Mutual Funds: Equity, Bond, and Money Market Varieties - Essay Example

Mutual Funds: Equity, Bond, and Money Market Varieties The pooling of investments is the underlying principle of a mutual fund. Rather than allocating one's money to a particular investment, for instance a stock or a bond, a collective fund is established, professionally managed, and then invested on behalf of a large group of investors. Rather than benefiting in terms of a specific dividend payment or bond interest, the investors benefit by receiving a proportionate share of the mutual fund's investment return or suffer by absorbing a proportionate share of the mutual fund's investment loss. The precise nature of the gain or loss, whether ordinary or capital in nature, depends upon the nature of the underlying investment in which the fund participates. The main concept, in short, is that individual investors pool their investments through the larger investment vehicle known as a mutual fund. It can be misleading, in some respects, to speak of a mutual fund as a uniform type of investment vehicle. This is because mutual funds are possessed of many different characteristics, with different investment goals, and with different areas of investment expertise. Some mutual funds, for instance are more suitable for long-term investors while others focus their research and trading strategies on particular industries or financial indexes. This essay will discuss the fundamental characteristics and the significance of the mutual fund as an investment option in the United States of America. It will then examine the different types of mutual funds in which individual investors may participate. Particular attention will be paid to the definition of the mutual fund structure and the creative ways in which mutual fund investment opportunities have been made available to the common investor as well as the professional investor. 1.1 Definition and Structure: What is a Mutual Fund As an initial matter, it is important to note what types of investment structures constitutes a mutual fund and which types of investment structures do not constitute a mutual fund. This is an area of tremendous complexity. As stated by the United States Securities and Exchange Commission (SEC) a "mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities" ("Mutual Funds": np). As a matter of definition, therefore, the first point to be aware of is that a mutual fund is a company. Investors, as a result, are investing their money in a company rather than in an individual stock or other financial instrument. These companies are also known as "open-ended companies" and are not to be confused with other types of investments, such as close-ended funds and unit investment trusts. The mutual fund is distinguished from other investment structures in a variety of ways. First, the mutual fund is a flow-through investment structure; more particularly, the individual or institutional investor must purchase shares of the mutual fund from the investment company itself or through a registered broker. The initial shares purchased, consequently, are in the mutual fund itself rather than in any outside secondary markets. The price paid for these mutual fund shares is determined by calculating a net asset value (NAV) for the investments underlying a particular mutual fund in addition to associated purchase or broker fees. A second major characteristic of a mutual fund is that its shares are redeemable. This is an important and distinguishing characteristic. Rather than being able to sell their mutual fund shares to outside investors, it is instead required that the mutual fund shares must be sold back to the mutual fund itself or to a broker authorized to transact business on behalf of the mutual fund. A third feature of a mutual fund is that the mutual fund company will sell its shares on a rolling basis. This means that, as a general rule, the mutual fund company continues to make available its shares to interested investors; as noted by the SEC, however, a mutual fund may restrict share availability when the investment base becomes too large ("Mutual Funds": np). The final feature of a mutual fund is the fact that its investment portfolios are professionally administered and managed. This management function is most often undertaken by separate financial management entities registered with the SEC. These investment advisers are compensated for their management expertise and bound by ethical codes established by the SEC and related professional associations. These open-ended investment companies, characterized by the aforementioned structural and operational features, constitute the general concept of a mutual fund. The traditional wisdom is that mutual funds are attractive because they allow a tremendous degree of diversification, because they make professional financial management expertise available as a part of the underlying investment, because they are a very liquid investment option given their redeemable nature, and because the economies of scale lower transaction costs when compared to a more direct and individualized investment setting (Investopedia: np). As a caveat, it is extraordinarily important to remember that a mutual fund is simply an umbrella designation with a variety of different types of investment options. While the aforementioned features characterize the mutual fund both legally and generally, the mutual fund structure is both broad enough and flexible enough to accommodate investment preferences of all types. The remainder of this essay will examine, in more detail, some of the different types of mutual fund investments that are available. The main types of mutual funds are designated as equity funds (also known as stock funds), bond/income funds, and money market funds. Even within these general mutual fund designations, however, there are many sub-types. 