Mutual Fund Categories

We detoured from our review of investment funds to look at a few strategies and analytical ratios often used by investors.

In our Mutual Fund Introduction, we saw that there are an overwhelming number of mutual funds on offer. And that these funds cover the entire spectrum of asset classes and sub-classes.

How can investors possibly make sense of these investments? Truthfully, it is hard.

Today we will look at a few available mutual fund types.

Money Market

Money market instruments are short-term debt instruments (i.e., less than 1 year to maturity). Investments are considered extremely safe due to the nature of the fund investments.

Interest income is paid to investors.

While the returns are not high, they are better than what one would receive from savings accounts. And as the fund aggregates money from many individual investors, it can obtain higher returns on treasury bills and other short-term debt than a small investor could achieve on his own.

Money market funds may be available in foreign currencies. This may create foreign exchange gains or losses as compared with the investor’s domestic currency. In some cases, this can greatly enhance investor returns or possibly create losses.

Always take care when investing in money market funds – or any asset – that are not in your own currency.

Fixed Income Funds

You may also see these termed “bond funds”.

These funds invest in government and corporate debt. Some include preferred shares as well.

Within the fixed income style, there are many sub-categories.

Quality of Issuer

Some funds focus only on high quality debt issuers.

Other funds specialize in high risk issuers in the expectation of receiving higher returns. This latter group of non-investment grade fixed income instruments is known as “high yield” or “junk bonds”.

The quality of the issuer is based on ratings assigned by one of the bond rating agencies. For example, bonds with ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.

Terms to Maturity

Some funds concentrate on specific terms to maturity. Perhaps only investing in bonds with maturities between 5 and 10 years. Or maybe only in bonds with over 20 years life remaining.

Or you may see “bond ladders”. These funds spread out maturity dates like rungs of a ladder to smooth interest rate and reinvestment risks.

Regardless of Type

Fixed income funds attempt to generate a steady cash flow of interest (or dividend) income to investors. Although the objective is income, there may be capital gains or losses as well.

As interest rates fall, the market value of existing bonds will increase. This can create a capital gain if the bond is sold prior to maturity. Should interest rates rise, bond prices will fall, causing a capital loss if the bond is sold.

Due to the underlying investments and longer maturity dates, fixed income funds should generate greater interest income than money market funds. However, in times of rising interest rates, money market funds may outperform fixed income funds if the fixed income funds experience capital losses. Something to watch out for when investing in fixed income.

Balanced Funds

Balanced funds try to provide a balance between security, income, and capital appreciation.

The funds invest in a mix of money market, fixed income, and equity instruments to achieve this objective. As a result, the fund generates both dividend and interest income as well as capital gains (or losses).

The asset mixture is defined in the fund’s stated objectives. They do not need to be “balanced” equally.

Combination of asset classes may be fixed (e.g., 5% money market, 35% fixed income, 60% equities) or have a range of maximum and minimum investment levels for each of the three classes (e.g. 0-10% money market, 20-50% fixed income, 40-70% equities).

Investment percentages may further be broken down into asset sub-classes. For example, if 60% is allocated to equities, perhaps 30% is United States, 25% Other International, and 5% Canada.

The fund’s prospectus will lay out the investment strategy and restrictions.

Do not confuse balanced funds with asset allocation funds.

Asset Allocation Funds

Although similar in nature, there is usually greater flexibility in an asset allocation fund. This allows the portfolio manager to take advantage of changes in the business cycle to maximize investments in an asset class.

For example, as the economy heats up, stocks will begin to rise and fixed income assets should fall in value. An asset allocation portfolio manager has the flexibility to shift the bulk of the portfolio assets into equities and out of under-performing asset classes like bonds.

Balanced funds have less or no leeway in altering the asset mix.

Because of the extra work involved by the asset allocation managers, it is normal for asset allocation funds to charge higher fees than similar balanced funds.

Target-Date Funds

Like balanced or asset allocation funds, target-date funds invest in multiple asset classes.

However, target-date funds automatically reset the portfolio asset mix based on the stated investment time horizon.

With a long maturity, investments are skewed towards riskier assets. As the maturity date gets closer, assets shift into less risky investments.

