Like a curated playlist, funds can give you easy access to a diversified mix of investments in a single package. Here's everything you need to know about different types of funds.
Fund definition
A fund is simply a collection of money earmarked for a specific goal. Even if you've never invested a dollar before, you're probably familiar with the concept: You might have a jar where you stash a rainy-day fund or a separate savings account where you're building a fund to replace your roof or upgrade your computer.
What's key in any case is that the dollars you save have a clear purpose. When that purpose is potentially growing more money, many people turn to a particular type of fund: the investment fund.
How does a fund work?
Investment funds provide investors with a professionally managed portfolio of investments that may help investors grow their money over time. They're often started when investors pool their money together to buy more kinds of investments than they could on their own. The investors then receive a number of shares in the fund reflecting how much they contributed. The value of the shares may go up or down primarily based on changes in the value of the fund's underlying investments. For ETFs, the market price may also be affected by supply and demand and may differ from the value of the fund's underlying holdings. Investors can generally sell their shares for cash when they decide to sell them.
Fund components can include a range of investments but are generally stocks and bonds.
Types of funds
There are many different types of investment funds, but some of the most common include:
Traditional mutual funds One of the original types of funds the average investor could invest in, traditional mutual funds let you buy shares of a portfolio of investments, which typically contains stocks, bonds, or a mix of both. Many traditional mutual funds are actively managed, meaning professional portfolio managers research and carefully select all of the investments and may adjust fund holdings in response to real-time trends or events.
Some, however, are managed passively: A passively managed fund aims to track the performance of a specific market index, such as the S&P 500®,1 an index of 500 leading large-cap US companies. The fund adjusts its investments as needed to reflect changes in the index, including when the index is rebalanced or when companies are added or removed. Notably, traditional mutual funds trade only once per day, after trading on the major stock exchanges has stopped.
Exchange-traded funds (ETFs) By and large, ETFs are similar to traditional mutual funds. Both let you buy shares representing an interest in a portfolio of investments. Depending on its strategy, a fund may offer broad diversification across many investments or more focused exposure to a particular area of the market. Like traditional mutual funds, ETFs can be actively or passively managed. One of the differences is that unlike traditional mutual funds, ETFs trade throughout the day like stocks.
Index funds Index funds are passively managed ETFs or traditional mutual funds that simply seek to replicate the performance of major stock market indexes. In addition to the S&P 500, common indexes include the Dow Jones Industrial Average,2 Nasdaq Composite,3 and Russell 2000.4 Index funds may be aligned to the US stock market at large, specific sectors of the stock market, stocks in different countries, and even bond indexes.
Target date and target allocation funds As their name implies, target date and target allocation funds are mutual funds that have a target in mind.
Target date funds provide a single-fund option, typically for retirement investing or college saving. You simply pick a fund whose target year matches when you want to retire or when you expect your student to begin college and contribute money to it. Then the fund manager updates the fund's asset allocation over time so that they're more aggressive during accumulation years and more conservative when the fund reaches its target date and beyond.
Target allocation funds aim to maintain a specific target split of asset classes, such as 80% stocks and 20% bonds. They shift their holdings periodically as markets move to keep the fund's target split.
Advantages of funds
Convenience With investment funds, you don't have to worry about conducting extensive, granular investment-level research yourself or choosing the most opportune time to buy shares of a particular company. Instead, you're turning to the expertise of fund management professionals—or even simply the market itself, in the case of index funds. What's more, products such as target date funds allow you to easily invest in a whole professionally managed portfolio of investments in one place.
Diversification When you invest in individual stocks, you concentrate your dollars in a handful of companies, which can raise the risk that you lose the money you invest. By buying into a fund, you're spreading your investments across tens or perhaps hundreds of stocks, bonds, or other securities. This may lower the risk that any poor-performing investment brings down your entire portfolio's value.
The bottom line on funds
While funds can make it easier to build and manage a diversified portfolio, they still involve investment risk. Make sure you buy funds that align with your financial goals, willingness to take on risk, and investing timeline.