2.7: Categories and Types of Mutual Funds
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Many decades ago, there were three types of mutual funds. Some mutual funds invested in stocks, some invested in bonds, and some invested in a balance of stocks and bonds. The mutual funds that invested in stocks were called stock mutual funds. The mutual funds that invested in bonds were called bond mutual funds. And the mutual funds that invested in a blend of stocks and bonds were called balanced mutual funds. Life was simple.
Life ain’t so simple anymore.
What follows is a catalog of the broadest categories of mutual funds. There are many, many more. Study and learn and memorize these major categories and know that all the others are variations on these major themes. You will want to have the attached Mutual Fund Types Scramble Sheet available to help. We recommend that you print a copy for your reference while reading and watching the presentation.
Stock Mutual Funds
In our discussion of stock mutual funds, we are going to use an analogy that may or may not help you. If it helps, great. If it doesn’t help please accept our apologies and just ignore it. We will liken the choices of stock mutual funds to a buffet table and we will start with the riskiest stock mutual funds ‒ the spiciest offerings ‒ and move to the least risky stock mutual funds ‒ the most boring, often ignored, items on the buffet table.
The riskiest stock mutual funds are called aggressive growth funds. These funds seek outsized capital gains by investing primarily in companies that are experiencing the strongest growth in the markets. They also often engage in extensive trading to attempt to offer eye-popping short-term results. Although the funds often report excellent returns in some years, as one would expect, they also are the funds that will fall the fastest and furthest when the markets stumble. These funds are the spicy jalapeño and habanero peppers of the mutual fund world. When we visit the buffet table, do we fill our plates with just the spiciest foods? No, most of us put a little bit of spice on our dishes, maybe 10% or even 20%. So it should be with aggressive growth mutual funds.
However, some adventurous folks may decide to fill their plates with the spiciest mutual fund alternatives. Hence, they must also be prepared for the inevitable downturns. Herein lies the danger with aggressive growth funds. Someone just starting out in the world of investing might take a look at the long-term results of the funds in their employer-sponsored 401k plan at work and say, “Look at this! The Getritch, Quik, and Retyre Aggressive Fund has the highest returns of all the choices. That’s what I want!” Does this person understand the risks they are taking? Are they emotionally prepared for the rollercoaster-like plunges that are in their future? Will they pull their money from the fund at the worst possible time, after a 30% or 40% or 50% or more decline?
To make matters worse, there are one or two categories of mutual funds that are riskier than aggressive growth funds. They often have “Ultra” or “Pro” in their names. They use exotic strategies to enhance the positive returns of the fund. As you would expect, those exotic strategies also can enhance the negative returns. Do you remember the Janus 20 fund that only had 20 stocks to decrease the diversification to the least amount allowable by law? Do you also remember that the Janus 20 mutual fund was merged into another mutual fund to bury the evidence of unsatisfactory returns for the investors? Aggressive mutual funds will exhibit severe volatility. And if you remember, volatility is our industry euphemism for, “Aye, I lost a whole lotta’ money!”
Our second category consists of growth mutual funds. Like their aggressive growth siblings, growth mutual funds will primarily invest in companies with growth prospects higher than the economy and most all stocks. Unlike their aggressive growth siblings, they typically do not take the same level of risk as their aggressive growth siblings. However, they will still demonstrate strong volatility. They are still spicy! Prudent, long-term investors would do well to temper their enthusiasm and limit their allocations of growth mutual funds to 20% to 40% of their overall portfolio.
Here is where it starts to get tricky and you will see how complicated categorizing mutual funds can be. A third category of mutual funds consists of capital appreciation funds. Capital appreciation is just a generic term that describes a rise in the value of an investment. Therefore, capital appreciation funds seek long-term growth of capital. They seek to increase the value of your investment. So how does that differ from a growth or aggressive growth fund? The differences are very subtle. Most growth funds and aggressive growth funds will have a provision in their prospectus that states they will invest primarily in growth stocks, usually staying between 80% and 100% invested in these types of companies. Capital appreciation funds can invest in anything they like and anywhere they like. They can invest in slow growing companies or out-of-favor companies if the investment managers deem that there is the opportunity for the value of the company to rise for whatever reason. Another analogy that we may use is that capital appreciation funds paint with a broad brush and can invest in any type of company whereas growth and aggressive growth funds paint with a narrow brush and primarily choose growing companies.
