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In simplest terms, mutual funds fall into two broad groupings: stock funds and bond funds.
In general, stock funds deliver greater returns over the long term than bond funds. But stock funds are less predictable and more likely to deliver sharp losses as well as gains over relatively short spans of time, leaving short-term investors unsure of how much they'll have when they need their money.
Stock funds rely on their holdings to rise in value in order to deliver good returns. Bond funds achieve much of their return by collecting interest on the securities they own.
Within each of these broad groupings exist several fund categories. Stock funds are divided this way:
- Aggressive growth. These strive for big profits, generally by investing in small companies and developing industries or by concentrating on volatile issues. Some use speculative techniques, such as trading with borrowed money and short selling. The greater the drive for high profits, the greater the risk.
- Growth. These look for long-range capital gains by buying the stocks of companies that supposedly have unique characteristics enabling them to grow faster than inflation.
- Growth and income. These funds have much the same objective as growth funds, but they put greater emphasis on capital preservation and try to produce more current dividend income for shareholders. These funds invest in bonds, preferred stocks, and high-yielding common stocks.
- Index funds. These assemble portfolios designed to track as precisely as possible one or more broad stock or bond index. Funds that track the Standard & Poors 500 are perhaps the best known, but there are many others. When the market is moving relentlessly upward, as it did for most of the 1990s, index funds are tough to beat.
- International funds. International funds are U.S.-based but invest in securities of companies traded on foreign exchanges. Global funds reserve the right to mix in some U.S. issues as well. They are good places to be when the value of the dollar is falling because their holdings may be denominated in foreign currencies and investors profit from the favorable exchange rates on those currencies.
- Exchange-traded funds. Exchange-traded funds (ETFs) own a fixed portfolio of securities and can be bought and sold through a broker any time of the day that the stock market is open. An ETF's portfolio represents a slice of the market -- an index, a subsector of an index, or a particular industry. ETFs also come in more varieties than conventional index funds and tend to cost even less than the least costly traditional index fund. However, you have to pay a brokerage commission each time you buy or sell one.
Other stock-fund categories are sector funds, which invest in a single industry or economic sector; balanced funds, whose assets include large percentages of both stocks and bonds; and utility funds, which invest in income-heavy utility stocks.
Bond funds are divided among those that hold:
- High-grade corporate bonds
- High-yield (and high-risk) corporate "junk" bonds
- Mortgage securities
- Government bonds
- Tax-free municipal bonds
- Overseas issues
Money market funds are similar to bond funds, but they have a few very distinct features, such as check writing abilities and a fixed $1 net asset value. These funds invest in short-term corporate and government debt and pass the interest payments on to shareholders. Their stability and liquidity make them ideal for short-term savers or investors looking for a safe place to stash their cash.