This is the second post in the series of how to choose mutual funds for investment. Part I covered the very basics (what is a mutual fund) and common terms needed for this article. So now, on to the types of funds themselves and when to buy them…
Money Market Fund – These are very safe, low yielding funds that primarily invest in short-term government bonds and established companies. They are so safe that on financial statements they are considered “cash,” not “investments.” They are not a place to put your money for a long time since returns are low, and may not even beat the rate of inflation. Time Horizon: 6 months-2 years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: very low
Bond Fund – “Bonds” are essentially loans that you give to a company. In return, these companies pay you interest. A bond fund is a nice mix of short- and long-term bonds of good companies that pay a rate of interest beating inflation. Almost everyone should own at least some bonds in their investment portfolio.
Time Horizon: 2-3+ years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: low to medium
Short-term bond fund – These funds invest primarily in short-term bonds (generally loans that mature in less than 3 years). Short-term bond funds fluctuate in value less than regular bond funds, but also pay less interest. They are a good short-term investment.
Time Horizon: 1-3 years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: very low to low
World/International Bond Fund – These bond funds invest in companies all over the world. Since keeping track of the world takes more work, MERs are higher, and world bond funds thus generally under perform. World bond funds tend to fluctuate in value more than regular bond funds.
Time Horizon: 2-3+ years; Best time to buy: growth phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: medium to high
Long-term bond fund - These funds invest primarily in long-term bonds (generally loans that mature in more than 5 years). Long-term bond funds fluctuate in value more than regular bond funds, but also pay more interest. They are a good long-term investment.
Time Horizon: 2-3+ years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (long-term bond funds lose value when interest rates begin to rise); Volatility: medium to high
High-Yield Bond Fund – A bond fund that intentionally invests in low-quality companies that may be close to bankruptcy. In theory, by investing in many low-quality companies, any losses will be offset by their higher interest rates, resulting in a good overall gain. In reality, most high-yield bond funds under perform regular bond funds due to high MERs and losses. Time Horizon: 3-5+ years; Best time to buy: recovery to growth phase; Worst time to buy: boom and bubble phases (a good economy can hide mediocre business performance); Volatility: high to very high
Equity Fund – An equity fund is any fund that primarily buys company stocks. Generally these funds have a name, such as “US Equity fund” or “Emerging Markets fund,” that tell you where the companies invested in are located. In an equity fund, you pay a manager for choosing the stocks for you, and pay a management fee to do so. Usually these managers do not beat the market, so you are better off buying an Index Fund with a lower MER (ex. buy a US S&P 500 Index Fund instead of a US Equity Fund)
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: high to very high
Equity Index Fund – This is a type of equity fund that, instead of having a manager that chooses the stocks, simply follows a stock market index. For example, many index funds follow the “S&P 500 stock market index,” a list of 500 of the biggest companies in the United States. By owning an S&P 500 index fund, you will own a small portion of 500 different companies. The advantage of index funds is that since there is no active manager, the MER is very low (below 1%). And, because you are only buying large, respected companies, returns are good. For investors with a long time horizon, index funds should form a substantial portion of your total portfolio (50%-80%).
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: high to very high
Dividend Fund – This fund is a type of equity fund that invests in stable, generally older companies that make more money than they need for their internal growth, and so they pay out their extra earnings as dividends. Dividend funds largely consist of old-school companies like banks, insurance companies, and railroads. Though they can fluctuate in value, dividend funds make excellent long-term investments.
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: medium to high
Asset Allocation Fund – This fund is an equity fund that attempts to “time” the market, adjusting to buy the best performing companies at each phase in the market cycle. For investors, these funds usually under perform, due to the high amount of turnover (fees and taxes for buying and selling) and higher MER fees.
Time Horizon: 3-5+ years; Best time to buy: never, in my opinion; Worst time to buy: boom and bubble phases; Volatility: high to very high
Guaranteed Funds – These funds, which go by various names, all have a common feature: if you leave your money in for a certain period of time (usually several years), your principle is guaranteed. That is, if you invest $10,000, you are guaranteed to have your $10,000 returned to you by the maturity date, even if the stock market drops terribly. As compensation for this insurance, these funds typically charge a high MER, or allow you to keep only a percentage of the overall stock market return. Since the maturity date is far in the future, there is very little risk to the issuer that the final level will be below the initial investment; essentially, you are paying for peace of mind. If you have any tolerance for volatility, it’s better to simply own an equity fund with full participation in the market. Guaranteed funds are good, though, for those who are psychologically unable to tolerate volatility or declines. Time Horizon: specific to each fund; Best time to buy: post-crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: guaranteed principle
Income Trust Fund – An income trust is a fund that invests in companies with generally stagnant growth (such as sugar refiners and telephone book printers), but that make a steady income. Income trusts also invest in oil and gas companies, or real estate (known as a REIT). The income trust pays out regular dividends. In a sense then, an income trust is in-between a bond fund and an equity mutual fund. The holder receives regular payments (like a bond fund but with higher interest), but is also subject to higher volatility (like an equity fund). Income trusts are a nice addition to a portfolio.
Time Horizon: 3-5+ years; Best time to buy: post-crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: medium to high
Hedge Fund – To “hedge” means to reduce risk. In the old days, the goal of a hedge fund was to generate a reasonable rate of return, regardless of whether the stock market went up or down. These days, hedge fund refers to a fund that uses large amounts of debt to fund ultra-risky purchases, hopefully providing a great rate of return. Hedge funds typically make spectacular rates of return for a few years, only to lose everything in a single season. Hedge funds are only open to investment by “accredited investors,” meaning either finance industry professionals, or those who are wealthy enough to lose their entire investment and not be destroyed.
Time Horizon: 3-5+ years; Best time to buy: never, unless you know enough about investing to make your own hedge fund; Worst time to buy: boom and bubble phases; Volatility: extreme
A good portfolio should consist of a mix of funds. Generally speaking, the longer the time horizon, the more should be invested in high and medium volatility funds; the shorter the time horizon, the more should be invested in low to medium volatility funds. There is nothing worse then seeing your portfolio value decline just days before you need the money: good time horizon and volatility selection will make sure your funds are available when you need them, yet still get a good rate of return. Good luck and happy investing!
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“Risk is the possibility that the holder of an investment may have to sell it at a time when the price is below cost (including inflation since purchased). ‘Risk’ is often wrongly used to describe cyclical or temporary declines in stock prices, even if the holder need not sell at that time.” Benjamin Graham, The Intelligent Investor.