If you refer to the mutual fund scramble sheet, you will see that we show capital appreciation funds wrapping around the aggressive growth and growth funds. They are normally associated with aggressive growth and growth funds but they are technically not the same. In general, they tend to be as risky as growth and aggressive growth funds although not always. The well-known Fidelity Magellan Fund is a capital appreciation fund. It was managed by famed investor Peter Lynch from 1977 to 1990 and returned an astonishing 29% annual yearly return. Mr. Lynch was very good at choosing all types of companies, growth and non-growth, that had capital appreciation potential.
Yet another example of the confusion inherent in the mutual fund industry is the fact that one of the nation’s oldest and largest capital appreciation funds is called The Growth Fund of America. If you accosted the fund managers of The Growth Fund of America and asked them how they account for the apparent inconsistency with regard to the name of their fund, they would counter, “Excuse us. The Growth Fund of America was named long before the category of capital appreciation fund emerged in the industry.” This is common when researching and investing in mutual funds. The industry can’t even decide upon how best to categorize the thousands of funds available.
The next category of stock mutual funds is called growth and income. These funds primarily invest in stocks for growth of capital and income from dividends. Most funds emphasize capital gains while some may emphasize growth of income from dividends. The fund manager may also sometimes own bonds to augment the income when they believe the opportunity for income is lacking from stocks. They are also sometimes referred to as blend funds. We shall see that some in the industry use the term blend fund to designate another category that we will cover later on. To further complicate the categorization of mutual funds, some will refer to growth and income funds as value funds. Referring to the mutual fund scramble sheet, we see that we have wrapped the terms blend and value around the term growth and income. We will discuss the subtle difference and uses of the terms blend and value in the investment world later on.
Where will we find the growth and income funds on our buffet table? These funds are the main entrees. They are the pasta dishes, the meat and potatoes, the lasagna. Most people will have from 50% up to 75% or even 100% of their plate filled with the main entree and so it is with growth and income funds, especially younger adults up into their late 30’s. These funds will exhibit less volatility than their riskier brethren described above. However, they often have returns very close or on par with growth and aggressive growth funds. A well-run growth and income stock mutual fund is an excellent choice for what is sometimes called a core mutual fund for your portfolio. None other than Sir John Templeton, founder of The Templeton Funds (now merged with FranklinTempleton), believed that if you were to own just one fund during your working years, it should be a global growth and income stock mutual fund.
The last category of stock mutual funds is equity income. Recall that equity is another term for stocks and that income from stocks is in the form of dividends. These are mutual funds that primarily are seeking income from stocks. The investment manager can also use bonds to augment the income. Equity income funds are the least riskiest of stock mutual funds. They primarily invest in slow-growing companies that are paying generous dividends. These funds will not participate in the festivities when the markets are rocketing upward. On the other hand, they will typically hold up very well when there is a market downturn or a crash. They are still stock mutual funds; they will go down in a panic but they will not fall anywhere near as far as the stock funds described above.
Would it not be more descriptive to use the term stock dividends funds? Once again, we apologize on behalf of our industry. We often use very confusing, vague, and obtuse terms to describe an investment in place of more common-sense descriptions. This is why we need you, Dear Students, to become the Investment Gurus for your friends, family, and colleagues. They need your help and guidance! Stick with us, Rising Investment Gurus!
In our buffet analogy, equity income funds are the oatmeal, the broccoli, the lima beans, the stuff your mother always told you to eat when you were a child. Equity income funds are not exciting but they are very good for us, especially as we enter our late 40’s, our 50’s, and beyond. A 30% decline in an equity income fund is much easier to stomach for middle-aged investors than a 70% decline in an aggressive growth mutual fund. This is exactly what happened during the late 1990’s Internet mania when equity income funds lagged the market badly and were derided as stodgy, boring, out-of-touch investments that invested in “Old Economy” companies. In the subsequent Internet meltdown bear market of 2000 to 2002, equity income funds did very well, some even went up as many aggressive growth funds lost 70%, 80%, and even 90% of their value. And in 2022, many equity income funds lost less than many bond funds, no small feat!
We have gone from the most riskiest to the least riskiest stock mutual funds. It is now time to add two other types of categories, market capitalization and domesticity. Market capitalization refers to the size of the companies. We will discuss this concept in detail in our next chapter. There are three broad categories of market capitalization, usually referred to as large-cap, mid-cap, and small-cap. They refer to large companies, mid-sized companies, and small companies. In general, large company stock mutual funds exhibit the least risk while small company stock mutual funds exhibit the most risk. Of course, mid-sized company mutual funds find themselves somewhere in between but are normally closer to their small company cousins with regard to risk.
