The Retirement Corporation of America

Your Guide to the World of Mutual Funds

MUTUAL FUNDS COME in all "flavors", and ever-changing new combinations of flavors, which sound awfully intimidating. Not to worry. Most mutual funds are variations on just three basic types:

•  Stock.

•  Bond.

•  Money market.

Diversify those funds into a portfolio that makes the most sense, given your:

1. Current financial situation.
2. Goals and dreams.
3. Ability to handle risk.

Later in the lesson, you'll learn how to do the best job of mixing and matching funds for your purposes. But the most important thing, for right now, is to understand what each kind of fund invests in and what it can offer you.

Stock Funds

Here are the different types of stock mutual funds from the highest risk to the lowest risk:

•  Aggressive growth funds. These go after capital gains with a vengeance. They buy highly speculative stocks and their share prices can be just as volatile. Never buy these funds for current income. They are for all-out growth and capital gains. Few of the stocks such funds invest in pay any dividends whatsoever.

•  Growth funds. These try to beat the market by investing in companies with prospects for better-than-average growth, whatever their size. However, they often buy the stocks of small companies or even brand-new ones, and their share prices can be volatile. Their primary goal is long-term capital appreciation. They pay only modest dividends.

•  Growth and income funds. These funds split the difference between income and growth by investing in stocks that offer both. The typical stock owned by a growth-and-income fund would be one with strong growth potential that also is sturdy and profitable enough to pay dividends on a regular basis.

•  Equity-income funds. These funds split the difference between income and growth, but with the emphasis on income. The typical stock owned by an equity-income fund would have at least some growth potential but would also be profitable enough to pay a fairly substantial dividend on a regular basis.

There are further breakdowns among stock mutual funds. One such breakdown is by the size of the company the fund invests in:

•  Large-cap funds. Cap refers to market capitalization, which is the total market value of the company's stock. That is measured by multiplying the number of shares outstanding by the price of those shares. A large-cap fund would have a capitalization of at least $5 billion. Large-cap funds stick to "blue-chip" stocks of leading companies. Their twin goals are reasonable capital appreciation and steady income.

•  Mid-cap funds. That's easy to figure out. Mid-cap stocks fall between large-cap and small-cap. They ideally offer most of the growth potential of small-cap funds with less of a risk of loss.

•  Small-cap funds. They are the opposite of large-cap funds since small-cap stocks are those with a market capitalization of $1 billion or less. Small-cap funds stick to fast-growth, low-income types of companies. Most feature fairly high risks in hopes of fairly high rewards.

Another breakdown among funds would involve their investment philosophy. Here the basic breakdown would be between:

•  Growth funds. As you have already learned, growth funds invest in growth stocks—stocks that have already demonstrated their ability to grow faster than the economy or that appear to have the potential for very fast growth. Such stocks rarely sell at bargain prices in the market. The fund manager earns his or her keep by picking stocks with sufficient growth potential to justify their high prices.

•  Value funds. Such funds look for bargains in the market—stocks that, for one reason or another, are selling at what are relatively cheap prices. Maybe the company has temporarily fallen on hard times, or maybe the entire industry has temporarily fallen out of favor. The idea is to find stocks that are depressed now but that have the potential to do lots better in the future. The fund manager earns his or her keep by finding those bargains in the market.

Finally, there are the special funds—funds with investment styles all their own:

•  Sector funds. These can be risky because they buy only stocks in a certain segment of the market, such as the stocks of financial services or technology companies. If investors sour on those companies, or one or two major ones do poorly, all the stocks in that category can suffer. And so can the share prices of these funds. Their goal may be capital gains or income or both, depending on the kinds of stocks they buy. Sector funds that invest in utilities pay lots of income because utility stocks themselves are high-yield. Technology sector funds may not pay any dividends because they invest in lots of small companies.

•  Index funds. Other funds pick their shots—buying only stocks of a certain size or type. Index funds focus on a universe—the 500 stocks that make up the Standard & Poor's 500-stock index, for instance. Then they buy most of the stocks in that universe. If the universe does well, the index fund based on that universe does well. The selling point for index funds is that no fund manager can consistently pick winning stocks. So the best approach is to just buy everything in sight. For many investors, an index fund is the place to start. Some investors may only want to own index funds.

Bond Funds

Bond funds invest in bonds. Here are the different kinds of bond funds ranging from the least to the most risky:

•  U.S. Treasury/government funds. As the name implies, these funds invest in the securities of the United States government and sometimes in federal agencies that are sponsored by the U.S. government. Either way, they carry what amounts to an iron-clad guarantee that the bonds your fund has invested in will always be paid off. Other bond funds pay higher rates of interest to investors, but there isn't a better borrower than Uncle Sam. These funds can be short-, intermediate-, or long-term.

