Investment Policies
Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. For example, money market mutual funds hold the short-term, low-risk instruments of the money market , while bond funds hold fixed-income securities. Some funds have even more narrowly defined mandates. For example, some bond funds will hold primarily Treasury bonds, others primarily mortgage-backed securities. Management companies manage a family, or “complex,” of mutual funds. They organize an entire collection of funds and then collect a management fee for operating them. By managing a collection of funds under one umbrella, these companies make it easy for investors to allocate assets across market sectors and to switch assets across funds while still benefiting from centralized record keeping. Some of the most well-known management companies are Fidelity, Vanguard, Putnam, and Dreyfus. Each offers an array of open-end mutual funds with different investment policies. In early 2011, there were over 8,000 mutual funds in the United States, which were offered by 669 fund complexes. Some of the more important fund types, classified by investment policy, are discussed next.
Money market funds These funds invest in money market securities such as commercial paper, repurchase agreements, or certificates of deposit. The average maturity of these assets tends to be a bit more than one month. They usually offer check-writing features, and net asset value is fixed at $1 per share, 1 so that there are no tax implications such as capital gains or losses associated with redemption of shares.
Equity funds Equity funds invest primarily in stock, although they may, at the portfolio manager’s discretion, also hold fixed-income or other types of securities. Equity funds commonly will hold about 5% of total assets in money market securities to provide the liquidity necessary to meet potential redemption of shares. Stock funds are traditionally classified by their emphasis on capital appreciation versus current income. Thus income funds tend to hold shares of firms with high dividend yields that provide high current income. Growth funds are willing to forgo current income, focusing instead on prospects for capital gains. While the classification of these funds is couched in terms of income versus capital gains, it is worth noting that in practice the more relevant distinction concerns the level of risk these funds assume. Growth stocks—and therefore growth funds—are typically riskier and respond more dramatically to changes in economic conditions than do income funds.
Specialized sector funds Some equity funds, called sector funds, concentrate on a particular industry. For example, Fidelity markets dozens of “select funds,” each of which invests in a specific industry such as biotechnology, utilities, precious metals, or telecommunications. Other funds specialize in securities of particular countries.
Bond funds As the name suggests, these funds specialize in the fixed-income sector. Within that sector, however, there is considerable room for further specialization. For example, various funds will concentrate on corporate bonds, Treasury bonds, mortgage-backed securities, or municipal (tax-free) bonds. Indeed, some municipal bond funds invest only in bonds of a particular state (or even city!) in order to satisfy the investment desires of residents of that state who wish to avoid local as well as federal taxes on interest income. Many funds also specialize by maturity, ranging from short-term to intermediate to long-term, or by the credit risk of the issuer, ranging from very safe to high-yield or “junk” bonds.
Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. For example, money market mutual funds hold the short-term, low-risk instruments of the money market , while bond funds hold fixed-income securities. Some funds have even more narrowly defined mandates. For example, some bond funds will hold primarily Treasury bonds, others primarily mortgage-backed securities. Management companies manage a family, or “complex,” of mutual funds. They organize an entire collection of funds and then collect a management fee for operating them. By managing a collection of funds under one umbrella, these companies make it easy for investors to allocate assets across market sectors and to switch assets across funds while still benefiting from centralized record keeping. Some of the most well-known management companies are Fidelity, Vanguard, Putnam, and Dreyfus. Each offers an array of open-end mutual funds with different investment policies. In early 2011, there were over 8,000 mutual funds in the United States, which were offered by 669 fund complexes. Some of the more important fund types, classified by investment policy, are discussed next.
Money market funds These funds invest in money market securities such as commercial paper, repurchase agreements, or certificates of deposit. The average maturity of these assets tends to be a bit more than one month. They usually offer check-writing features, and net asset value is fixed at $1 per share, 1 so that there are no tax implications such as capital gains or losses associated with redemption of shares.
Equity funds Equity funds invest primarily in stock, although they may, at the portfolio manager’s discretion, also hold fixed-income or other types of securities. Equity funds commonly will hold about 5% of total assets in money market securities to provide the liquidity necessary to meet potential redemption of shares. Stock funds are traditionally classified by their emphasis on capital appreciation versus current income. Thus income funds tend to hold shares of firms with high dividend yields that provide high current income. Growth funds are willing to forgo current income, focusing instead on prospects for capital gains. While the classification of these funds is couched in terms of income versus capital gains, it is worth noting that in practice the more relevant distinction concerns the level of risk these funds assume. Growth stocks—and therefore growth funds—are typically riskier and respond more dramatically to changes in economic conditions than do income funds.