The domesticity of a mutual fund refers to where the stock investments are based. The three broad categories are domestic, global, and international, also called overseas or foreign. Recall that the term domestic refers to investments that are based in the United States, global refers to investments based anywhere around the world, and international describes investments based outside the United States. Decades ago, the conventional wisdom was that domestic funds were the least riskiest, international funds were the most riskiest, and global funds were somewhere in between. Also recall from our discussion in the first chapter that these distinctions are not as important and pronounced as they once were. The world is indeed a very small place economically these days.
What the industry did is overlay these two types of categories on top of the first type of category. Refer to the mutual fund scramble sheet. In their efforts to be more competitive, a mutual fund company would offer a global, large-cap growth fund or a domestic, small-cap aggressive growth fund. Pick one from column A, one from column B, and one from column C. And of course, if one mutual fund company does it, many others believe they need to follow suit. Do you see how the industry wound up with approximately 12,000 different mutual funds? Ask your statistics professor to help you compute how many permutations there are for all the possible combinations.
Wait! There is more! There are regional stock mutual funds that invest in a certain region of the world such as Latin America, the Nordic countries, Canada, Japan, and the Far East. There are emerging market stock mutual funds that invest in developing countries such as India, Brazil, the Philippines, Russia, and China. There used to be a mutual fund that invested only in companies based in California but that fund seems to have vanished. Upon analysis, this actually was not such an eccentric idea. California by itself ranks as the fifth largest world economy, ahead of India and behind Germany. (If anyone can uncover what happened to this fund, please contact us.)
There are also stock mutual funds that invest in companies based in just a certain sector of the economy such as energy or real estate or wireless communications. These are called sector funds. Both regional mutual funds and sector funds are an attempt to enhance returns by concentrating the portfolio of the investor. Some investors may have some intimate knowledge of the region or the sector of the economy. If that is so, then, just like the aggressive growth funds, placing 10% or maybe even up to 20% of your portfolio may be a decent choice providing you are aware of the risks. However, we investors use mutual funds to diversify, not concentrate, our portfolios. Regional and sector funds should generally be avoided by prudent, long-term oriented investors.
One last category of stock mutual funds consists of mutual funds that use market timing as their primary strategy. We will discuss market timing as a strategy in our next chapter on stocks. Suffice to say that only speculators and traders should ever consider market timing. Prudent, long-term oriented investors should never mention market timing in polite company.
We have spanned the world of stock mutual funds. Study these categories thoroughly. It is time to turn our attention to bond mutual funds.
Bond Mutual Funds
Bond mutual funds primarily invest in fixed-income bond securities. Recall that bonds are essentially loans to corporations, state and local municipalities, and the Federal government. Bond investors lend their money to the bond issuer, the corporation, the state or local municipality, or the Federal government. In return, the bond issuer agrees to pay interest to the bond investor and eventually repay the principal. Bonds, and therefore bond mutual funds, are far less risky than stock funds. We will see later on that bonds often move in the opposite direction of stocks. When stocks are experiencing a market downturn, bonds often move up, or at least keep their value. Hence, many investors use bond mutual funds for stability and preservation of capital. In the following discussion, as we did with the stock mutual funds, we will start with the riskiest bond mutual funds and then move to the least riskiest.
The riskiest bond mutual funds are high-yield bond funds. This is the polite name. Usually these funds are referred to as “junk” bond funds. High-yield bonds are also known as junk bonds, speculative bonds, distressed bonds, and non-investment grade bonds. They pay much higher rates of interest. By now, you obviously understand why. These bonds are issued by entities that have low credit standing and, in many cases, are in danger of default. Default is another polite term we use in the industry for an individual or entity who cannot make good on the financial promises they made. High-yield bond funds typically invest in the bonds of corporations that are in distress but there are also high-yield municipal bond funds that invest in state and local governments and entities that are also in distress.
