17 What do mutual funds invest in?
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This article is from the FAQ, by with numerous contributions by others.
17 What do mutual funds invest in?
Almost anything. There are funds that invest in almost anything
an investor could want to invest in. The most common types are
described below.
(1) Money market funds: these try to maintain a constant (usually
$1) NAV per share (though they cannot guarantee that), while
yielding dividends from their investments in short term debt
securities. They offer very low risk, but usually low long
term return. Most restrict investments to the top two (out
of four) Moody's and Standard and Poor ratings for short term
debt; some (including national government only funds) restrict
themselves to only the top rating, providing a bit of extra
credit safety, usually at a slightly lower yield. Most also
invest in repurchase agreements (repos) collateralized by short
term debt securities; these are subject to credit or fraud risk
of the other party in the repo (regardless of the credit risk
of the securities being repoed). Their market value is NOT
insured by the FDIC or other government agency. Enough defaults
in the fund's securities can cause it to be unable to maintain
its constant NAV.
(a) Regular funds: invest in short term debt of all types.
(b) Government funds: invest only in national government or
government agency debt or repos involving such debt.
Slightly lower credit risk than regular funds.
(c) Treasury funds: invest only in direct obligations of the
national government or repos involving these securities.
Lowest credit risk and dividend distributions are exempt
from state income taxes in most states.
(d) Municipal funds: invest only in debt of state or local
governments. For most individuals, dividend distributions
are exempt from national income taxes.
(e) Single state municipal funds: invest only in debt of
one state or its political subdivisions. For most individuals,
dividend distributions are exempt from national income
taxes and that state's income taxes. Note that a single
state fund is usually less diversified than a regular municipal
fund and might be considered riskier for this reason.
(2) Bond funds. These invest in longer term debt securities.
Thus the short term risk is greater than the infinitesimal
risk of the money market. But returns are usually higher.
Their NAVs may fluctuate due to both interest rate risk and
defaults. Unlike individual bonds, most bond funds do not
mature; they trade to maintain their stated future maturity.
The types of debt are similar to those of money funds (but
longer term); however, futures and options are sometimes used
for hedging purposes. The other classifications are described
below:
Time to maturity, interest rate risk:
(a) Short term: usually less than 5 years maturity. Interest
rate risk is low.
(b) Long term: up to 30 year average maturity. Interest rate
risk is high.
(c) Mortgage backed securities: have some unusual interest rate risks.
When interest rates rise, they lose value like other bonds.
When interest rates fall, homebuyers refinance, causing them
to prepay old mortgages, which in turn causes bonds backed
by these mortgages to be called. In addition, when rates rise,
the MBSs extend due to slower prepayments --- thus
their duration goes up with interest rates and the bonds lose
money at an accelerating rate. When rates fall the prepayments
speed up and the bond gains money at an ever slower rate. This
property is called Negative Convexity. It is also a gross
over-simplification. There are MBSs with positive convexity.
A 14 year old 13% MBS's prepayments are functionally independent
of rate moves for example, also prepayment risk is shuffled all
over the place in CMOs.
The compensation paid to MBS holders for the negative convexity
is in higher yield. Basically the buyer of a mainstream MBS is
betting that rates will not change too much (that interest rate
volatility will be lower than the volatility implicit in the
price). Over time this is true. MBS indices have outperformed
Treasuries in all but a couple of the last 12 years.
(d) Adjustable rate: this type of fund is like other mortgage
backed funds, but it invests in adjustable rate mortgages.
Therefore, the two sided interest rate risk faced by fixed
rate mortgage backed bonds in considerably reduced. However,
the interest income will fluctuate widely, even though the
principal value is more stable. Since most adjustable rate
mortgages have caps on how high the rate can go (typical
limits are a 2% increase during a year and 6% increase during
the life of the loan), risk increases if interest rates
increase quickly or by a large amount.
(e) Target maturity: the few funds in this category buy only
bonds of the given maturity date. Thus one can actually
hold these to maturity.
Credit risk:
(a) Investment grade: restricted only to bonds with low to
medium-low credit risk (national government bonds are
usually considered lowest risk). This generally means the
fourth highest Standard and Poor's or Moody's rating
(S&P BBB or Moody's Baa). Some funds have higher standards.
(b) High yield or junk: buys bonds of any credit rating,
seeking maximum interest yield at a greater risk of default.
(3) Stock funds. These invest in common and/or preferred stocks.
Stocks usually have higher short term risk than bonds, but
have historically produced the best long term returns.
Stock funds often hold small amounts of money market investments
to meet redemptions; some hold larger amounts of money market
investments when they cannot find any stock worth investing in
or if they believe the market is about to head downward.
Some of the possible investment goals are described below.
They are not necessarily mutually exclusive.
(a) Growth. These funds seek maximum growth of earnings and
share price, with little regard for dividends. Usually
tend to be volatile.
(b) Aggressive growth. Similar to growth funds, but even more
aggressive; tend to be the most volatile.
(c) Equity income. These funds are more conservative and seek
maximum dividends.
(d) Growth and income. In between growth funds and income funds,
they seek both growth and a reasonable amount of income.
(e) Small company. Focuses on smaller companies. Usually of the
growth or aggressive growth variety, since smaller companies
usually don't pay much dividends.
(f) International. Focuses on stocks outside the USA, generally
investing in many nations' companies.
(g) Country or regional funds. These funds buy stocks primarily
in the designated country or region.
(h) Index funds. These funds do no management, but just buy some
index, like the Standard and Poor 500. Some index funds,
particularly those emulating indices with large numbers of
stocks such as the Wilshire 4500 or Russell 2000, emulate
the index by buying a subset with similar industry mix,
capitalization, price/earnings ratio, etc. Expenses are
usually very low.
(i) Sector funds. These funds buy stocks only in one industry.
Usually considered among the riskiest stock funds, though
different sectors tend to have different levels and types
of risk.
(4) Balanced funds. By mixing stocks and bonds (and sometimes other
types of assets) a balanced fund is likely to give a return
between the return of stocks and bonds, usually at a lower
risk than investing in either alone, since different types of
assets rise and fall at different times. An investor can create
his/her own balanced fund by buying shares of his/her favorite
stock fund(s) and his/her favorite bond fund(s) (and other funds,
if desired) in the desired allocation.
(a) Regular balanced funds: These funds usually hold a fixed
or rarely changed allocation between stocks and bonds.
(b) Asset allocation funds: These funds may switch to any
allocation, usually based on market timing to some degree.
(5) Multifunds. These funds buy primarily other mutual funds.
They choose other funds based on one or more of the investment
goals outlined above.
(a) No-management funds: These funds hold fixed proportions
of other funds. They are offered by fund companies as
cheap balanced funds -- the underlying funds are other
funds managed by the same company. There are generally
little or no expenses other than those of the underlying
funds.
(b) Managed funds: In these funds, a manager picks which other
funds s/he believes are managed well. Sometimes these
funds are market timing funds which prefer to leave the
stock picking to other managers. These funds have
expenses above and beyond those of the underlying funds.
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