Book of Wise Investors

Given the inherent risks involved and minimum capital required for adequate diversification when owning the three main asset classes directly – stocks, bonds and real estate, most of us can only participate in the long run returns from them through active management of passive managed index funds, and to reduce risks of losing everything as well.

This post is going to talk about the different ways in which stock mutual funds are classified, knowing what types of stock mutual funds you are buying aids greatly in determining the levels of risks and rewards that one is exposed to. As such, it will assist greatly in constructing an optimal portfolio that will better match a person’s profile.

Despite the fact that there are more than 8000 active mutual funds and more than 1000 passive index funds, including exchange-traded funds for each type (it can be quite daunting to choose a few from among so many of them), each of them can be differentiated using the following characteristics.

1. Average size of companies

The size of the companies is measured in terms of market capitalization.

Large cap means companies worth more than US$5 billions, mid-cap means worth between US$1 billions to US$5 billions, small cap means worth between US$250 millions to US$1 billions and finally micro cap are companies valued by the stock market at between US$50 millions to US$250 millions.

Usually and for most of the mutual funds, each will only contain companies from one cap size group and hence the risk and return by virtue of that cap size is easily determined. All things being equal, a diversified group of small cap companies will achieve higher returns in the long run of more than 10 years compared with a group of large cap companies, but of course with great volatility along the way to the 20 years later.

2. Country and regional sectors

In many cases, other than cap sizes, mutual funds are also available based on where most of the companies operated at, that is where they mostly generate their revenue from. Since mutual funds are mostly contain many companies numbered at least in the hundreds and the hundreds are from a country or regional place, the general economic and political conditions of a country or regional area affect the earnings and hence stock prices when taken as a whole.

Remember that you are now investing through mutual funds, not individual stocks, financial statements of a listed company matter less when choosing which mutual fund to invest in, in fact, no one reads and interpret a financial statement of bear sterns before placing $100 000 in an index fund tracking S&P 500, most will analyze the economic conditions of United States where bear sterns operates to decide when to buy the index fund.

When all is said and done, a fund like Vanguard European Stock Index Fund tracking companies in a regional area like Europe will be less risky than a fund tracking stocks located in a single country in Europe, for example, Sweden or Italy.

For the case of two mutual funds tracking a country and the region where it is in, I would prefer the one containing stocks within a region as there will be less risk without reduction in expected returns.

3. Developed and emerging markets

To appeal to those wanting higher returns, there are now more and more funds introduced that invested in stocks of companies operating in developing countries. Commonly known as BRIC nations, the four largest emerging markets, meaning emerging to become developed economies in the years ahead, they are Brazil, Russia, India and of course China. Take note that they are extremely volatile, though can yield higher returns for each dollar invested compared to maybe S&P 500.

Developed markets are places like United States, Canada, United Kingdom, France, Japan and Australia. In the past decade and most possibly in the next decade, the total returns for stocks in these developed countries are about the same. As what modern finance theory said, the lower the risk, the lower the return.

Various mutual funds offered can be under either developed or emerging markets. If your portfolio already contains substantial holdings in S&P 500, it may be wise to invest the rest in emerging markets instead of other developed markets like Europe as the risk and return will be similar.

4. Value and growth

Other than the above three, mutual fund companies like Vanguard and Fidelity also got offer two identical funds that are the same in the above three aspects and differ in their average price-earnings ratios.

Value stocks refer to those with lower price-earnings ratio than growth stocks. They are usually stable and slow growing like natural resources, banking and utilities. While growth stocks, with their characteristics high price-earnings ratios, consists of companies in technology and pharmaceuticals sectors. Due to the fact that they move in different business cycles, it will be wise to buy and sell them at different times.

5. Industry Sectors

Last but not least, there are funds after the above four classifications, then divided according to the industry sectors that they are in. Meaning to say that funds containing solely companies from one industry sector and for example, also large cap, S&P 500 and growth.

Some examples of industry sectors in which companies can be under are technology, health care, energy and financial. Further diversify down to industry sectors will be wise for those already owned businesses in one sector and need to hold stocks in the others instead of buying everything based on the above four groups.

Related posts:

1. Neglected risk when invest in stocks and bonds through mutual funds and ETFs
2. Essential 7 guidelines for actively managed mutual funds investing
3. Are you aware of what your mutual funds own?
4. Risks inherent in mutual funds