High-yield “junk” bond mutual funds also have a characteristic unlike other bond funds; they tend to follow the stock market up and down. This is counter to most other bond funds. However, when investigated further, it makes sense. Often, the stock market falls in response to falling economic conditions. When economic conditions are falling, companies that are in distress are in far more danger of defaulting. Therefore, the high-yield “junk” bonds that populate the high-yield “junk” bond mutual funds become more likely to default and the high-yield “junk” bond mutual funds suffer along with the stock market and stock mutual funds. When economic conditions improve, the stocks and the stock market typically rebound and so do the high-yield “junk” bonds. We say that high-yield “junk” bond mutual funds are positively correlated with the stock market and the stock mutual funds. We will discuss correlation in more detail later on in our journey together.
The next bond fund category consists of corporate bond mutual funds. Corporations borrow money for many of the same reasons that you and I borrow money; the difference is just that the numbers are orders of magnitude greater. Most individuals repay their debts and that is true of most corporations. With the exception of the high-yield “junk” bond funds described above, most corporate bond mutual funds have a long track record of earning interest income and returning principal repayments to bond fund investors.
There is a caveat that needs to be addressed here. Since the Global Financial Crisis of 2008, interest rates for many bonds have fallen to levels not seen since the Great Depression. Bond mutual fund investors were accustomed to 5% or 6% or higher annual returns over decades. They became unhappy with the 2% or 3% or lower returns that their corporate bond funds were now returning. In response, many corporate bond mutual fund money managers began to incorporate corporate bonds of lower credit quality, including some that would be categorized as high-yield, distressed “junk” bonds. In the industry, this is referred to as stretching for yield. This led Morningstar, the mutual fund research and reporting company, to create separate bond funds into two new categories, core and core-plus. The term core-plus is misleading as it might tempt potential bond mutual fund investors to believe that core-plus funds are somehow higher quality or better quality than core funds. In reality, the exact opposite is the case. The core-plus funds are the funds incorporating higher yield but lower quality bonds into their portfolios.
Sliding down the risk versus reward spectrum to our next category, we find municipal bond mutual funds. These funds invest in the bonds issued by state and local municipalities, such as states, cities, counties, school districts, bridge and water authorities, and other local governmental entities. In general, these governments and institutions will suffer default far fewer times than corporations. Some municipal bond mutual funds will even invest in municipal bonds that are insured to further reduce the risk of default.
One of the major benefits of investing in municipal bond mutual funds is that interest from municipal bonds is tax-exempt at the Federal level. This makes municipal bonds and municipal bond mutual funds very popular with high net worth investors in higher tax brackets. In addition, if an investor chooses a municipal bond fund that invests in municipal bonds domiciled in their state of residence, the interest from the municipal bond will also be tax-exempt at the state and local level. Hence, state-specific municipal bond funds are often called double tax-exempt. Because of this tax advantage, it is difficult to compare the returns from municipal bond funds to other bond funds. Later on, we will learn how to compute the taxable-equivalent yield of municipal bonds and municipal bond funds. The taxable-equivalent yield will allow us to compare municipal bond funds with other bond funds.
The next two categories consist of bonds that are either issued by the United States Treasury or an organization that is somehow backed by or associated with the United States government. Over the decades, the United States government chartered various private institutions such as Fannie Mae and Freddie Mac and other such entities. Their purposes were to issue bonds to raise funds for such worthy goals as increased home ownership and offering student loans. The representatives in the United States Legislative branch of government, the Congress, and the Executive branch of government, the White House, always maintained that these institutions were separate from the United States government. No way would the United States taxpayer ever be asked to bail them out of default. Over the years, the investment community never believed these assertions. The bonds issued by the organizations were normally considered to be as safe as those from the United States Treasury.
In the Global Financial Crisis of 2008, the investment community’s belief was borne out. When Fannie Mae and Freddie Mac and others were in danger of default, none other than the United States Treasury came to the rescue. As of this writing, these companies are still under the protection of the United States Treasury. Thankfully, they have come back from the brink of disaster and now add billions of dollars of earnings to the Treasury each year. Although there is often much talk about how important it is for the government to extricate itself from these institutions, there is very little agreement about how it should be done. Consult your Political Science professor for more discussion of this vexing situation.
The last category consists of United States Treasury bond mutual funds. They are also often referred to as government bond funds. These carry the least amount of risk of default. The United States Treasury has never defaulted and it is safe to say that it will never default in our lifetimes. Over the past few decades, the issue of raising the debt ceiling has come into the news. There have been times when rabble-rousing politicians have threatened default by not allowing the debt ceiling to be raised. This is pure political theater. The United States government will pay its debts. In fact, there are constitutional experts who argue that the debt ceiling is a ruse and can be ignored by the Treasury. The 14th Amendment of the Constitution states, “the validity of the public debt of the United States, authorized by law...shall not be questioned.” This is yet another delicate matter for your long-suffering Political Science professor.
