Note: this is another in a series of articles exploring mutual funds and how investors in the stock market can use them to meet financial goals.Many people who prefer individual stocks for the primary investment vehicle, also use mutual funds in their investment strategy.
Mutual funds give investors in the stock market many options to help meet financial goals. A wise use of mutual funds by stock investors can reduce overall portfolio risk and allow the investor to concentrate on individual stocks.
Investors have thousands of mutual funds to choose from that are offered by hundreds of investment companies. Fortunately, most mutual funds fall into one of the categories listed below. There is ample room for bending definitions in the market, but most funds stay close to these broad categories.
Active vs. Passive Management
Mutual fund companies employ two basic forms of management and these forms define two distinct types of funds. Active and passive management describe the two distinctly different roles of fund managers in the day-to-day management of their respective fund's assets.
An actively managed mutual fund employs a manager, researchers, and stock and bond traders who are engaged daily in researching and analyzing companies for possible inclusion (or elimination) from the fund's holdings.
Depending on the fund's objective, the managers will focus on those stocks and/or bonds that fit the fund's guidelines, but often have wide latitude when choosing investments. This can including options, futures contracts and other derivatives.
The managers of an actively managed fund focus on "beating the market," which is often the S&P 500 Index or another market barometer. The management team's goal of frequently buying and selling stocks and bonds is to boost the fund's return above the market index that is their gauge.
A passively managed fund, which means an index fund as a practical matter, does not employ a large professional staff because the funds seldom buy or sell stocks or bonds and have no need of researchers. They follow a stock or bond index and mimic its holdings.
Another way actively and passively managed funds differ is the stated goal. Most passively managed funds do not try to beat the index, they simply follow it.
Investors will notice a big difference between active and passive funds when they look at expenses. The costs to run an actively managed fund are much higher than those of a passively managed fund.
Fund expenses are an important determinant in predicting success - the higher the expenses, the harder it is to consistently meet the fund's goals.. The prospectus for the fund will detail the management style and whether it is actively or passively managed.
Index funds are passively managed funds. These funds mimic in holdings the indexes they follow. Investors find them attractive for their low expenses. Index funds track a stock or bond index by investing in the same stocks or bonds that make up the index.
An S&P 500 Index mutual fund would own all 500 stocks that make up this popular stock market index. Many investors consider the S&P 500 "the market" for comparison purposes.
Although the S&P 500 index funds are the most popular, there are funds for almost any sector of the stock market, from small companies to technology stocks to foreign companies. Index funds allow investors to buy these markets without having to research individual companies within each sector.
Index funds that capture broad sections of the market and move with the market, while sector index funds can be very volatile because they focus on small slices of the market.
The big advantage of index funds is their low cost. With no large professional staff, the funds keep expenses low. The only time they trade stocks or bonds is when the underlying index changes components.
The trade-off for investors is avoiding the under-performance that marks 80 percent of the actively traded funds, while missing out on the 20 percent that do better than the market.
Growth mutual funds focus on companies with higher than average growth and continued potential growth. The funds look for companies that reinvest profits to fund new growth rather than pay out dividends to shareholders. They target companies that are market leaders and hold dominant positions in their industry.
Growth funds invest primarily in stocks. This is important because investors consider stock investments more risky than investing in bonds. If the name or description mentions growth, the mutual fund invests in stocks.
The next article in this series will explore more types of mutual funds and how investors can use them to meet financial goals.