Do you know the differences between the types of mutual funds, it will be easier to weigh their advantages and risks and decide which to invest in based on your goals and profile. Mutual funds can be classified based on various criteria. One such criterion is their investment strategy, i.e., the type of assets in which the fund’s capital is invested and the risks investors bear.
Individual and institutional investors can also invest in various types of funds with the goal of making money. Examples include mutual funds, which pool the money of many investors and invest it in a diversified portfolio of assets, and hedge funds, which invest the assets of high-net-worth individuals and institutions designed to earn above-market returns.
What are the most popular types of investment funds?
Mutual funds are defined as a portfolio of capital belonging to many investors who participate in it and benefit from it collectively.
An investment fund offers a wider range of investment opportunities, greater management expertise, and lower investment fees than investors might be able to obtain on their own. Types of investment funds include mutual funds, exchange-traded funds, money market funds, and hedge funds.
With mutual funds, individual investors don’t make decisions about how to invest the fund’s assets. They simply select a fund based on its objectives, risks, fees, and other factors. The fund manager oversees and decides which securities to hold, in what quantities, and when to buy and sell them. An investment fund can be broad, such as an index fund that tracks the S&P 500 , or it can be highly focused, such as an ETF that invests only in small-cap technology stocks.
1. Mutual funds:
Mutual funds are the oldest type of investment fund. Like other types, they are instruments that pool money from investors to purchase securities. The basket of assets is priced and sold to the public on a daily basis.
The key feature of the day-trading format is its significant advantage. Unlike other types of mutual funds, which we’ll discuss shortly, a mutual fund’s price changes exactly once a day. In an actively managed mutual fund, managers may trade assets within the fund throughout the trading day. However, you cannot make money trading fund shares during the day.
This is one of the reasons why mutual funds are more commonly used as retirement or post-retirement plans. They are not good for day traders, but they are great for savers who want to grow their money over a long period of time.
Mutual funds come in a few flavors, and closed-end mutual funds are one of the simplest. These closed-end funds have a fixed number of shares that can only be bought or sold when they become available in the market. There are also open-end mutual funds, which can create new shares and dispose of others at the investor’s request. Then there are unit investment trusts (UITs), which are fixed portfolios of securities without management.
Mutual funds have many advantages. They allow investors to buy into a diversified portfolio of high-value assets without having to manage that portfolio. However, this convenience comes at a price. Mutual funds (especially actively managed ones) often charge fees that can eat into the value of returns and reduce them.
Another drawback of mutual funds is their tax inefficiency. Funds in a mutual fund are typically tax-exempt as long as they remain invested. However, when a mutual fund sells part of its portfolio at a profit, it is legally required to distribute those profits to shareholders. These payments are taxable.
2. Exchange-traded funds:
An exchange-traded fund (ETF) is a listed security that tracks an index consisting of a portfolio of specific individual securities. Similar to mutual funds, when you purchase an ETF, you don’t choose a specific security. Instead, you can choose a specific asset class, sector, theme, country, or investment strategy.
Two prominent types of ETFs are leveraged ETFs (which track some multiple of the price of their underlying assets) and inverse ETFs (which track the inverse multiple of their underlying assets). These funds give traders the ability to amplify or hedge their bets without using complex instruments such as derivatives.
The ability to trade ETFs during the day can be an advantage in certain situations. If the market crashes, for example, you can sell before the end of the trading day. With mutual funds, for example, you would have to wait until 4 p.m. to sell, and by then the fund may have lost a significant portion of its value.
But the ability to trade actively can also be an obstacle. Those who trade frequently often risk trading out of impulse or anxiety. This can sometimes lead to buying high and selling low. These mutual funds don’t give you the option to make rash day trading decisions, protecting you from losses.
With ETFs, you can invest in everything from US stocks, bonds, and the tech sector to Dividend Aristocrats, Russian small-caps, and even a timber company. ETFs also offer distinct advantages over traditional mutual funds. You can buy and sell ETFs as easily as buying a share of Apple (Nasdaq: AAPL).
ETFs tend to be slightly cheaper than mutual funds. They don’t have to distribute realized capital gains to shareholders, so they tend to have a smaller tax bill. Many ETFs are also passively managed, resulting in lower expense ratios.
Exchange-traded funds (ETFs) have no minimum investment limits. They are generally more tax-efficient. You can invest in ETFs that offer leverage or even profit when markets decline. It’s no wonder ETFs have dominated the stock market over the past decade.