1.2 Type One: Equity/Stock Funds Mutual fund companies which invest primarily in stocks are designated as equity funds or as stock funds. These types of mutual funds make up the largest percentage of mutual funds in the United States of America; indeed, as pointed out in a recent study by the Investment Company Institute, equity funds possess 55 percent of the total investment funds invested in mutual funds in America compared to 23 percent for money market funds, 15 percent for bond/income funds, and 6 percent for hybrid funds (Frequently Asked Questions About Bond Mutual Funds: np). In terms of the overall amount of money invested in mutual funds, therefore, the equity/stock funds are the most significant. The typical investment objective is to generate a longer-term investment return. There may be some dividend earnings from the underlying stock, but the basic idea is to provide capital growth for investors. How these investment goals are achived by a particular investment fund varies; to be more precise, different equity funds pursue their investment goals in a variety of ways. For purposes of illustration, some common considerations encountered by equity funds involve capitalization, growth versus value equities, and the selection of index benchmarks versus a more active management approach to stock selection. The first consideration pertains to market capitalization. This focusses on the market capitalization of the companies trading their stock. For purposes of capitalization analysis, these types of equity options are treated as micro-cap stocks ($54.8 - 539.5 million), small-cap stocks ($182.6 million - 1.8 billion), mid-cap stocks ($1.8 - 13.7 billion), and large-cap stocks ($1.8 - 386.9 billion) (United States Indexes: np). Equity funds may choose to focus on a particular area of capitalization or they may diversify their capitalization strategies. A fund may invest in high-cap equities during periods of macroeconomic instability in order to anticipate future recoveries and capital growth. Other funds may adopt a contrary investment strategy; they may, for example, invest in micro-cap and small-cap stocks with little prospect of immediate dividends in exchange for the possibility of greater than average capital growth. The point is that equity funds have the ability to specialize. Market capitalization is an important factor in the specialization of equity funds. An additional aspect of an equity fund's specialization involves a consideration of what financial experts designate as the trade-off between growth and value. Some equity funds concentrate their efforts on what are commonly known as growth funds. These growth funds are interested in the stocks of companies which are deemed to have the potential for large capital growth. Other equity funds concentrate instead on what are known as value funds. These value funds seek out equities which may be undervalued for a variety of reasons. These types of equity funds, growth and value, offer different sets of incentives and different sets of risks for investors. Growth funds offer the possibility of significant capital growth. Implied in its very name, however, is the inherhant risk. Regular dividends are often minimized or eliminated in order to be reinvested in hopes of capital growth. Thus, income is often a tangential consideration and the bet is that the anticipated or forecast capital growth will, in fact, materialize. That this growth may never materialize is the risk associated with mutual funds concentrating on growth as opposed to value. Other funds may focus on a heathier short-term balance of dividends and moderate growth for their investors. In sum, growth versus value is a central consideration addressed by equity funds. Finally, equity funds vary significantly in terms of how they decide to manage and benchmark equity selection. Index funds are a type of equity fund which restricts its investments to companies listed on a particular exchange. In this way, index funds are managed in an attempt to approximate the performance of a particular index. Expectations are tied to index performance and investment goals are judged in large part by how well the index itself performs. As alluded to earlier, however, other mutual funds are actively managed. These types of equity funds are frequently motivated, not to approximate a particular index's performance, but to exceed average investment returns. For investors, the index funds are usually less expensive, involving fewer transactions, than the actively managed equity funds. It can be seen that equity funds constitute the largest percentage of mutual funds in the United States of America. It can also be seen that equity funds come in several different shapes and sizes. There are issues of market capitalization, issues of growth versus value, and issues as whether to link a particular equity fund to an index, to a sector, or to rely on a more actively managed equity fund. 1.3 Type Two: Bond/Income Funds As a preliminary matter, it is important to clarify the different terminology which refers to this same fundamental type of mutual fund. For all practical purposes, a fixed-income fund, a bond fund, and an income fund are the same basic type of mutual fund. Unlike the previously mentioned equity funds, which concentrate primarily on long-term capital growth, these bond funds concentrate instead on generating a steady income for investors on a predictable basis. Implied in this type of mutual fund is the suggestion of stability and security. Also implied is an occupation with more immediate and short-term returns as opposed to longer-term goals. As explained by the SEC, this type of mutual fund typically invests in "bonds or other types of debt securities. Depending on its investment objectives and policies, a bond fund may concentrate