Mutual funds allow investors to pool their money into an investment fund that is professionally managed.
These experienced, professional managers will act on behalf of investors, buying and selling securities.
It is a diverse investment vehicle, and as such, several different types of mutual funds exist.
Here are the most common types of mutual funds:
1. Equity Funds
Equity funds (also known as stock funds) are the largest category of mutual funds, invested primarily in stocks.
These funds are typically named for the size of the companies that they invest in (i.e. small, mid, large-cap) or their growth strategy.
Examples of Mutual Funds in Canada include the Scotia Canadian Growth Fund or the TD Dividend Income Fund.
Equity funds are made up of domestic or international stocks determined by the fund’s management team.
The geographic location does not limit them; an equity fund can also target specific business sectors such as agriculture, real estate, healthcare and others.
A typical equity fund’s portfolio can range from being invested in as little as twenty companies to numbering in the thousands.
Like other mutual funds, equity funds allow for exposure to a broad range of companies instead of just holding a single stock, helping mitigate investment risk.
2. Fixed-Income Funds
Fixed-income funds are a classification of mutual funds that primarily focus on investments in debt securities.
These can be in the form of bonds which can be adjusted on a semi-annual basis.
Fixed income funds are an excellent place to keep money long-term since they historically have kept pace with inflation and can return the adjusted principal upon their maturity.
Like all investments, fixed-income funds have areas where they may excel or fall short.
Some advantages of mutual funds that invest in bonds are:
- Predictable Income
As long as the bond’s issuer makes the interest payments, investors know exactly how much to expect in returns. - Stability
Historically, bonds are not as volatile as the stock market. - Low Correlation
Bonds may have a low or inverse correlation with the stock market. This means that they may do well when the market dips and can be used to mitigate that risk.
3. Money Market Funds
Money market funds are mutual funds that target highly liquid and near-term investments such as cash, high-credit-rating, and debt-based securities.
This type of fund aims to give investors very high liquidity and a low level of risk.
These are also sponsored by investment fund companies and carry no principal guarantees.
Money market funds fall under one of two categories: tax-free and taxable.
Tax-free funds are limited in options, but they generally invest in short-term debt issued by federally tax-exempt entities and have low yields.
Regardless of which money market fund is chosen to invest in, it is usually wise not to keep money there for long-term investment goals since they don’t offer good returns in terms of capital appreciation.
However, for the short term, it is a good stepping stone place to park money before deciding on a long-term investment plan
4. Index Funds
Index funds are a type of mutual fund that are invested in securities of all companies (or just a representative sample) of a specific index.
They provide broad exposure to the market since they track the movement of a financial market index, with the most well-known index fund being those built based on the S&P 500.
Index funds are attractive to investors for several reasons including low risk and low operating expenses.
They have also been the most successful type of fund, beating other mutual funds consistently if measured by total return.
This is partly due to them being passively managed, leading to huge savings over the long haul.
Since they aren’t traded regularly, they also don’t generate as much taxable income as actively managed mutual funds.
See our comparison of index funds vs mutual funds for further details on the similarities and differences.
5. Balanced Funds
Balanced funds, also known as asset allocation funds, are a type of mutual fund that usually invest in a fixed ratio of stocks and bonds.
For example, a balanced fund can have an 80% stock/20% bond split between the securities it manages.
The money the fund invests into each of the asset classes must be within the threshold of the minimum and maximum values.
The goal of a balanced fund is to balance both income and growth since bonds usually pay a fixed rate of return.
Investors who have a lower risk tolerance and want to play it safe with their investments are best fitted to invest in balanced funds.
Since they don’t change the ratio of stocks to bonds, balanced funds usually have lower fees or Management Expense Ratios (MER).
6. Specialty Funds
Specialty funds, also known as sector funds, are mutual funds that focus on a specific market or industry.
They limit their investments to companies within a targeted segment of the economy.
Since specialty funds are focused on a segment of the economy rather than a broad range of companies across different segments, the potential for reward is higher if the segment booms but equally as risky if the segment dips.
For example, a specialty fund focused on the crude oil industry may see high returns during a strong economy with lots of travel but falter during a global pandemic, as seen in the first year of lockdown during COVID-19.
In Summary
Mutual funds are a great way to invest money and hedge against inflation in the long run.
They can keep stability through a balanced portfolio that allows securities that are doing well to pick up the slack for the ones that aren’t.
However, all investments carry some risk and have the potential to lose the capital invested in them.
For long-term investors, mutual funds have historically done well.
Research which mutual funds would work best with your risk tolerance and start investing towards a fruitful retirement.
Frequently Asked Questions
- Are mutual funds a good investment?
- Do mutual funds have fees?
