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Types of mutual funds: The basics

There are many types of funds to invest in. Here’s a brief breakdown.

Stock mutual funds

Stock funds invest primarily in common stocks of corporations to provide growth in value. They bring the stock market to the investor who may not have the time or ability to pick stocks or construct a portfolio. These funds are usually growth-oriented, since stocks provide growth.

Growth funds are a type of stock fund structured to grow over time. These funds invest primarily in stocks of corporations that are viewed to have potential for growth. Growth funds may choose businesses or smaller companies that have the potential to grow quickly. Growth companies often forgo paying dividends to their customers because growth companies reinvest their earnings.

Bond mutual funds

Bond funds invest primarily in bonds to provide income with safety of principal. They bring the world of bond investing to the small investor. Most bond funds are conservative, focusing on payment of dividends. That said, investing in bond mutual funds still involves risk, including possible loss of principal. Investors can choose among several types of bond funds. Below are some of the most popular:

Municipal bond funds

Municipal bond funds invest in debts issued by state and local governments. Their dividends may be free from federal taxes.

Government bond funds

Government bond funds invest in debts of the US government and its agencies. These funds include mortgage-backed securities as well as bills, notes, and bonds of the US Treasury.

mutual funds
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Corporate bond funds

Corporate bond funds invest in debts issued by companies in the private sector.

Zero coupon bond funds

Zero coupon bond funds are pools of zero coupon bonds. A zero coupon bond is a bond that is sold to an investor at a discount. It does not pay interest. When it matures, the investor receives the face value of the bond. The difference between the face value and the discounted purchase prices is treated as interest.

International bond funds

International bond funds invest in debts of governments and corporations of other nations.

Convertible securities funds

Convertible securities funds invest in debt securities that can be converted into stock. These funds have the objective of current income and growth with preservation of principal. Thus, they offer characteristics of stocks and bonds.

Goals of bond funds

Bond funds generally pay periodic income dividends, which can be taken in cash or reinvested. Their primary goal is current income and preservation of principal, although bond fund prices fluctuate and may result in loss of principal in an unfavorable bond market.

Additional notes about bond mutual funds

Municipal bond funds: Subject to availability and change in price. Municipal bonds in the fund are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income on some private activity bonds may be subject to the alternative minimum tax. Exempt-interest dividends are federally tax-free, but other state and local taxes may apply with special rules often applying to residents buying bonds issued by their own state.

Government bond funds: An investor can lose money when investing in government bond funds. The funds themselves are not guaranteed, and the funds' performance will vary.

Zero coupon bonds: Zero coupon bonds are subject to large price fluctuations if sold prior to maturity. Investors pay ordinary income tax on zero coupon bonds every year even when no payments have been received.

Money market mutual funds

Money market mutual funds invest in the short-term debts of corporations, federal and state governments, and their subsidiaries.

What money market funds invest in

They bring these investments to the small investor for an initial investment as low as $500 (depending on the fund). Money market funds invest in Treasury bills, commercial paper, banker's acceptances, negotiable certificates of deposit, repurchase agreements, and short-term debts of US government agencies. A fund's prospectus lists each investment and how much of it the fund has bought.

The returns on money market funds depend on the yields of their individual holdings. Money market instrument yields can fluctuate greatly. This causes the yields of money funds to fluctuate as well. Investors who hold money market funds can track the funds' yield changes in the financial pages of most major newspapers.

An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

Hybrid mutual funds

There are mutual funds that do not specialize in a particular security such as stocks or bonds, but may instead combine several types of securities in their portfolios. These funds are structured to meet an objective such as rapid growth, matching a market index, or investing in one area of the economy. They use combinations of securities to meet their goals. We will look at several of these "hybrid funds."

Income funds

Income funds are structured to provide regular income dividends to their investors. These funds invest in "income securities" of corporations or governments (including preferred stock, bonds, and money market investments). Such securities yield relatively stable current income. They focus on paying dividends as their top priority while de-emphasizing the growth in value of their portfolios. Preservation of capital is a concern. Income funds are popular with investors who want stable income from their mutual funds.

Index funds

Index funds are popular among investors wishing to keep their mutual funds' performance in line with "the market." These funds buy the securities that make up major market indexes. The advantage of index funds is that they are always in line with their market index. Their downside is that they cannot outperform the market. Some funds divide their holdings evenly among the various stocks. Some use dollar weighting so that bigger companies make up a larger share.

Balanced funds

Balanced funds seek to balance growth and income in one portfolio. To do this, they invest in common stock, preferred stock, bonds, and cash equivalents. Hypothetically, these funds have a "balanced" ratio of these asset types. Managers of balanced funds can, however, shift this ratio one way or the other to take advantage of high interest rates or stock market growth. Balanced funds generally have low volatility and are popular with investors seeking current income with growth potential.

Growth & income funds

Growth & income funds are similar to balanced funds. However, they rely mostly on growth stocks that pay dividends.

Funds that mix stocks, bonds, money market instruments, as well as other class assets are better able to allocate capital toward the end of achieving a particular investment goal. Such funds are used by investors with similar investment goals.

Dive deeper: Mutual funds: Here's what they are and how they work

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