its investments in a particular type of bond or debt security-such as government bonds, municipal bonds, corporate bonds, convertible bonds, mortgage-backed securities, zero-coupon bonds-or a mixture of types" ("Mutual Funds": np). The underlying investment, therefore, is in debt. The investor is getting, in return for his investment, a promise to pay at a stated rate of return. This right to be paid is vested through the bond fund's status as a creditor vis--vis the debtor. The notion that bond funds provide a secure and reliable source of income, however, can be misleading. It can be misleading because, like equity funds, there are a variety of risk factors. A corporation might go bankrupt. A government debtor might refuse to honor its obligations in total. Some bond funds, for example, invest in what have become to be known as junk bonds. These are high risk investments in debt instruments which promise great rewards and the possibility of a complete loss. These are hardly suitable types of mutual funds for the conservative and retired investors often associated with fixed-income funds. In addition to credit risks, there is also the risk that investors in certain bond funds will be prepaid and not reap the income benefits anticipated. Bond funds are also subject to fluctuations in interest rates and inflationary pressures. One special benefit of some bond funds, particularly municipal funds, is that interest income often qualifies for certain tax benefits. Dividend income from equity funds is like to be taxed whereas interest income from bonds may qualify as tax-free. In the end, there is a tremendous variety of bond funds. Some are high risk and others are much safer and even tax-exempt. There would appear to be a bond fund for every type of investor. 1.4 Type Three: Money Market Funds The final main type of mutual fund is designated a money market fund. This type of mutual fund holds more of the total mutual fund investment in the United States of America than bond funds, but less than equity funds. The main purpose of the money market fund is to minimize risk for the investing public. As stated by the SEC, A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money market deposit account" at a bank, money market funds are not federally insured ("Mutual Funds": np). Money market funds typically invest in government debt instruments, in certificates of deposit, and in low-risk investments. Treasury bills are a common type of investment for this type of mutual fund. The investment goals are short-term and income is stressed over an underlying asset appreciation. It is important to note that these money market funds are not federally insured. While low-risk is emphasized, the fact is that risk remains. And while it is certainly uncommon for these types of funds to lead to large-scale losses, it is not impossible. That said, by having only a dividend yield which goes up and down, the principal is generally safe. 1.5 Other Types of Mutual Fund The fundamental features of a mutual fund have been presented. In addition, it has been shown that there are three fundamental types of a mutual fund: a stock/equity fund, a bond/income fund, and a money market fund. Even within these three fundamental designations there are literally thousands and thousands of specific funds. The considerations and the combinations seem limited only by one's imagination (Carhart, 1997: 61). It is worth noting, for purposes of illustration, a few additional fund types which appeal to investors. Balanced funds have been promoted as something of a hybrid type of mutual fund. The stated objectives are for the investor to have the best of both worlds; in effect, the promoters of these balanced funds attempt to achieve capital appreciation, relative security, and income. These balanced funds may invest, for example, 65 percent in equities and 35 percent in bond funds. Though superficially attractive, the same considerations mentioned above apply. How a balanced fund chooses its equities and its bonds affects potential rewards as well as risk. Still, this type of hybrid fund allows investors to seek the best of both worlds. Recently, a number of specialty funds have entered the market. These are mutual funds which concentrate their investments in certain regions, in certain industrial or technological sectors, and it what has become known as socially responsible companies. These specialty funds may be either national or global in scope. Some international funds may invest abroad exclusively or they may invest also in the United States. The options are endless. 1.6 Conclusions In the final analysis, the study of mutual funds is rather complex. It is not that the definition is difficult, it is not, but that there are so many types of mutual funds with different objectives and different strategies. In general, equity funds provide opportunities for capital growth while bond funds and money market funds offer income streams for investors. There are many hybrid funds and, to be sure, there is a fund for every investing mindset. References Carhart, M. (March, 1997). "On Persistence in Mutual Fund Performance". Journal of Finance 52 (1): 56-82. Investment Company Institute. Frequently Asked Questions About Bond Mutual Funds. Retrieved January 2, 2007. Available: http://www.ici.org/funds/abt/faqs_bond_funds.html Investopedia. "Mutual Funds: What Are They" Retrieved January 2, 2007. Available: http://www.investopedia.com/university/mutualfunds/mutualfunds.asp United States Indexes: Construction and Methodology (Russell Indexes). Retrieved January 2, 2007. Available: http://www.russell.com/Indexes/about/construction_methodology/US/russell_us_indexes_methodology.asp United States Securities and Exchange Commission. "Mutual Funds" Retrieved January 2, 2007. Available: http://www.sec.gov/answers/mutfund.htm Read More