Types of Mutual Funds

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

Mutual funds and other investment companies are often labeled by the objectives they hope to accomplish, such as current income or growth.

Mutual fund families may have a number of different funds available to meet various objectives. Note, however, that there is no guarantee that any mutual fund will actually attain the desired objective.

In any event, the funds can be loosely classified as one of these:

(1) diversified common stock fund,

(2) balanced fund,

(3) bond and preferred stock fund,

(4) municipal bond fund, and

(5) money-market fund.


In comparing one mutual fund to another, it is important that both funds have a similar investment objective. For example, it wouldn't be fair to compare the expenses of an intensely managed aggressive growth fund to those of an index fund. Each type of fund has a different investment objective that requires it to take a different investment approach, and those differing approaches are going to affect each fund's expenses.

However, it would be fair to compare the expenses of one aggressive growth fund to another aggressive growth fund, or the expenses of one index fund to another index fund. To begin with, then, the investor has to determine which investment objective he or she wants to achieve, and then compare the funds that have that investment objective.

Once an investor has determined his or her investment objective, there are three major factors by which mutual funds can be compared.

Performance
A record of successful growth or appreciation in the fund's capital value in the past is a positive sign, but it is no indication that the growth will continue in the future. The larger and more successful a fund becomes, the more difficult it is to maintain that growth. Performance rankings of the top funds change considerably over a period of time.

Risk
Every investment involves risk. Investors hope that, if they are willing to take a greater risk, they will be rewarded with a greater return. Analysts use "risk-adjusted performance" to rank funds of a given type on their rate of return adjusted for risk, measuring a fund's performance in both up and down markets. A volatile fund may produce above-average gains when the market is up. But it may also lose value much faster than average in a falling market. Funds that have performed well in both good periods and bad may be ranked higher than more volatile funds with a greater return.

Cost
A final element for comparison between funds is cost. The expense ratio gives you the fund's operating expenses for the year expressed as a percentage of the fund's average net assets. In general, the lower the expenses, the greater the return to the investor.

The management advisory fee, somewhere around 0.5% of net assets, is usually the largest single component of operating expenses. Most funds will try to keep their operating expenses around 1% of the fund's assets. But currently funds range from a low expense ratio of .29% to as high as 9% of assets. The average stock fund in the early 1990s had an expense ratio of 1.6%. Expenses higher than average will reduce the investor's return.

Investors will find many features that cannot be compared statistically from fund to fund. Nevertheless, the special features may weigh heavily with specific investors. The presence or absence of features like telephone transfers, exchange privileges, front-end or back-end loads, or minimum purchase amounts may override differences in performance with these investors.

Most mutual funds offer a variety of ways for an investor to purchase shares. One of these is an open or regular account. Under this arrangement, an investor establishes the account by making a substantial lump-sum investment with no commitment to make regular purchases. However, because the account is "open," the investor may make additional investments as desired and as money is available.

Because there is usually a sales charge assessed on each individual purchase, investors should be aware that they may benefit from accumulating small dollar amounts into larger amounts before each investment. In addition, there are generally specified dollar amounts--say $5,000--at which the sales charge is reduced.

Dollar cost averaging can reduce an individual's concern about making an investment at the "wrong" time. Investors sometimes delay investing when the market has been rising rapidly because they feel that it may be due for a correction. Meanwhile, the market continues to rise and they lose what would have been a good opportunity to invest. Or they may delay investing when the market has been falling because they fear it may be in a long-term downward trend. They wait until the market shows some strong upward movement, and then they find themselves on the other side of the vicious circle--continuing to delay while they wait for a correction.