In this article, we will dwell upon different types of mutual funds: what they are, how they work and how they are classified. Investment funds have a very important role in our economy because they provide the necessary capital for business growth and thus contribute to developing economies of scale while stimulating all levels of the economy. By acquiring participations in companies, they are a key promoter of economic growth.
Most types of mutual funds are a specialized branch and have particular methods of investment. However, they are not legally distinguished from other types of investment funds and must submit to the same legislation, namely the Investment Company Act of 1940, which extensively regulates the activity of such entities.
By the end of this article, you will have a better general understanding of what different types of mutual funds do and of how they are classified.
What Are Mutual Funds?
Mutual funds have only recently become popular in the US, but today almost half of all households invest in one. What they basically do is connect people who invest in the fund to all kinds of stock and other securities. People who invest in the fund own shares which are a portion of the fund’s holdings.
Investing in mutual funds can be very lucrative, depending on what type of stock you are interested in. The most common returns from participating in mutual funds come in the shape of dividends from shares, and interest from bonds. The mutual funds will pay these sums to the fund owners on a regular basis. If the value of the securities owned by mutual funds increases, the increase is capital is also distributed to fund investors. Finally, if the fund’s holdings become more valuable but are not sold by the fund, the added value will be reflected in the mutual fund’s shares, which can then be sold.
Advantages and Disadvantages
Investing in a mutual fund has several advantages, including:
- Expert Management. People who invest in mutual funds often do not have the time to manage their own portfolios. So, they choose to pass on the management of their investment to a specialized fund.
- Investment Diversity. Mutual funds can help you to spread your investment over a wide range of different securities, which lowers risk in case one section loses value.
- Cash Convertibility. On request, mutual funds can convert your share holdings into cash.
Some types of mutual funds can also have notable drawbacks, such as:
- High Fees. Investing in a mutual fund is not without cost, and managing your portfolio with the help of a team of experts does not come at a small price. Fees can become a serious consideration if your holdings are not consistent, and, in the end, they might amount to a larger expense than the sum your returns. This is why careful planning is needed before committing your investment portfolio to a mutual fund.
- Investment Dilution. Mutual funds can offer diluted investment solutions. While these minimize risk by spreading your holdings across securities from many companies, a higher return for one slice of your investment will not have a great impact on your overall income. In this context, remember to opt for a balanced approach to investment diversity.
- High Taxes. The selling of securities is subject to a capital-gains tax. If the sum of these taxes is a source of concern, try to look for types of mutual funds which are tax-sensitive. You can also keep returns from a non-tax-sensitive mutual fund in a tax-free account.
Types of Mutual Funds
Mutual funds are classified in two ways: by the method of dealing with investors and by the types of securities that they choose to invest in. Let’s take a look at each one in turn.
Types of Mutual Funds – General Classification
- Open-End Funds. These types of mutual funds are obliged to buy back shares that investors in the fund previously purchased from the investment fund if investors wish to sell. These shares are priced differently every day, at a net asset value (NAV). In addition, open-end funds regularly sell shares to the general public on a daily basis. Investor’s portfolios are under the management of a professional investment manager. Open-end funds are also allowed to issue as many shares as they like. These types of mutual funds are the most common in the US, with almost 8000 funds managing assets estimated somewhere at around $16 trillion dollars.
- Closed-End Funds. These types of funds only issue shares to the general public once, during their Initial Public Offering (IPO), and do not issue shares at a later date. Listed for trading on the stock exchange, these shares cannot be sold back to the mutual fund once they have been bought. They can, however, be sold to any other investor on the market. Because prices for shares in closed-end funds float on the stock exchange, the selling price can be higher or lower than the net asset value (NAV), depending on market conditions. Less popular than open-end funds, there are only around 600 closed-end funds in the US, managing somewhere around $300 billion worth of assets.
- Unit Investment Trusts. These mutual funds issue shares just once, at their IPO, in a similar fashion to closed-end mutual funds. However, unit investment funds close at a pre-set date. Investors can either wait for the fund to close and recover their shares, or recover them at any time, with the possibility of subsequently selling them on the stock market.
Types of Mutual Funds – Classification by Investment
In terms of the types of securities invested in, we can mention the following main mutual fund types:
- Money Market Mutual Funds. This kind of mutual fund invests in low-return but very reliable securities, such as government bonds and treasury bills. This is considered to be the safest form of investment in mutual funds.
- Fixed Income Mutual Funds. This type of mutual fund invests in securities that pay a fixed rate, like government bonds and corporate bonds. It aims to sustain a constant income flow, but it a little riskier than a money market mutual fund.
- Equity Mutual Funds. This type of mutual fund is riskier than the abovementioned ones, but can also yield a higher It invests in all kinds of stock from a wide variety of companies.
In addition, there are also many types of specialized funds which invest in special financial instruments and in other investment funds. Check out a list of top US mutual funds here.
All types of mutual funds manage your investment portfolio for you and can yield considerable gains. If your investment is sufficiently large to warrant fund fees and taxes, this can be a very good way to safely manage your portfolio and save a lot of time.