3. Hedge funds:
Hedge funds pool huge sums of money from wealthy investors, Wall Street banks, and yes, even other hedge funds. Their goal is to make money regardless of the direction of the stock market. Some of these funds invest in bonds, commodities, foreign markets, futures, and options. Some short stocks, betting on their prices falling, not rising.
Other funds convert virtually any type of cash flow—including credit card payments, home loans, corporate loans, aircraft leases, and even movie theater revenue—into tradeable securities. Today, hedge funds wield unparalleled influence over global financial markets. They are responsible for a significant portion of stock trading on the market.
Much of what these funds do is a good thing. For example, hedge funds help spread investment risk among multiple partners. In a sense, this “risk dispersion” has served as a safety valve for investment banks and other lenders. However, with so much leveraged money flowing into these investment funds, the potential for huge losses is ever-increasing. Hedge funds struggle to beat the market but still charge higher fees.
4. Index funds:
Index funds are also a type of investment fund just like ETFs and mutual funds.
As the name suggests, index funds are baskets that attempt to contain all the securities in a particular index. You can spend a fortune buying a weighted amount of stocks in the 500 largest public companies in America, or you can just buy a few shares in an S&P 500 index fund.
Index funds represent some of the most diversified investment vehicles on the market. Instead of picking and choosing different securities, you get a piece of everything by investing in these funds. This strategy can generate consistent returns with lower risk.
Index funds can be valuable to long-term investors due to their simple strategy. Betting on long-term market trends can also be a great move.
A few active managers and traders have been able to outperform benchmark indices over decades. However, an actively managed fund may generate greater short-term gains than an index fund. [1]
Conclusion : As you can clearly see, mutual funds, exchange-traded funds, hedge funds, and index funds are all investment vehicles that can be leveraged to achieve the highest possible returns and gains while maintaining diversification. However, there are a number of subtle differences between them that every investor should strive to understand. Furthermore, these investment funds relieve you of the responsibility of management and give you the opportunity to benefit from the expertise and experience of the fund manager.
Types of investment funds according to investment areas
Investment funds may be classified according to the investment areas they pursue to achieve their objectives, as follows:
1. Money market funds:
These funds invest in the money market, and are characterized by their high liquidity, short investment terms, and low risk compared to other types of funds, which results in relatively low returns. Although money market funds are generally classified as low-risk, they are not risk-free, as the amount invested may decrease or fluctuate significantly due to several factors. [2]
2. Fixed-income debt instruments funds:
These funds invest in debt instruments such as sukuk, bonds, and others issued by companies, governmental and quasi-governmental entities, or any other entity authorized to issue any type of debt instrument. The prices of debt instruments, including sukuk and bonds, are affected by several risk factors, including, but not limited to: interest rates, bond ratings by rating agencies, and the risk of interruption of periodic payments.
3. Equity funds:
These funds invest primarily in the stocks of companies, whether local, international, or regional. Equity funds fall into several categories, depending on the fund’s objectives, as follows:
- Income funds: seek income by investing primarily in the stocks of companies with a strong track record of dividend yields.
- Growth equity funds: These funds seek to grow their capital by investing in companies whose market value is expected to increase. The fund’s performance relies primarily on capital gains, with dividend income not considered a significant factor.
- Growth and Income Equity Funds: Seek to generate profit by combining capital growth with income generation.
- International equity funds: seek to invest in shares of non-local companies, and limit their operations to shares in one or more countries’ markets.
- Global equity funds: invest in stocks in the markets of several countries from around the world.
- Sector funds: invest in stocks of a specific sector, such as mining, agriculture, petrochemicals, real estate, or other specific industries.
4. Balanced funds:
They are investment funds that combine stocks and bonds in their assets, and allocate a portion of their investments to short-term financial instruments.
Types of investment funds by structure
Open-ended funds: These are funds in which units are open for purchase or redemption throughout the year. All purchases/redemptions of these fund units are made according to the prevailing net asset value. Essentially, these funds allow investors to remain invested as long as they wish, as there are no restrictions on the amount that can be invested in the fund. These funds also tend to be actively managed, meaning a fund manager is responsible for selecting the assets to be invested in. These funds also charge fees that can be higher than those charged by passively managed funds due to active management. [3]
This type of investment fund is ideal for those seeking liquidity because it is not bound by any specific maturity dates. This means investors can withdraw their funds at any time, providing them with the liquidity they need.
Closed-end funds: These are funds in which units can only be purchased during the initial offering period. Units can only be redeemed on a specified maturity date. To provide liquidity, these units are often listed on an exchange. Unlike open-end mutual funds, once units or shares are purchased, they cannot be resold back to the mutual fund and must instead be sold through the stock market at the prevailing share price.
