Investment Policies
Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. For example, money market mutual funds hold the short-term, low-risk instruments of the money market (see Chapter 2 for a review of these securities), while bond funds hold fixed-income securities. Some funds have even more narrowly defined mandates. For example, some bond funds will hold primarily Treasury bonds, others primarily mortgage-backed securities.
Management companies manage a family, or “complex,” of mutual funds. They organize an entire collection of funds and then collect a management fee for operating them. By managing a collection of funds under one umbrella, these companies make it easy for investors to allocate assets across market sectors and to switch assets across funds while still benefiting from centralized record keeping. Some of the most well-known management companies are Fidelity, Vanguard, Putnam, and Dreyfus. Each offers an array of open-end mutual funds with different investment policies. There were over 8,000 mutual funds at the end of 2000, which
were offered by fewer than 500 fund complexes.
Some of the more important fund types, classified by investment policy, are discussed next. Money market funds: These funds invest in money market securities. They usually offer check-writing features, and net asset value is fixed at $1 per share, so that there are no tax implications such as capital gains or losses associated with redemption of shares.
Equity funds: Equity funds invest primarily in stock, although they may, at the portfolio manager’s discretion, also hold fixed-income or other types of securities. Funds commonly will hold about 5% of total assets in money market securities to provide the liquidity necessary to meet potential redemption of shares.
It is traditional to classify stock funds according to their emphasis on capital appreciation versus current income. Thus income funds tend to hold shares of firms with high dividend yields that provide high current income. Growth funds are willing to forgo current income, focusing instead on prospects for capital gains. While the classification of these funds is couched in terms of income versus capital gains, it is worth noting that in practice the more relevant distinction concerns the level of risk these funds assume. Growth stocks—and therefore growth funds—are typically riskier and respond far more dramatically to changes in economic
conditions than do income funds.
Bond funds: As the name suggests, these funds specialize in the fixed-income sector. Within that sector, however, there is considerable room for specialization. For example, various funds will concentrate on corporate bonds, Treasury bonds, mortgage-backed securities, or municipal (tax-free) bonds. Indeed, some of the municipal bond funds will invest only in bonds of a particular state (or even city!) in order to satisfy the investment desires of residents of that state who wish to avoid local as well as federal taxes on the interest paid on the bonds. Many funds also will specialize by the maturity of the securities, ranging from short-term to
intermediate to long-term, or by the credit risk of the issuer, ranging from very safe to highyield or “junk” bonds.
Balanced and income funds: Some funds are designed to be candidates for an individual’s entire investment portfolio. Therefore, they hold both equities and fixed-income securities in relatively stable proportions. According to Wiesenberger, such funds are classified as income or balanced funds. Income funds strive to maintain safety of principal consistent with “as liberal a current income from investments as possible,” while balanced funds “minimize investment risks so far as this is possible without unduly sacrificing possibilities for
long-term growth and current income.”
Asset allocation funds: These funds are similar to balanced funds in that they hold both stocks and bonds. However, asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each sector. Hence, these funds are engaged in market timing and are not designed to be low-risk investment vehicles.
Index funds: An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in proportion to the security’s representation in that index. For example, the Vanguard 500 Index Fund is a mutual fund that replicates the composition of the Standard & Poor’s 500 stock price index. Because the S&P 500 is a value-weighted index, the fund buys shares in each S&P 500 company in proportion to the market value of that company’s outstanding equity. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy—that is, to invest
without engaging in security analysis. Of course, index funds can be tied to nonequity indexes as well. For example, Vanguard offers a bond index fund and a real estate index fund.
Specialized sector funds: Some funds concentrate on a particular industry. For example, Fidelity markets dozens of “select funds,” each of which invests in specific industry such as biotechnology, utilities, precious metals, or telecommunications. Other funds specialize in securities of particular countries.
Notice that the funds are organized by the fund family. For example, funds sponsored by the Vanguard Group comprise most of the figure. The first two columns after the name of each fund present the net asset value of the fund and the change in NAV from the previous day. The last column is the year-to-date return on the fund.
Often the fund name describes its investment policy. For example, Vanguard’s GNMA fund invests in mortgage-backed securities, the municipal intermediate fund (MuInt) invests in intermediate-term municipal bonds, and the high-yield corporate bond fund (HYCor) invests in large part in speculative grade, or “junk,” bonds with high yields. You can see that Vanguard offers about 20 index funds, including portfolios indexed to the bond market (TotBd), the Wilshire 5000 Index (TotSt), the Russell 2000 Index of small firms (SmCap), as well as European- and Pacific Basin-indexed portfolios (Europe and Pacific). However, names of common stock funds frequently reflect little or nothing about their investment policies. Examples are Vanguard’s Windsor and Wellington funds.
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