There are over 18,000 mutual funds available to US investors. Each of them have different characteristics, objectives, investment styles and strategies – making mutual fund research potentially complex. If you’re a new investor to the world of mutual funds, terms used to describe funds such as “a mid-cap value stock fund” or an “international large cap growth fund” may be daunting when you first get started, though they’re likely to become second nature in no time.

Here are some basic concepts to help you understand all that jargon.

Fund Categories

There are three main categories of mutual funds: stock funds, bond and income funds (including money market funds), and balanced funds, classified according to the types of assets they invest in.

Certain funds can be further grouped according to their specialization:

- Stocks are grouped into different market sectors according to their core business activities, such as finance, technology, or health care. A sector fund invests predominantly in a single sector. Sector funds tend to be relatively more risky, since they are less diversified than funds that invest in a broad range of sectors.

- Bond funds are categorized based on the type of bonds they primarily invests in. Government or Treasury bonds are composed primarily of Treasury securities (government debt). Government-insured mortgage-backed bonds are made up of home mortgages insured by Fannie Mae and Freddie Mac, which are government-sponsored enterprises. Municipal bonds issued by state and local governments and agencies are attractive to investors in upper tax brackets, since the interest is exempt from federal income tax. Corporate bonds are issued by companies wanting to raise capital and are guaranteed by the issuing company. A diversified bond fund invests in a range of bond types including government, municipal, and corporate. For more information on bond funds, you can read our post “What is a bond fund?”

- Balanced funds are categorized by investment objective and mandate: Asset allocation funds typically invest in stocks, bonds, and cash equivalents across a variety of markets. The proportions of these assets may change (within a range) in response to developments in the economy and financial markets. Balanced funds invest in stocks and bonds in a fixed proportion. For example, a 60/40 split between stocks and bonds. Flexible funds, like asset allocation funds, invest in a variety of asset classes. There is generally no restriction on where the fund’s assets may be invested. Convertible funds invest in bonds and preferred shares that can be converted into common stock.

Katrina Lamb’s excellent post on “Choosing between stock, bond and balanced funds” illuminates some other key considerations and is worth reading on this subject.

Geography

A U.S. (or domestic) mutual fund invests only in stocks or bonds in the United States. International funds invest only outside the U.S. An international fund that excludes emerging markets invests only in non-U.S. regions with developed economies, such as the United Kingdom, Europe, Japan, and Australia. Emerging markets funds invest in nations whose economies are rapidly developing, such as Brazil, Russia, India, and China.

Index funds versus actively managed funds

An index fund is a type of mutual fund chosen to represent a particular sector of the market. Examples of indices include the Barclays Capital Aggregate Bond Index, the S&P 500, and the Russell 2000. An index fund (which can also be called an index tracker or passively managed fund) aims to reproduce the returns of an index. The fund manager is simply trying to match (track) the return of the chosen index. This is in contrast to actively managed funds where fund managers rely on research and their experience to outperform an index. Tracking is achieved by investing in all of the assets in the index, in the same proportions as the index or by statistically sampling the market and holding representative assets. Fees of index funds are generally lower than those of active funds.

Market capitalization

Market capitalization is a way to measure the size of a company. Company size is an important factor in determining an investor’s asset allocation. There are three broad categories: Large-cap funds invest primarily in large companies (typically with more than $10 billion in market capitalization). Mid-cap funds invest primarily in medium-sized companies (typically with a market capitalization between $2 billion and $10 billion). Small-cap funds invest primarily in small companies (typically with $2 billion or less in market capitalization).

Investment style

For detailed information on style investing, read our three part series “A practitioner’s guide to style investing”. In the meantime, this summary will give you the gist of what you should know:

– Value funds primarily invest in stocks that are determined to be of good quality (healthy companies) but are currently out of favour and therefore undervalued in terms of share price. The value investor is betting that at some stage, value with be realized when market sentiment turns in favour the stock. A “buy and hold” value style often appeals to long-term investors with the patience to wait for a rebound in the price of quality stocks that are currently out of favor.

- Growth funds primarily invest in stocks that have experienced strong growth in earnings, sales and cash flow. The premise is that these rapidly growing companies will continue to outperform, which leads to an increase in the share price. Growth investors often have a shorter-term focus and choose to invest in stocks that are already favored by the market.

- Blend funds are a combination between value and growth. Blend funds invest in both growth and value stocks.

The next time your broker recommends an “international large cap growth fund”, or a “domestic small cap index fund”, hopefully you’ll be in a better position to understand the implications.