Investment Categories

Once you decide on your asset allocation, you need to go out and buy those stocks, bonds and mutual funds to set up your allocation. This process is called portfolio construction. Mutual funds have some advantages over individual securities, including easier diversification, lower transaction costs and access to professional money management.

A mutual fund publishes its investment objective in its prospectus. The Securities and Exchange Commission requires every mutual fund that sells its shares to the public to publish a prospectus. You should always read the prospectus before investing in a fund.

A fund's investment objective explains how it intends to achieve its desired results. The investment objective identifies the types of investments the fund can and cannot buy. For example, a growth fund seeks to invest in growth stocks, while a government bond fund seeks to invest in Treasury bonds and other government-issued securities.

Here are some of the major mutual fund investment categories, beginning with stock funds:

Value. Value stock funds invest in value stocks. These are stocks that are considered cheap relative to other stocks by such valuation measures as price-to-earnings and price-to-book ratios. The quintessential value investor is Warren Buffett, president and chairman of Berkshire Hathaway, an Omaha, Nebraska-based investment company. Buffett shunned the Internet stock bubble of the late 1990s and was scorned by some investors for missing out on some big gains. The collapse of the bubble and revived interest in "value investing," however, has restored his almost-mythic reputation as a value investor.

Growth. Growth stock funds invest in growth stocks. Growth stocks are stocks of companies whose sales and profits are expected to grow quickly. Growth stocks tend to retain any profits and avoid paying dividends. Investors seek to earn investment returns on growth stocks from a rise in share prices. Growth stocks are riskier than value stocks. Even riskier than growth stocks are aggressive-growth stocks, a high-octane version of growth stocks.

Income. Income stock funds invest in income stocks. Income stocks generate dividends, a predictable and steady source of cash that appeals to more conservative investors. Income stocks tend to have higher dividend yields and often represent mature companies and industries such as utilities, financial-services firms and large-cap stocks. Income stocks are generally less risky than value and growth stocks because of their tendency to generate steady income.

Foreign. Foreign stock funds invest in foreign stocks. These are stocks of companies that are registered outside of the U.S. Since foreign stocks' investment returns often have a low correlation with U.S. stocks, an allocation to foreign stock funds may help to reduce investment risk through diversification. There are several specialized categories of foreign stock funds, including global, international, country, regional and emerging market funds.

Market cap. Market-cap funds invest in stocks of companies with a market capitalization that falls within a certain range. Market capitalization is the share price of a company times the number of issued and outstanding common shares. Investors often rotate among market-cap funds at different points in the economic cycle. Market-cap funds include large-, small- and mid-cap funds. Micro-cap stock funds invest in companies whose market caps are even smaller than small-cap stocks.

Sector. Sector funds invest in the shares of companies that are concentrated in a particular industry. Common sector funds include biotech, media, financial services, retail, telecom and pharmaceuticals.

Index. Index funds invest in a basket of stocks that mirrors the constituent stocks of a popular stock index such as the S&P 500. John Bogle, founder of fund giant Vanguard Group, is an advocate of index funds. Index funds are "passive" funds since they don't require actively buying and selling securities to outperform the index. Instead, an index fund aims to match the return of the index at the cheapest cost. Index funds have lower transaction costs and are more tax-efficient than actively managed funds.

ETFs. Exchange-traded funds are a relative newcomer to mutual funds. Nicknamed "Spiders" because of their SPDR acronym, the first two ETFs, introduced in 1993 and 1995, are based on a Standard & Poor's stock index. SPDRs mimic the S&P 500 index and Midcap SPDRs mimic the S&P Midcap 400 index. ETFs track the performance of widely used stock indexes the way shares of traditional index funds do.

Hybrid. Hybrid mutual funds come in two major types: balanced and convertible bond funds. Balanced funds invest in a combination of stocks, bonds and cash and offer diversification and built-in asset allocation benefits. Convertible bond funds invest in convertible bonds. These bonds can be exchanged for shares of stock in the same company when a price change occurs that favors conversion.

Let's also take a look at some of the major bond fund investment categories:

Government. Government bond funds invest in bonds issued by the U.S. Treasury and other governments. Funds that invest in Treasury bonds are among the safest of government bond funds. The U.S. Treasury has never defaulted on its debt and Treasury securities are backed by the full faith of the U.S. government.

Agency. Agency bond funds invest in agency bonds, which are backed by a government agency or government-sponsored enterprise. Agency bonds include mortgage-backed securities" issued by Fannie Mae, Freddie Mac and Ginnie Mae. Agency bonds have a unique type of risk called prepayment risk that makes these bonds riskier than government bonds.

Corporate. Corporate bond funds invest in corporate bonds. Corporate bonds include investment-grade or high-yield bonds. High-yield, or "junk," bonds are among the riskiest of bond fund categories since they have a higher default risk.

Tax-exempt (muni). Tax-exempt bond funds invest in bonds whose interest is exempt from federal and, in some cases, state income taxes. Tax-exempt bonds are also called municipal bonds. A muni bond whose interest income is exempt from federal and state income tax is a double-exempt muni bond. If interest income is also exempt from local tax, it is called a triple-exempt muni bond.

Zero-coupon. Zero-coupon bond funds invest in zero-coupon bonds. Zeros are bonds sold at a substantial discount to par value. Over the bond's term to maturity, the bond price gradually rises to reach par value when it matures. Bond investors don't actually receive interest income, but owe taxes on the amount of imputed interest income earned. Investors may decide to buy zero-coupon bonds for a tax-advantaged account since the account lets them defer income taxes until they begin to take money out.

Foreign. Foreign bond funds invest in the bonds issued by companies registered outside of the U.S. A semantic distinction: In the U.S., foreign bond funds generally exclude U.S. government bonds in their holdings. Global bond funds may include U.S. government bonds.

A money market mutual fund is a mutual fund that invests in deposits, Treasury bills and short-term corporate IOUs. Money market funds are often used as a proxy for cash. Investors often allocate some of their investments to cash, rotating in and out of stocks and bonds occasionally. Shares of a money market fund can be generally be redeemed quickly, adding to their attractiveness as vehicles to "park" cash. However, unlike CDs or money market accounts, money market funds are not insured by the FDIC -- You can lose money with a money market fund.

This information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.

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