The Mutual Funds Market

There are three main categories of mutual funds:

Stock funds, also called equity funds, invest primarily in stocks
Bond funds invest primarily in corporate, agency, or government bonds
Money market funds make short-term investments, trying to keep their share value fixed at $1

FIRST MUTUAL FUND
The first investment trust, a forerunner of modern mutual funds, was put together by Robert Fleming in the 1800s. Fleming collected money from some fellow Scots and traveled to the US, where he invested — with notable success — in growing enterprises. And he shared the profits with other investors.

The first US mutual funds, The Massachusetts Investors Trust and the State Street Research Investment Trust, were established in 1924 and are still doing business. But today there are almost 8,000 mutual funds to choose from.

THE PART DIVERSITY PLAYS
Most funds diversify their holdings by buying a wide variety of investments that correspond to their category. A typical stock fund, for example, might own stock in 100 or more companies providing a range of different products and services. The value of diversification is that losses from some stocks may be offset — or even outweighed — by gains in others.

On the other hand, some funds are extremely focused. For example:

Precious metal funds trade chiefly in mining stocks
Sector funds buy shares in a particular industry, such as healthcare, electronics, or utilities
High-yield bond funds buy low-rated bonds

The appeal of focused funds is that when they're doing well, the returns can be outstanding. The risk is that a change in the economy or in the sector can wipe out any gains and even produce substantial losses.

STOCK FUNDS
The name says it all: Stock funds invest in stocks. But stock fund portfolios vary, depending on the fund's investment objectives. For example, some stock funds invest in well-established companies that pay regular dividends. Others invest in younger, more growth-oriented firms or those that have been operating below expectation for several years.

Unlike individual investors, who might buy stocks with different market capitalizations to diversify their portfolios, a fund often concentrates in one area, like blue chips, mid-cap, or small-company stocks. A fund's prospectus identifies its major holdings and its investment goals — though funds sometimes buy more widely to try to provide stronger returns.

There are several different types of stock funds. A key distinction among them is that some stress growth, some income, and some a combination of the two. Some funds involve more risk to capital than others because they buy stock in emerging companies. But all equity investing involves risk, including the possibility that you could lose principal. The profits on all stock fund distributions are taxable (unless you hold them in a tax-deferred retirement account), but no tax is due on the increased value of a fund until you sell it.

BOND FUNDS
Like bonds, bond funds produce income. Unlike bonds, however, these funds have no maturity date and no guaranteed repayment of the amount you invest.

On the plus side, though, you can automatically reinvest your dividends to buy more shares. And you can buy shares in a bond fund for much less than you would need to buy bonds on your own — and get a diversified portfolio to boot. For example, you can invest $1,000 to open a fund account, and make additional purchases for smaller amounts.

Bond funds come in many varieties, with different investment goals and strategies. There are investment-grade corporate bond funds and riskier junk bonds often sold under the promising label of high-yield funds. You can choose long- or short-term US Treasury funds, funds that combine bond issues with different maturities, and a variety of tax-free municipal bond funds, including some limited to particular states. Other funds buy agency bonds, such as mortgage-backed Ginnie Maes.

The two main categories of bond funds are taxable and tax-free. Distributions earned on corporate and US government funds (including Treasurys and agency funds) are taxed. There's no federal tax on municipal bond fund distributions, and no state or local taxes for investors who live in the municipality that issues the underlying bonds. New Yorkers, for example, can buy triple-tax-free New York funds and keep all their interest earnings.

MONEY MARKET FUNDS
Money market funds invest to maintain their value at $1 a share, so that they're described as cash equivalent investments. Money market funds are not FDIC-insured, so you could lose money, although a few funds do offer their own insurance.

Most money market funds let investors write checks against their accounts. There's usually no charge for check-writing — although there may be a per-check minimum. In that way, the funds resemble interest-bearing checking accounts, but typically pay higher rates and may require smaller minimum deposits.

Money market funds also come in two varieties, taxable and tax-free. Taxable funds buy the best-yielding short-term corporate, agency, or government issues available, while tax-free funds are limited to buying primarily municipal debt. Taxable funds pay slightly higher income than tax-free funds, but you must pay tax on any distributions they make. In either case, the rate a fund pays is roughly the same as bank money market accounts or CDs.

IT'S ALL IN THE FAMILY
Mutual fund companies usually offer a variety of funds — referred to as a family of funds — to their investors. Keeping your money in the family can make it easier to transfer money between funds, but, like most families, some members do better than others.

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