Balanced, Index, and Specialty Mutual Funds

It's often difficult to choose among the many types of mutual funds. Some funds offer growth, others offer value, and still others offer income. Some funds offer immediate diversification while others invest in specific industries, commodities, or countries. Let's explore these options in more detail.

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Three Basic Types of Mutual Funds

Balanced funds attempt to provide a balanced approach to growth and income, both of which should figure prominently in an older investor's portfolio.

Index funds provide diversification by holding all of the stocks in the index they track. Whether it's the S&P 500, the Russell 2000, or even the Wilshire 5000, index funds simply provide an investor with a cost-effective way to participate in the overall market.

Specialty or sector funds do just the opposite. They hold stocks and/or bonds of a very narrow range of companies or countries. While the rewards of these types of funds can be quite large, the risks are much greater than diversified funds. When one stock or bond falls, most of the others within the fund will drop as well.

Understanding how each type of fund fits in your portfolio will help you build an investing plan that protects against excessive losses and builds your nest egg faster.

Choosing Balanced Mutual Funds

Balanced funds hold a combination of stocks and bonds. They may also hold money market instruments like corporate paper, along with cash. The fund will usually have a higher proportion of stocks or bonds, depending on the goals and objectives of the fund manager. If the fund is slightly more aggressive and holds more stocks, the mix might be 60% stocks, 40% bonds. If it is more conservative and focused on generating income, it might hold 60% bonds and 40% stocks.

For the most part, balanced funds are geared towards investors who need safety, capital appreciation, and income. Therefore, balanced funds are almost always recommended for people who are approaching retirement age. While the income component of the fund may not yet be critical, a balanced fund provides a diversification of assets and risk-offset that becomes increasingly important as investors get older.

Capital appreciation is the function of a balanced fund that is often overlooked. In order for an investor to be able to retire comfortably, he or she needs to have investments that continue to grow. Holding cash and CDs is important, but these won't grow fast enough to outpace inflation.

Balanced funds are also a good choice for investors in their 40s and 50s who are risk averse. Even though these investors don't need the income from the fund yet, they may be much more comfortable with an investment that provides greater stability from a thorough mixture of assets. Further, the expense ratio and tax-efficiency of a balanced fund are often less than more actively managed funds because the turnover of assets happens less frequently.

Investing in Index Mutual Funds

Index funds provide the greatest single diversity of all funds available. Funds that track the S&P 500 in particular are subject to the gains and losses of the overall market, not one or two specific sectors. If the banking sector is down but the healthcare sector is up, the end result might be no change in the value of the fund or a smaller loss. But the gains will be smaller, too.

Index funds are not actively managed and are therefore inexpensive and tax-efficient. But they can, and often do, beat actively managed funds. All fund managers have a benchmark that they measure their funds against. If the benchmark is the S&P 500 and it increases by 4% for the year, a fund manager wants to make sure the fund is up at least 4%. But that's very difficult to do. So rather than paying for an actively managed fund that may not return as much as an index, many investors choose to simply invest in index funds.

ETFs that trade the major indices are becoming increasingly popular. Index ETFs track the index in the same way a mutual funds does, and they are even more cost-effective and tax-efficient. Investors looking at index funds should also consider index ETFs. They're easy to understand, easy trade, and quite frankly, are just a little bit more fun.

Using Specialty Mutual Funds to Boost Returns

Specialty and sector funds present the largest potential for increases, but also the most significant risk of loss. Specialty funds can invest in anything from a specific industry, country, commodity, or type of security. Specialty funds do not offer diversification, unless several funds that invest in different areas are held. And even then, the gains in one fund may not be enough to offset the losses in another.

Be very careful not to get caught up in specialty fund hype. Just like stocks, when specialty funds are hot, investors rush to purchase shares. This artificially inflates the price of the fund, which leads to larger than normal losses when investors sell. Like all funds, specialty funds should be considered as medium- to long-term investments. They should not be bought and sold frequently. Investors who want to buy and sell specific industries or market sectors more often should look to ETFs.

One way to take advantage of specialty funds is to hold them in conjunction with other funds that represent a different market. For example, holding an S&P 500 index fund along with an index fund that tracks one or more European indices would offer some diversification, as world markets don't always move in tandem.

Even though they present more risk than balanced and index funds, specialty funds are a good way to take a calculated risk in order to increase the value of a portfolio. For example, if you think that hybrid cars will begin selling in greater numbers in the next five years, you might consider a specialty fund that contains the stocks of the companies that will make the cars, the parts, and all of the other companies that will have a hand in getting the hybrid cars to market. If you're right and sales of hybrid cars are off the charts in five years, chances are you will see an increase in the value of the fund. If not, you can sell the fund and write-off the loss (if it's not part of a tax-qualified account).

While we've covered the basics of mutual fund investing here, there is much more to maximizing the success of your fund investment strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

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