•  Corporate bond funds. These funds invest in the bonds of American corporations. They typically buy high-quality bonds of well-known companies—companies deemed able to keep paying off their bonds as they come due. Corporate bond funds aren't quite as safe as Treasury bond funds, but they pay a higher yield to offset the slightly higher risk.

•  Municipal bond funds. These bonds are issued by states, cities, and other units of local government to finance everything from government operations to the local school system, to building a new airport or a sports stadium. The dividends from all municipal bonds are exempt from federal taxes. You can also buy "muni" funds filled with securities from only your state and/or city, whose dividends are also exempt from your state and local income taxes. Municipal bond funds aren't for everyone. But the higher your tax bracket, the more value you gain from having tax-free income.

•  GNMA funds. They invest in mortgage securities issued by the Government National Mortgage Association—known as GNMA or Ginnie Mae. What you buy is a share in a pool of mortgages that have been guaranteed by the federal government. GNMA funds typically pay a higher return than Treasury or corporate bond funds—making them suitable for retirement accounts.

•  Income funds. Strictly speaking, these aren't bond funds since they split your money among both corporate bonds and high-yield income stocks, such as utility stocks. What you get is the highest current income from bonds combined with at least some of the potential for capital gains and for offsetting inflation from stocks.

•  High-yield funds. Investment pros call these "junk-bond" funds, and for good reason. They can offer eye-popping yields compared with other bond funds. But they invest in lower-quality corporate bonds. Since you get what you pay for in life, you take a higher risk with junk bonds—the risk being that such bonds owned by your fund may not be able to keep paying interest and may default. But you earn a higher return on your money for taking that risk. An investment pro picks bonds for a junk bond fund—making them less risky.

Money Market Funds

They invest in high-quality, short-term securities such as U.S. Treasury bills and certificates of deposit (CDs) from giant banks. And because they invest in high-grade, short-term securities, they stress safety most of all. Because bank accounts are insured and money market funds are not, money market funds may pay a little more than bank CDs.

Money market funds are usually the most convenient way to hold cash, but they offer no chance for your capital to appreciate and they don't offer much protection against inflation. With money market funds, safety and convenience are the most prevalent features.
So what's the skinny on money market funds?

•  Everybody should have one. They are great places to keep cash for emergencies and for any other money you might need in a hurry. Money market funds are ideal places to keep money you plan to invest, but haven't decided where. You can write checks on them just like your checking account, although there is often a minimum amount that you need to write individual checks for.

•  Money market funds pay competitive yields. They pay interest pretty much in line with what CDs are paying. The big difference is that the rate on a bank CD is fixed over its life, while the return on a money market fund will fluctuate in line with changing interest rates in the marketplace. Most of the time, the difference in rates won't be significant.

•  They are managed to maintain a constant $1-per-share price. This makes money market funds unique since the prices of all other mutual funds goes up and down according to changing market conditions. Your $1,000 investment will always buy you 1,000 shares of a money market fund priced at $1 each.

•  They are convenient. Once your money is in a bank CD, you may have to pay a penalty to withdraw money. Money in a money market fund can be withdrawn at any time without incurring a penalty—often just by simply writing a check.

Consider tax-exempt money market funds if you're in the 25 percent bracket or above (taxable income over $59,400 married, $29,700 single). But ask before you decide. The sales representative for any money market fund you consider can determine—given your income tax bracket—whether a taxable or a tax-exempt fund makes the most sense for you.

Some Other Kinds of Funds

Some funds don't fall neatly into one of the above categories.

•  Balanced funds. Like income funds, balanced funds invest in both stocks and bonds. But they tend to opt for a higher percentage of stocks than income funds do—meaning they usually yield less than income funds but offer a greater potential for growth. As a rule, balanced funds are stodgy performers since the stock portion drags down yield, and the bond portion drags down capital growth. Once you gain investment experience, you would generally be better off buying bond funds and stock funds separately.

•  Real estate funds. They buy real estate stocks or real estate investment trusts (REITs), as you might guess. Besides capital gains, these funds may also give you some tax-sheltered current income. They pay higher dividends than most stock funds, while offering the growth potential that stocks offer.

•  International funds. These stock and bond funds give you access you ordinarily wouldn't have to securities markets around the world. They can reward you with great returns. You wouldn't tackle these markets on your own, so international funds are the vehicle of choice.

•  Global funds. International funds invest only in foreign stock markets. Global funds cover the world by investing in both the U.S. and foreign markets—according to which look the most attractive at the time.

•  Gold funds. These mostly buy stocks of gold-mining companies. When interest rates are soaring, owning some shares is a good inflation hedge.

•  Closed-end stock and bond funds. Both look and act more like stocks in that they trade on stock exchanges and have a fixed number of shares outstanding. They can offer big returns. But watch out: Their prices are typically highest when they are first offered to the public. After that, their prices often drop like rocks.