Interval funds: These funds combine the characteristics of both open-end and closed-end funds, opening the door to share repurchases at various intervals during the fund’s life. The fund’s management company offers the opportunity to repurchase units from existing unitholders during these same periods. If unitholders so desire, they can then sell shares to the fund.
Types of investment funds by asset class
Equity funds: These funds invest in stocks, or shares of companies. These funds are considered high-risk, but they also tend to provide high returns. Equity funds can include funds specializing in, for example, infrastructure stocks, fast-moving consumer goods, and banking services. These funds are tied to the markets and are therefore subject to a certain degree of volatility.
Debt funds: These funds invest in debt instruments, such as corporate bonds, government bonds, and other fixed-income assets. This type of investment is considered safe and provides steady returns. These funds do not withhold taxes at source, so if the investment profit exceeds, say, $1,000, the investor is responsible for paying the tax themselves.
Money market funds: These funds invest in liquid instruments, such as Treasury bills, bonds, etc., and are considered safe investments for those looking to store surplus funds for immediate but moderate returns. Money markets, also referred to as cash markets, come with interest, reinvestment, and credit risks.
Balanced or hybrid funds: These are funds that invest in a mix of asset classes. In some cases, the proportion of equity is higher than debt, while in others, it’s the opposite, balancing risk and return. An example of such a fund is a fund where 65% to 80% is invested in equities, and the remaining 20% to 35% is invested in the debt market. This is because debt markets carry less risk than the stock market.
Types of investment funds according to risk level
Low-risk funds: These are mutual funds invested in by those who do not want to risk their money. These investments are invested in the debt market and tend to be long-term. Due to their low risk, the returns on these investments are also low. One example of a low-risk fund is gilt funds, which invest in government securities.
Medium-Risk Funds: These are investments that carry a moderate level of risk for the investor. They are ideal for those willing to take some risk with their investments. These funds tend to offer higher returns. These funds can be used as an investment to build wealth over a longer period of time.
High-risk funds: These mutual funds are ideal for those willing to take higher risks with their money and looking to build wealth. One example of a high-risk fund is inverse mutual fund. Although investing in these funds carries higher risks, they also offer higher returns.
Types of investment funds in terms of management method
Actively managed funds: As the name suggests, the fund manager actively selects the underlying investments held within the fund on behalf of investors, with the goal of outperforming the market and their peers. The fund manager will continually conduct the necessary research and analysis and then update the fund’s investments when they feel it is necessary. This means that over time, the fund will buy and sell various assets based on market conditions.
Passively managed funds: These funds aim to match the performance of a particular stock market index—often by simply investing in each stock tracked by the index. The FTSE 100 (a list of the 100 largest companies in the United Kingdom) is an example of a commonly followed index. These funds can provide a convenient and low-cost way to generate good returns across a wide range of investments.
The main difference between active and passive fund management is the fees charged. Because they require less daily management, passive funds typically charge their investors lower ongoing fees. With actively managed funds, the additional work and analysis involved means investors generally have to pay more fees. However, knowing your funds are being well managed can justify this additional cost.
Note: Mutual funds are a different type of fund. They are traded on the stock market (not directly through the fund manager). As such, unlike funds, which typically appreciate in value once a day, the stock price moves up and down when the stock market is open.
While there are many high-quality mutual funds available, mutual funds often involve more complex techniques than regular funds, such as the manager borrowing money to try to increase returns. This can make them a higher-risk investment.
How do I choose investment funds?
With so many different types of mutual funds available on the market, the investments you choose for your portfolio should depend on your goals and investing style. Here’s how to make the decision.
The first step in choosing investments is to understand the principles that will help you achieve success. Then, you’ll be ready to narrow down your investment options.
Choosing a fund that suits your investment needs is no easy task. The simplest advice is to first understand your own needs. The next step is to determine your investment objective, which often relates to whether you want to build wealth slowly or quickly. Once this is determined, the final key consideration is how much risk you are willing to take. The highest returns are generally earned from funds that offer the highest risk. Therefore, if you want quick returns and are willing to take risks, this is the fund you should invest in. If your goal is to build wealth slowly, a mutual fund with medium or low risk is ideal. [4]
Since investment funds always come with a certain level of risk, no matter how small, it’s essential that investors carefully read their policy documents before investing. It’s also a good idea to read the document to ensure they understand exactly what they’re investing in and all the benefits available to them through that investment.
