A Guide to Mutual Fund Investing

Types of Mutual Funds

Mutual funds also are called open-end investment companies because, each business day, the fund issues new shares to investors and buys back shares from investors wishing to leave the fund. Mutual funds are subject to a special set of regulatory, accounting and tax rules. They are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders.

Mutual funds are managed according to a variety of investment mandates. For example, they are available as diversified equity funds, taxable US bond funds, municipal bond funds, sector and specialty funds, global and international equity funds and hybrid funds.

Diversified Equity

Diversified equity mutual funds invest in common and preferred stocks of companies, and may emphasize current income, capital appreciation, or some combination of the two. These funds may build portfolios that consist of stocks issued by a broad range of companies, diversified across industries, geographies and economic sectors, or they can focus on specific investment styles such as large cap, small cap, growth or value.

Taxable US Bonds

These mutual funds focus on high-quality instruments, such as Treasuries, government agencies and investment-grade corporate bonds, all of which generate interest income that is taxable by the federal government. Others may add lower-grade high-yield bonds into the portfolio, which provide attractive rates of return at a somewhat higher level of risk.

Tax-Free Bonds

Municipal bond funds seek to pay income exempt from federal income taxes (and, in some cases, also exempt from state or local income taxes). These funds invest in bonds issued by state and local governments and agencies. Professional managers monitor bond ratings and credit quality, and usually seek to broadly diversify the portfolio and avoid adverse events or defaults that might impact a given sector, region or issuer. Many municipal bond closed-end funds make use of leverage—using borrowed capital to enhance return potential—to pursue potentially higher returns.

Sector and Specialty

These funds focus on stocks of a particular industry such as financial services, natural resources, technology, healthcare or on specialized securities such as preferred stocks or convertible securities. They can offer a way for investors to participate in the fortunes of a specific economic sector, industry group or specialized security, while reducing risk through owning a basket of securities.

Global and International Equity

Mutual funds can be the building blocks of globally diversified portfolios of stocks or fixed income investments. Funds that invest substantially in both US and foreign securities are called "global," while those that focus on non-US investments only are considered "international." Some funds specialize in emerging market securities, which can be highly volatile and less liquid under adverse market conditions.

Mixed Asset

Mixed asset mutual funds comprise a combination of securities, such as stocks and bonds, which can vary proportionally over time or remain fixed. Because they invest in a wide array of dissimilar securities, mixed asset funds can offer considerable diversification in a single purchase. In most cases, if the fund manager perceives a turn in financial markets, he may change the fund's mix of investments.