Specialized sector funds Some equity funds, called sector funds, concentrate on a particular industry. For example, Fidelity markets dozens of “select funds,” each of which invests in a specific industry such as biotechnology, utilities, precious metals, or telecommunications. Other funds specialize in securities of particular countries.
Bond funds As the name suggests, these funds specialize in the fixed-income sector. Within that sector, however, there is considerable room for further specialization. For example, various funds will concentrate on corporate bonds, Treasury bonds, mortgage-backed securities, or municipal (tax-free) bonds. Indeed, some municipal bond funds invest only in bonds of a particular state (or even city!) in order to satisfy the investment desires of residents of that state who wish to avoid local as well as federal taxes on interest income. Many funds also specialize by maturity, ranging from short-term to intermediate to long-term, or by the credit risk of the issuer, ranging from very safe to high-yield or “junk” bonds.
International funds Many funds have international focus. Global funds invest in securities worldwide, including the United States. In contrast, international funds invest in securities of firms located outside the U.S. Regional funds concentrate on a particular part of the world, and emerging market funds invest in companies of developing nations.
Balanced funds Some funds are designed to be candidates for an individual’s entire investment portfolio. These balanced funds hold both equities and fixed-income securities in relatively stable proportions. Life-cycle funds are balanced funds in which the asset mix can range from aggressive (primarily marketed to younger investors) to conservative (directed at older investors). Static allocation life-cycle funds maintain a stable mix across stocks and bonds, while targeted-maturity funds gradually become more conservative as the investor ages. Many balanced funds are in fact funds of funds. These are mutual funds that primarily invest in shares of other mutual funds. Balanced funds of funds invest in equity and bond funds in proportions suited to their investment goals.
Asset allocation and flexible funds These funds are similar to balanced funds in that they hold both stocks and bonds. However, asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each sector. Hence, these funds are engaged in market timing and are not designed to be low-risk investment vehicles.
Index funds An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in proportion to the security’s representation in that index. For example, the Vanguard 500 Index Fund is a mutual fund that replicates the composition of the Standard & Poor’s 500 stock price index. Because the S&P 500 is a value-weighted index, the fund buys shares in each S & P 500 company in proportion to the market value of that company’s outstanding equity. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy—that is, to invest without engaging in security analysis. Nearly 25% of assets invested in equity funds in 2012 were in index funds. Of course, index funds can be tied to nonequity indexes as well. For example, Vanguard offers a bond index fund and a real estate index fund.
Table 4.1 breaks down the number of mutual funds by investment orientation. Sometimes the fund name describes its investment policy. For example, Vanguard’s GNMA Fund invests in mortgage-backed securities, the Municipal Intermediate Fund invests in intermediateterm municipal bonds, and the High-Yield Corporate Bond Fund invests in large part in
Balanced funds Some funds are designed to be candidates for an individual’s entire investment portfolio. These balanced funds hold both equities and fixed-income securities in relatively stable proportions. Life-cycle funds are balanced funds in which the asset mix can range from aggressive (primarily marketed to younger investors) to conservative (directed at older investors). Static allocation life-cycle funds maintain a stable mix across stocks and bonds, while targeted-maturity funds gradually become more conservative as the investor ages. Many balanced funds are in fact funds of funds. These are mutual funds that primarily invest in shares of other mutual funds. Balanced funds of funds invest in equity and bond funds in proportions suited to their investment goals.
Asset allocation and flexible funds These funds are similar to balanced funds in that they hold both stocks and bonds. However, asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each sector. Hence, these funds are engaged in market timing and are not designed to be low-risk investment vehicles.
Index funds An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in proportion to the security’s representation in that index. For example, the Vanguard 500 Index Fund is a mutual fund that replicates the composition of the Standard & Poor’s 500 stock price index. Because the S&P 500 is a value-weighted index, the fund buys shares in each S & P 500 company in proportion to the market value of that company’s outstanding equity. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy—that is, to invest without engaging in security analysis. Nearly 25% of assets invested in equity funds in 2012 were in index funds. Of course, index funds can be tied to nonequity indexes as well. For example, Vanguard offers a bond index fund and a real estate index fund.
Table 4.1 breaks down the number of mutual funds by investment orientation. Sometimes the fund name describes its investment policy. For example, Vanguard’s GNMA Fund invests in mortgage-backed securities, the Municipal Intermediate Fund invests in intermediateterm municipal bonds, and the High-Yield Corporate Bond Fund invests in large part in
speculative grade, or “junk,” bonds with high yields. However, names of common stock funds often reflect little or nothing about their investment policies. Examples are Vanguard’s Windsor and Wellington funds.
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