This is much like Life-Cycle funds (also known as “Aged-Based” funds).

We will consider these funds further when we look at investor profiles and strategies.

Equity Funds

The largest class of funds are equity funds. They also have the most sub-categories.

In general, equity funds strive for long-term capital appreciation. Some may also generate income, but that is normally a secondary consideration. The exception being equity income funds that specifically seek dividends.

Equity funds may be aggregated in a variety of ways.

Market Capitalization

They may focus on stocks of companies that have certain levels of market capitalization. Large cap or small cap equity funds are common variations.

Type of Company

They may focus on characteristics and style fits of companies.

For example, value or growth equity funds.

Some funds focus on companies that pay high dividends. Others on companies that pay no dividends.

Geographics

You will also see funds based on the geographic location of the underlying companies. These equity funds may be designated domestic, international, and global.

Domestic equity funds are those that contain stocks listed on stock exchanges in the same country as the investor.

International equity funds are those whose companies are listed on stock exchanges outside the investor’s country of domicile. International funds may also be called “foreign” funds.

Global equity funds may contain shares of companies from anywhere in the world.

For example, consider the Credit Suisse (CH) Swiss Blue Chips Equity Fund UB. It invests mainly in large cap companies located in Switzerland. Nestle, Novartis, Roche, UBS, etc.

As a Swiss investor, this would be domestic fund. To an Canadian investor, it would be an international fund.

In contrast, the Credit Suisse (Lux) Global Value Equity Fund BH CHF invests in a wider range of equities. Its scope includes “undervalued companies which are listed worldwide on regulated and accessible markets.”

Because it has shares of companies from both within and outside Switzerland, it is a global fund to a Swiss investor. And to a Canadian investor as well.

Sector

Within the broader categories, you may see smaller fund compositions, such as by industry or business sector.

For example, Fidelity offers equity funds that cover: Consumer Staples, Consumer Discretionary, Energy, Industrials, Telecommunications, Financial Services, Health Care, Materials, Natural Resources, Precious Metals, Technology, Utilities.

Countries or Regions

Funds also exist that narrow the geographic segments into regions and countries.

T. Rowe Price has a Global Stock fund. But they also provide more geographically focussed equity funds including: Africa & Middle East, Emerging European & Mediterranean, Emerging Markets, European, Japan, Latin America, New Asia.

Or you may even see subsets of subsets. A BRIC fund is a good example. This is an emerging market segment that includes only Brazil, Russia, India, and China. The four largest emerging markets.

Speciality Funds

Speciality funds are those that do not fit into one of the above boxes. Hard to believe, I know.

That said, some people include sector and regional funds as specialty funds.

Real Estate

In this category, you usually find investments in real estate companies or assets.

Some funds invest in operating companies that manage hotels, develop properties, etc.

Precious Metals

You may also see funds that invest in precious metals.

This can be achieved by investing in companies involved in precious metals. Often this includes indirect involvement, such as service companies.

It may also include direct investments in the assets.

For example, Tocqueville Gold (TGLDX) invests about 80% of its capital into shares of mining and related companies. But up to “20% of the fund’s total assets may be invested directly in gold bullion and other precious metals.”

Collectibles

Some funds allow you to invest in other exotic assets such as collectibles.

There are many funds that specialize in tiny market segments, including fine art and vintage wine.

I would caution investors with these unique types of funds. Usually the management fees are extremely high, the ability to liquidate one’s investment may be limited, and the investment time frame required may be substantial.

While collectibles may be useful for diversification, I would not recommend their purchase for most investors.

Environment, Social, and Governance (ESG)

A very popular investment niche over the last decade or so.

These funds invest in specific areas or exclude specific investments from their options in an attempt to be socially responsible or ethical.

For example, the Pax Ellevate Global Women’s Index Fund (PXWIX) employs “a global, index-based investment strategy designed to capture investment returns associated with gender diversity and women’s leadership.”

Or consider The American Trust Allegiance Fund (ATAFX). Its investment strategy seeks positive returns, while “avoiding companies involved in the alcohol, gambling, tobacco and health care industries.”

That is an overview of common fund categories. Over time, I will discuss these in more detail as we look at constructing diversified portfolios.