Comparing 4 Different Types of Mutual Funds
Understanding the four main types of mutual funds can help beginner investors decide which mutual funds they might want to invest in.
By Kristina Russo | American Express Credit Intel Freelance Contributor
5 Min Read | February 1, 2022 in Money
Equity mutual funds primarily invest in stocks, which usually means higher risk to your money but generate better returns.
Bond mutual funds and money market mutual funds invest in various forms of debt, which is considered lower risk – and with proportionately lower returns.
Balanced funds are hybrids that invest in equities and bonds, and so they have risk and return levels right in the middle.
When my daughter began her high school finance class, I was very excited about the new material her two CPA parents could discuss with her at the dinner table. My enthusiasm was quickly squashed when she told us we were speaking a foreign language using words like “mid-cap global growth fund” or “municipal bond fund.” To help her feel more confident, we launched into a primer on the different types of mutual funds.
If you’re just beginning to invest in mutual funds, the industry jargon may feel overwhelming for you, too. But it doesn’t have to be. Here’s a breakdown on the four main types of mutual funds and some of their variants.
A mutual fund is an investment created and operated by investment management firms. Mutual funds allow investors to pool their money together to buy a collection of stocks, bonds, or other financial securities. Investment managers choose which stocks and/or bonds to add to the collection, and how much of each. And they’re fairly popular: almost half of U.S. households own shares in at least one of the four main types of mutual funds,1 which are:
- Equity funds.
- Bond funds.
- Money market funds.
- Balanced funds.
A Quick Comparison of the Different Mutual Funds
|Equity Funds||Bond Funds||Money Market Funds||Balanced Funds|
|What they invest in...||Stocks||Bonds||Short-term debt||Stocks & Bonds|
|How they earn money...||Stock value appreciation||Bond interest payments||Interest payments||Stock value appreciation|
|Stock dividends||Stock dividends|
|Bond interest payments|
|Risk level...||High||Medium or low (based on bond ratings)||Low||Medium or low, (based on asset allocation)|
Equity mutual funds are often described as a “basket” of publicly traded companies’ common stocks. When you buy a share of an equity fund, it’s sort of like buying a small piece of each company’s stock inside the fund. This means equity mutual funds essentially enable investors to automatically diversify their holdings. If you’re interested in trading individual stocks, read “A Guide to Investing in Stocks.”
When you invest in equity mutual funds, you make money by selling your mutual fund shares at a higher price than you bought them. Equity mutual fund shares increase in value if the market price of the stocks inside the fund rise, or if they issue dividends (a tiny share of the company’s profits) that are reinvested in the fund. Typically, the fund manager selects stocks based on the fund’s stated investment goals and constantly buys and sells to achieve those goals – goals which are commonly indicated by the name of the fund itself. A private equity fund, for example, invests in privately held companies not traded in the stock market, whereas a mega-cap equity fund invests in the biggest companies around the world.
Bond funds are a type of mutual fund that invest in debt. Bond funds allow investors to indirectly lend money to private companies, governments, or other debt “instruments” in exchange for interest. The interest payments from the bonds are fixed – aka, always the same – and are used to pay regular dividends to the fund’s shareholders. Because of this, bond funds are sometimes called “Fixed Income” mutual funds, even though the dividends you receive may change over time as the fund buys and sells bonds.
Some fund shareholders opt to grow their investment by automatically reinvesting their dividends into more shares of the bond mutual fund, while others choose to take it as income. You can also earn money from bond mutual funds when bond fund shares increase in value.
The two main reasons investors might choose to invest in bond funds instead of simply buying bonds outright are the ability to buy and sell regularly, and to diversify risk.
There are two main categories of bond mutual funds:
- Government bond funds: These invest in either federal, state, or municipal bonds or bonds that are guaranteed by the U.S. government. Government bond funds typically have lower default risk and lower rate of return.
- Corporate bond funds: These mutual funds invest in bonds issued by private companies. Yields on corporate bonds, and the mutual funds that hold them, tend to be higher than government bonds, reflecting the increased risk of default.
Like with equity mutual funds, there are global and international versions of government and corporate bond funds. Experts recommend using the 30-day yield to compare the income streams of different bond mutual funds. The 30-day yield is an industry standard metric that helps investors project what a bond mutual fund’s interest might be for a full year, using a formula provided by the U.S. Securities and Exchange Commission.
Money market mutual funds are fixed income funds that invest in low-risk, short-term debt. They are not to be confused with money market bank accounts, which, despite the name, are a type of savings account that has nothing to do with the stock market. Since they’re short term and are limited to high-quality debt instruments, money market funds can help reduce uncertainty and therefore lower risk. But the trade-off for low risk is low returns. Money market mutual funds tend to be a popular choice for people who would prefer to preserve their money rather than have it grow aggressively.
Money market mutual funds are classified by the U.S. Securities and Exchange Commission (SEC) into three categories based on the fund’s holdings:
- Government money market mutual funds invest primarily in cash, U.S. Treasury bonds, and other securities guaranteed by the U.S. government.
- Prime money market mutual funds, also known as “general purpose” money market funds, can invest in debt from domestic and international private issuers as long as they meet certain SEC regulations. Prime money market funds usually include certificates of deposit and other private instruments of debt.
- Municipal money market funds invest in either federal or state securities whose interest is exempt from federal or state income taxes (or both).
Balanced funds are mutual funds that invest in both equities and bonds, usually according to a fixed ratio. Balanced funds, sometimes called “Asset Allocation” or “Hybrid” mutual funds, can use any kind of allocation ratio, the most common being 60% equity, 40% bonds. In general, balanced funds are considered more conservative as the allocation percentage of equity holdings decreases and bond holdings increase. A version of balanced funds, called “Target-Date” funds, automatically reallocate their holdings by increasing their bond component as the target date gets closer. This type of mutual fund is often used for college savings and retirement accounts, which have natural target dates.
Balanced funds can be a convenient way to diversify investment holdings, especially over time. They’re also lower risk, but they typically have higher fund expenses. Experts suggest comparing expense ratios when comparing balanced funds.
There are significant differences in the four main types of mutual funds, including what they invest in, how they potentially earn money for you, and their inherent risk levels. Understanding these differences is a first step in determining if investing in mutual funds is right for you, and which type(s) of funds to invest in.