The different Kinds of Mutual Funds Explained

Mutual funds are a popular investment instrument and every bank sells different kinds of such funds with different risk levels. Every investor wants to reach the highest return on their investments but it is necessary to keep their risk tolerance in consideration. Every bank will try to offer their clients mutual funds which reached a good performance in the past and which fits their investment strategy. The popularity of mutual funds has grown rapidly and the ease of diversification is maybe one of the most important reasons why people invest in mutual funds.

Every bank wants to sell mutual funds which are successful for their clients and they create almost every month new mutual funds and many people have difficulties to find their way in the market of mutual funds. Many funds look similar and the final decision to pick the best one is really difficult. People often don’t understand the differences between the different kinds of mutual funds.

Banks sell mutual funds with different investment strategies and here are some differences which may explain the different kinds of mutual funds:

1 Bond funds

Bond funds are mutual funds which invest in bonds. These funds have a lower risk profile than equity funds and also a lower return. These funds are safer than equity funds but there are still differences between the different types of bond funds. Bonds are a kind of loan of a company or the Government and some types may have a higher risk profile. Some types of bond funds are corporate bond funds, government bond funds, high yield bond funds, municipal bond funds, bonds of emerging markets, inflation linked bond funds, convertible bonds and some others. For example, high yield bond funds and bonds of emerging markets have a higher risk than government bond funds

An important issue if you buy bond funds is the interest rate when you buy these funds. Bond funds invest in bonds and if the long-term rate increases, the value of bond funds will decrease. This looks strange but can easy be explained. The fund manager of bond funds needs to sell bonds for a lower price and buy new ones with a higher interest rate.

A bond fund accumulates interest which can be capitalized or not. Inflation is an important issue; the FED will often increase the short-term interest rate and may cause also a raise of the long-term interest rate. Another important factor is that the growth of the economy is too fast or too slow. These factors will influence the value of bond funds.

2. Equity funds

Equity funds are mutual funds which invest in stocks and have a higher risk than bond funds. The returns of these funds are often higher if you respect the time horizon which is often ten years or more. There are also different types of equity funds with different risk levels. Some types are funds which invest in small caps, blue chips, one or different sectors, stock indexes, in one or more countries, emerging markets, diversified equity funds, and many others.

Equity funds may provide a dividend for the investors in these mutual funds. A dividend is a part of the profit which companies pay to shareholders. Mutual funds invest in stocks and can provide a certain dividend (income) for the investors in these equity funds.

3. Money market funds

Money market funds are the safest form of mutual funds but returns are also lower than equity funds and bond funds. Money market funds invest in cash and short term debt securities. The return is often twice as much as a savings account and a little bit less than most CD’s.

4. Strategy funds

Strategy funds are mutual funds which invest according a certain profile. There are different types of investors and the fund manager will buy and sell stocks and bonds which correspond with the risk level of the investor. A defensive strategy fund will invest for 25% in bonds and 75% in stocks; a balanced strategy fund will invest for 50% in bonds and 50% in stocks; an aggressive growth strategy fund will invest for 25% in bonds and 75% in stocks and a very aggressive growth strategy fund will invest 100% in stocks. There are some variations in these strategy funds concerning safety. Most banks offer strategy funds which offer a certain safety in your investments, for example your maximum loss in a safe defensive strategy fund will be 5%, a safe balanced strategy fund 10% and a safe aggressive fund 20%.

5. Capital guaranteed funds

These funds protect the capital which the investor has invested in capital guaranteed funds. This capital is only protected if you keep this fund in your portfolio until the end date of that fund, for example a capital guaranteed fund for 8 years of energy stocks. These funds are a safe investment but your return will also not high. Many investors think they invest in the energy sector but only 30% of this fund is invested in these stocks. These funds invest for 70% in bonds with a zero coupon rate to protect the capital of the investor and for the other 30% they can make some profit if the value of the portfolio of energy stocks will rise. You can consider these funds as an investment instrument with insurance.

There is plenty of choice in mutual funds and you will find every week new ones with a different investment strategy. Your risk tolerance is important to find out which will work best for you. It is often a matter of variation between the different kinds of mutual funds to spread the risk and to diversify. Strategy funds are maybe the best choice if you want a mutual fund according to your risk profile.