When you invest in the stock market, you can spend many hours looking up stocks, researching the companies that issue them, and choosing just the right mix to round out your portfolio -- or you can buy one or two mutual funds and let the fund managers do all the work for you. Given the overwhelming number of investments to choose from and the ocean of publicly available information to dive into, many investors choose the latter course. But before you start comparing mutual funds, it's important to choose the fund strategy that will best meet your investing goals.
Value investors are the stock market version of bargain hunters. They look for stocks that are temporarily underpriced so can buy shares cheap and profit from their rebound, as well as future gains. As a bonus, the types of stocks that qualify as value investments tend to pay respectable dividends, which adds to the returns produced by these stocks. Mutual funds that use this approach typically have the word "value" in the fund name. To save on fees, look for index funds that track value indexes.
Growth investing is almost the opposite of value investing. Rather than looking for established, temporarily undervalued companies, growth investors look for young, nimble companies that have lots of potential to expand. Growth investing is all about capital gains, as these companies tend to plow all their cash into their expansion efforts, rather than paying it out to investors in the form of dividends. If this sounds like your cup of tea, look for a mutual fund with "growth" in the fund name. As with value funds, many growth index funds exist, and choosing one can cut your fees down to the bone.
Some investors are focused on generating an ongoing stream of income through their investments, typically either by choosing stocks with high dividend yields or by buying bonds, which make regular interest payments. Many income investors are retirees looking for ways to supplement their fixed income. If you're looking for an income-centric mutual fund, you can choose one that has a mix of stock and bond investments (these are sometimes called "balanced" funds) and emphasizes income, or you can pick up a high-dividend stock mutual fund and pair it with one or more bond funds.
One of the drawbacks of investing in any mutual fund is that when the fund manager decides to sell shares, this activity will trigger tax bills for anyone who owns shares in the fund. This is one reason why index funds tend to outperform actively managed funds: There's a lot less buying and selling in an index fund, so you're less likely to get hit with a fat capital-gains tax bill at the end of the year. Some mutual funds aim to minimize the amount of taxes they generate for their shareholders by keeping transactions to a minimum, sticking with tax-free bonds and low-dividend stocks, and avoiding investments that are more likely to lead to a tax bill. These funds often have the words "tax efficient" or "tax managed" in their name.
Note that it's pointless to put such a fund inside a tax-deferred retirement account such as a 401(k) or IRA, because capital gains and dividends are already tax-free within such an account. Tax-efficient funds may be a good fir for a standard brokerage account, though.
Some mutual funds take the whole tax avoidance thing to the next level by choosing only investments that are completely tax-free. These funds typically invest in municipal bonds, which are always exempt from federal income taxes and are also exempt from state taxes for residents of the bond's state. To completely avoid taxes, it's important to choose a tax-exempt fund that buys municipal bonds from only your own state. If you live in a state that doesn't collect income taxes, then any municipal bond fund will work for you. As with tax-efficient funds, don't bother putting a tax-exempt fund inside a 401(k) or IRA.
Market capitalization funds
Many mutual funds focus on stocks whose market capitalization -- i.e., the total value of the company's outstanding shares -- falls within a certain range. When investors refer to a company's "size" or "worth," they are generally referring to its market cap. Most companies are classed as small-cap, mid-cap, or large-cap. The definitions of these categories vary, but by most accounts, small-cap companies have a market cap between $300 million and $2 billion; mid-cap companies are worth between $2 billion and $10 billion; and large-cap companies are worth over $10 billion. Historically, small-cap stocks have slightly outperformed mid-cap and large-cap stocks, but because small-cap stocks are shares of (relatively) small companies, they also tend to be somewhat riskier and more volatile. Still, many investors with a long-term buy-and-hold strategy choose to focus on small-cap funds in order to maximize returns.
Other fund strategies
Some funds adopt even more exotic or tightly focused strategies. Some invest in stocks from a particular sector of the market, some specialize in investments from specific geographic regions, and invest in commodities or derivatives. These more specialized funds may have a place in your portfolio, but you probably shouldn't base your entire investing strategy on them. If you remember the dangers of putting all your eggs in one basket, keep your investments diversified, and minimize your fees, then you'll set yourself up to make a profit without assuming much risk.
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