In 2014, there were 7,923 mutual funds, not including funds that invest in other mutual funds. But despite the massive number of choices, most mutual funds fit inside just five basic categories.
Your investment options in mutual funds generally boil down to:
- Equity funds
- Fixed income funds
- Balanced funds
- Index funds
- Specialty funds
I'll briefly explain each type of fund, and subtypes within each category, below.
This is what most people think of when they think of a mutual fund -- it's your classic mutual fund that invests in stocks (equities). The equity fund category naturally includes a number of subcategories.
- U.S. Equity funds: American stocks only.
- Sector equity funds: Funds that invest in certain sectors (broad industries).
- International equity: Funds that invest in stocks outside the United States.
- Growth: Funds that invest in companies with above-average growth potential.
- Value: Funds that typically invest in lower-priced, slower-growth companies.
Equity funds are generally the most expensive of all mutual funds. The average U.S. equity fund carried an expense ratio of 0.74% of assets in 2013, according to the Investment Company Institute (ICI).
Fixed income funds
Probably better known as "bond funds," these funds invest in debt issued by local and national governments and large companies. Some also invest in debt owed by individuals (mortgages, for example). The fixed income fund category can generally be broken down into three subcategories.
- Alternative funds: These hold assets like bank loans or junk bonds, which are less liquid.
- Taxable bond funds: Funds that invest in bonds issued by nations or corporations.
- Municipal bonds: Funds that hold debt issued by municipalities, and generally seek to generate tax-free income.
Fixed income funds generally carry lower fees than equity mutual funds because of their lower return potential. The average expense ratio on fixed income funds was 0.61% in 2013, according to the ICI.
Also called hybrid funds, balanced funds hold both equity (stock) and fixed income (bond) investments in one fund. The basic premise behind a balanced fund is that the manager has the opportunity to pick from a larger selection of assets (stocks and bonds, rather than one or the other).
In addition, balanced funds are designed for more conservative investors who also like a bit of convenience. Rather than hold a stock fund and a bond fund, a properly allocated balanced fund might fit the bill. Balanced funds carried an average fee of 0.80% when weighted by assets in 2013, according to the ICI.
The index fund is taking the world by storm, collecting the lion's share of newly invested assets. Index funds are funds that track an index like the S&P 500 Index for stocks, or the Barclays U.S. Aggregate Index for bonds.
By tracking an index, these funds avoid the high costs of hiring investment professionals. For example, S&P 500 index funds simply buy the stocks in the S&P 500 index, which basically includes the 500 largest companies on American stock exchanges.
Index fund investors are essentially guaranteed to receive the returns of an index minus a very small fee. That's a winning proposition, given most actively managed funds fail to match or beat the returns of an index. In 2013, the average index fund of stocks carried an annual expense of 0.12%, while bond index funds carried an average expense ratio of 0.11%, according to the ICI.
This group generally encompasses all the oddballs -- funds that generally focus on a very small subset of the stock market. The most common type of specialty funds are sector funds, which invest in just one of 10 sectors of the stock market.
- Consumer discretionary
- Consumer staples
- Information technology
These are fairly self-explanatory. Financial sector funds invest in things like banks, insurance companies, and real estate investment trusts. Consumer staples funds hold stock in companies that produce things like toilet paper, canned goods, and deodorant. Materials sector funds invest in metals and mining companies.
Sector funds probably don't have much place in the average saver's retirement fund, however, as they are generally underdiversified and their performance can deviate significantly from the performance of the stock market as a whole. Sector funds are typically indexed, and have expenses that generally mirror that of broad stock index funds.