up, junk bonds funds tend to do the best, as the better things are for business, the more likely that even the riskiest bond bets will pay off.