One often overlooked aspect of Treasury bond mutual funds is that the interest from Treasury bonds is exempt from state and local taxes. Hence, the interest from Treasury bond funds is also exempt from state and local taxes. This is an important benefit for those investors in higher tax states such as California and New York.
As we did with stock mutual funds, we will overlay two additional types of categories, the domesticity and the maturity of the bond funds. The categories of domesticity are identical to the stock mutual fund categories, namely domestic, global, and international, as is the risk versus reward profile. The second type of category refers to the bond maturity within the bond mutual fund. When will the bonds repay their principal? There are three broad categories, long-term, intermediate-term, and short-term. Long-term bond funds typically have bonds that will mature in 7, 10, 20, and up to 30 years. Intermediate-term bond funds favor bonds that mature in approximately 3 to 5 years. And short-term bond funds will populate their funds with bonds maturity in 1 to 2 to 3 years.
With regard to the risk versus reward profiles, one might be tempted to liken these categories to the large-cap, mid-cap, and small-cap categories of stock mutual funds. Large and long both start with the letter L, small and short both start with the letter S, and the terms mid and intermediate are very similar, right? The reality is that they are exactly the opposite of one another. Long-term bond funds are the riskiest and offer the greatest returns, short-term bond funds are the least riskiest and offer the least returns, and intermediate-term bond funds fall somewhere in between the two. Upon further investigation, this scenario fits with the facts. With regard to lending your money to others, the longer the time frame, the more opportunities there are for adverse events. Hence, investors would require a higher rate of return. The opposite is true for shorter time frames. In fact, short-term bond funds start to resemble short-term securities such as money market mutual funds as the maturities get closer and closer to short-term time horizons such as three, six, or nine months.
As they did in the stock mutual fund world, the mutual fund industry is guilty of the same fragmentation in the bond mutual fund world. According to the industry, more options is obviously better and so we experienced the same explosion of permutations and combinations of bond mutual funds as we saw with stock mutual funds. Referring again to the mutual fund scramble sheet, we randomly chose one category from column A, one from column B, and one from column C and, lo and behold, we brought forth a mythical domestic, long-term, high-yield bond fund, just one of dozens and dozens of variations. The mutual fund industry did likewise, but their creations are factual funds that contribute to the further bewilderment that is choosing a mutual fund.
Balanced Funds
The next category of mutual funds is balanced funds. Balanced funds traditionally offer a balance of stocks and bonds and are one of the original categories of mutual funds. Indeed, the nation’s oldest balanced fund has been around since 1929 so the idea of blending stocks and bonds together is not new. Since we said that we would be moving from the most riskiest to the least riskiest, one might be tempted to exclaim, “Wait a minute! If you blend stocks and bonds together, wouldn’t the resulting investment be less risky than stocks but more risky than bonds?” The answer is no. Balanced funds often exhibit less risk than either stock mutual funds or bond mutual funds. The reason has to do with the history of stock and bond price movements. Although every market downturn is different, in the past, often when the stock market fell, the bond market rose or at least stayed relatively stable. We will discuss this phenomenon in more detail much later on. It has to do with the aforementioned negative correlation of stock and bond prices. Note: In 2022, both stocks and bonds fell significantly in tandem. The last year this happened was 1969. It is a rare occurrence.
Typically, balanced funds will have an approximate allocation of 60% stocks and 40% bonds. The investment advisor can adjust the allocation as conditions in the economy and the stock and bond markets warrant, but in general, responsible money managers strive to stay balanced. One of the nation’s oldest and largest balanced funds states in its prospectus that the fund is “managed as the complete U. S. investment program of a prudent investor.” They can never be more than 75% stocks, 25% bonds or less than 50% stocks, 50% bonds.
Balanced funds are not immune to the confusion and puzzlement endemic in the mutual fund industry. A category of mutual fund that is closely associated with balanced funds is asset allocation funds. Asset allocation funds spread their investors’ money across stocks, bonds, and money market securities. They are similar to balanced funds, however, the investment advisor often more diligently tries to “fine-tune” the allocation as market conditions change. Whereas a balanced fund usually stays around 60% stocks and 40% bonds, an asset allocation fund might try to move money into cash when they thought the stock and bond markets might fall. Or they might move all the assets into stocks if they believed the stock market was ready to surge ahead. Critics at times accuse some asset allocation fund managers of being stealth market timers. For all their hype, the returns of many asset allocation funds are very close to balanced funds. Some asset allocation funds trail balanced funds considerably because they “timed the market” badly.
