Mutual Funds - Redemptions

On the stock markets, every time someone sells a share, someone buys it, or in other words, equal numbers of opposing bets on the future are placed each day. However, in the case of open-end mutual funds, every dollar redeemed in a day isn't necessarily replaced by an invested dollar, and every dollar invested in a day doesn't go to someone redeeming shares. Still, although mutual fund shares are not sold directly by one investor to another investor, the underlying situation is the same as stocks.

If a mutual fund has no cash, any redemption requires the fund manager to sell an appropriate amount of shares to cover the redemption; i.e., someone would have to be found to buy those shares. Similarly, any new investment would require the manager to find someone to sell shares so the new investment can be put to work. So the manager acts somewhat like the fund investor's representative in buying/selling shares.

A typical mutual fund has some cash to use as a buffer, which confuses the issue but doesn't fundamentally change it. Some money comes in, and some flows out, much of it cancels each other out. If there is a small imbalance, it can be covered from the fund's cash position, but not if there is a big imbalance. If the manager covers your sale from the fund's cash, he/she is reducing the fund's cash and so increasing the fund's stock exposure (%), in other words he/she is betting on the market at the same time as you are betting against it. Of course if there is a large imbalance between money coming in and out, exceeding the cash on hand, then the manager has to go to the stock market to buy/sell. And so forth.

 •Mutual Funds - Types of Funds

This article lists the most common investment fund types. A type of fund is typically characterized by its investment strategy (i.e., its goals). For example, a fund manager might set a goal of generating income, or growing the capital, or just about anything. (Of course they don't usually set a goal of losing money, even though that might be one of the easist goals to achieve :-). If you understand the types of funds, you will have a decent grasp on how funds invest their money.

When choosing a fund, it's important to make sure that the fund's goals align well with your own. Your selection will depend on your investment strategy, tax situation, and many other factors.

Money-market funds
Goal: preserve principal while yielding a modest return.
These funds are a very special sort of mutual fund. They invest in short-term securities that pay a modest rate of interest and are very safe. See the article on money-market funds elsewhere in this FAQ for an explanation of the $1.00 share price, etc.

Balanced Funds
Goal: grow the principal and generate income. These funds buy both stocks and bonds. Because the investments are highly diversified, investors reduce their market risk (see the article on risk elsewhere in this FAQ).

Index funds
Goal: match the performance of the markets. An index fund essentially sinks its money into the market in a way determined by some market index and does almost no further trading. This might be a bond or a stock index. For example, a stock index fund based on the Dow Jones Industrial Average would buy shares in the 30 stocks that make up the Dow, only buying or selling shares as needed to invest new money or to cash out investors. The advantage of an index fund is the very low expenses. After all, it doesn't cost much to run one. See the article on index funds elsewhere in this FAQ.

Pure bond funds
Bond funds buy bonds issued by many different types of companies. A few varieties are listed here, but please note that the boundaries are rarely as cut-and-dried as I've listed here.

Bond (or "Income") funds
Goal: generate income while preserving principal as much as possible. These funds invest in medium- to long-term bonds issued by corporations and governments. Variations on this type of fund include corporate bond funds and government bond funds. See the article on bond basics elsewhere in this FAQ. Holding long-term bonds opens the owner to the risk that interest rates may increase, dropping the value of the bond.

Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds)
Goal: generate tax-free income while preserving principal as much as possible. These funds buy bonds issued by municipalities. Income from these securities are not subject to US federal income tax.

Junk (or "High-yield") bond funds
Goal: generate as much income as possible. These funds buy bonds with ratings that are quite a bit lower than high-quality corporate and government bonds, hence the common name "junk." Because the risk of default on junk bonds is high when compared to high-quality bonds, these funds have an added degree of volatility and risk.

Pure stock funds
Stock funds buy shares in many different types of companies. A few varieties are listed here, but please note that the boundaries are rarely as cut-and-dried as I've listed here.

Aggressive growth funds
Goal: capital growth; dividend income is neglected. These funds buy shares in companies that have the potential for explosive growth (these companies never pay dividends). Of course such shares also have the potential to go bankrupt suddenly, so these funds tend to have high price volatility. For example, an actively managed aggressive-growth stock fund might seek to buy the initial offerings of small companies, possibly selling them again very quickly for big profits.

Growth funds
Goal: capital growth, but consider some dividend income. These funds buy shares in companies that are growing rapidly but are probably not going to go out of business too quickly.

Growth and Income funds
Goal: Grow the principal and generate some income. These funds buy shares in companies that have modest prospect for growth and pay nice dividend yields. The canonical example of a company that pays a fat dividend without growing much was a utility company, but with the onset of deregulation and competition, I'm not sure of a good example anymore.

Sector funds
Goal: Invest in a specific industry (e.g., telecommunications). These funds allow the small investor to invest in a highly select industry. The funds usually aim for growth.
Another way of categorizing stock funds is by the size of the companies they invest in, as measured by the market capitalization, usually abbreviated as market cap. (Also see the article in the FAQ about market caps.) The three main categories:

Small cap stock funds
These funds buy shares of small companies. Think new IPOs. The stock prices for these companies tend to be highly volatile, and the companies never (ever) pay a dividend. You may also find funds called micro cap, which invest in the smallest of publically traded companies.

Mid cap stock funds
These funds buy shares of medium-size companies. The stock prices for these companies are less volatile than the small cap companies, but more volatile (and with greater potential for growth) than the large cap companies.

Large cap stock funds
These funds buy shares of big companies. Think IBM. The stock prices for these companies tend to be relatively stable, and the companies may pay a decent dividend.

International Funds
Goal: Invest in stocks or bonds of companies located outside the investor's home country. There are many variations here. As a rule of thumb, a fund labeled "international" will buy only foreign securities. A "global" fund will likely spread its investments across domestic and foreign securities. A "regional" fund will concentrate on markets in one part of the world. And you might see "emerging" funds, which focus on developing countries and the securities listed on exchanges in those countries.
In the discussion above, we pretty much assumed that the funds would be investing in securities issued by U.S. companies. Of course any of the strategies and goals mentioned above might be pursued in any market. A risk in these funds that's absent from domestic investments is currency risk. The exchange rate of the domestic currency to the foreign currency will fluctuate at the same time as the investment, which can easily increase -- or reverse -- substantial gains abroad.

Fund of Funds
Goal: achieve diversification. A fund of funds, as the name suggests, is a mutual fund that holds shares of other mutual funds (stock funds, bond funds, maybe both). This is one way of achieving a high level of diversification. However, the expense ratio tends to be high since the fund must pay for itself as well as the expenses charged by the holdings. Further, because many mutual funds have similar holdings, buying shares in many different funds doesn't always result in diversification of holdings.
Another important distinction for stock and bond funds is the difference between actively managed funds and index funds. An actively managed fund is run by an investment manager who seeks to "beat the market" by making trades during the course of the year. The debate over manged versus index funds is every bit the equal of the debate over load versus no-load funds. YOU decide for yourself.

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