Adding to the befuddlement with regard to balanced funds comes from the tendency of some in the industry to also describe balanced funds as blend funds. Recall that the term blend funds was also used to describe growth and income stock mutual funds. However, even with all the accompanying unsettling distractions, well-managed balanced funds are a prudent choice for investors, especially for those who are nervous about investing in the stock market alone. They also become excellent options for those in retirement who are in good health with statistically many years of life ahead of them. Balanced funds allow us to eat reasonably well and sleep reasonably well.
Money Market Mutual Funds
The mutual fund category with the least amount of risk is money market mutual funds. We covered money market mutual funds, usually just referred to as money markets, in detail in chapter 1 in the section on short-term securities. To review, although money market mutual funds are not guaranteed by an entity of the Federal government, they are very secure. And we now understand that low-risk investments are accompanied by low returns. Currently, at the time of this writing, money market mutual funds are paying close to zero percent interest. Money market mutual funds are a place to park your money in the short term.
We have run through the major categories of mutual funds, from the riskiest to the least risky. It is now time to turn our attention to a few other categories of interest.
Mutual Funds of Mutual Funds
It was inevitable. You know it had to happen. There are now mutual funds that invest in other mutual funds. Some might throw up their hands in frustration and exclaim that the industry has simply gone mad. However, upon further investigation, we find that there are legitimate reasons for these so-called funds of funds. Many employers offer employer-sponsored retirement plans such as 401k or 403b plans to their employees. In an effort to promote their employees to save for their retirement, employers would often automatically place 3% or 4% or 5% of the employees’ salaries into the plan. The employee always has the option to “opt-out” of the plan but empirical evidence has shown that employees tend to allow inertia to take its course and the retirement savings continue with interruption. There was, however, a serious problem with this system that concerned the choice of investments.
Whenever an investment choice is recommended, whether explicitly or implicitly, if the investor is not happy with the choice, there is always the possibility that the investor may sue the individual or organization that made the recommendation. The investor may claim that the investment was not suitable to their circumstances, especially if the investor experienced unsatisfactory results. To guard themselves from these legal actions, employers would typically automatically place the savings into short-term investments such as money market mutual funds. These are very safe but also very low yielding. For someone just starting out in their careers, short-term investments are certainly not the most desirable long-term choices. Something needed to be done.
The Pension Protection Act of 2006 gave employers legal protection from lawsuits if the employer used an appropriate fund of funds for their employees. These funds are often called target-date mutual funds. They also go by the names target-retirement or lifecycle. The mutual fund manager then appends a year to the name. This year corresponds roughly to the approximate year that an employee plans to retire. For example, the Federal employees’ Thrift Savings Plan offers their so-called Lifecycle funds from Lifecycle 2025, Lifecycle 2030, on up to Lifecycle 2065. The Thrift Savings Plan uses the employee’s year of birth and chooses the appropriate Lifecycle fund. For the underlying investments in the funds, the manager chooses a mixture of other mutual funds that are appropriate for the year that the employee plans to retire. When the year of retirement is in the distant future, the investments are more growth oriented. As the year of retirement approaches, the underlying investments become more and more risk averse. Of course, the employee has full control over their contributions and the investments in their account but as mentioned, often employees simply allow the system to make the choices for them. The Thrift Saving Plan is the subject of one of your chapter 2 assignments. Enjoy!
Funds of funds are also popular for investors saving for a child’s education with names like College 2030 and College 2035. They are often paired with tax-qualified educational savings accounts such as 529 plans. The tax advantages of these plans are often skewed toward high net worth and high income families. For many others, a Roth IRA or other account might be a better alternative.
Specialty “Boutique” Funds
The mutual funds categories above constitute the majority of mutual funds available and hold the vast majority of investors’ assets. However, there are numerous specialty funds available. They are sometimes referred to as “boutique” mutual funds. The competition in the mutual fund industry is ferocious and new companies must do their best to differentiate themselves from other funds to attract investors. It is not hard to argue that many of these attempts have resulted in outlandish and laughable results. There was the StockCar Stocks fund that invested in companies that sponsored NASCAR races. There was the Pauze Tombstone mutual fund that invested in cemeteries, mortuaries, and casket makers. The investment manager of The Timothy Funds, “avoids investing in companies that are involved in practices contrary to Judeo-Christian principles,” and that it tries to, “recapture traditional American values.” Not to be outdone, The Amana Funds invest with Islamic principles foremost in mind which include avoiding interest, gambling, pornography, liquor, and pork. But the silliest of all attempts must certainly be The Chicken Little Growth Fund for investors who were afraid that the sky is falling. Fact is always stranger than fiction, Dear Readers.
Obviously, such gimmicks and grandstanding should be met with more than a skeptical eye by prudent, long-term oriented investors. However, there have been some specialty funds that may deserve attention. Some investors want to invest in more than just stocks and bonds and there are mutual funds that will allow them to do so. Some sector mutual funds invest in real estate, typically through Real Estate Investment Trusts (REITs). Also worthy of attention for a select group of aggressive investors are commodities funds that invest in hard assets such as foodstuffs and basic materials. Again, the prudent, long-term oriented investor would only choose this type of fund as a small percentage of their overall investment portfolio.
ESG - Environmental, Social, and Governance Funds
Every decade or so, a new theme emerges in investing. The typical response in the mutual fund industry is to create brand new funds that have the theme somewhere in the name of the mutual fund. So it is with the new theme of ESG ‒ Environmental, Social, and Governance. The belief is that companies that adhere to these three attributes will outpace all other companies going into the future. Since 2019, the inflows into these funds have been substantial. It is in the order of tens of billions of dollars. And in the mutual fund world, nothing succeeds like success. Depending upon the source, there are anywhere from approximately 400 to over 700 mutual funds touting themselves as ESG funds as of mid-2021. They have names such as Social Index Fund, USA ESG Select ETF, Green Alpha Fund, and Sustainable Future Fund 2025.
ESG is not a fad. These qualities are important and investors ignore them at their peril. The problem is that ESG is complex and multi-dimensional. Trying to marry climate change with human rights with executive compensation and a whole other host of issues and characteristics can make for some strange outcomes. There are two third-party analysis groups that monitor the ESG world and give grades to companies based on their research, Morgan Stanley Capital International (MSCI) and Sustainalytics. Sustainalytics is owned by Morningstar, the popular mutual fund research company that we will use in our chapter assignments. For an example of the contradictory outcomes, consider that MSCI gives Dollar General a high-risk rating while Sustainalytics gives Dollar General a low-risk rating. MSCI then gives 3M a low-risk rating while Sustainalytics gives 3M a high-risk rating. Who is right? Who do you trust?
ESG qualities need to be examined in the context of all the other components, aspects, and properties of a potential investment. The well-run mutual funds with decades of successful results already have incorporated ESG into their day-to-day research operations. These companies do not need to create new mutual funds simply to sop up inflows from uninformed investors who just saw on the Internet that ESG is the Next Big Thing and they had better get in now while the gettin’ is good. If history is any gauge, many of these new funds will have mediocre ‒ or worse ‒ returns and then will have their names changed or be merged into other funds. Burying the evidence in the mutual fund industry is a fad that never goes out of style.
Going back further into the history of mutual funds, we find that ESG was predated by the emergence of Socially Responsible Funds. Some Socially Responsible Funds go back many decades. These first took the form of mutual funds that would not invest in companies that produced alcohol or tobacco. Then starting in the 1970’s and beyond, Socially Responsible Funds began to avoid companies that polluted, built weapons systems or nuclear power plants, destroyed the rainforests, exploited their employees, etc. It was surprising that there were any companies left to invest in! Silliness aside, many Socially Responsible Funds did quite well for their investors and led to the current ESG movement. Possibly as a backlash to socially responsible funds and their perceived political overtones, there is a mutual fund called The Vice Fund. Yep! You guessed it! They invest in tobacco and alcohol and all the other corporate nasties you can think of such as gambling and military defense firms. Who said the investment world was dry and uninteresting?
We have covered the broadest mutual fund categories. There are many, many more. Luckily, most of the other categories are sub-categories or sub-sub categories of the broad categories discussed above. Memorize the categories above that we have covered, using the Mutual Fund Types Scramble Sheet as your study guide. In the meantime, peruse the following list of the mutual fund categories as defined by Morningstar as of mid-2021. No, Dear Students, no one will ever ask you to remember them all.
