FINANCIAL AWARENESS BULLETINS

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Vol. XV, No. 6
August 2007

Investment Fund Categories

Summary

Over the past decade, American investors increasingly have turned to variable funds to save for retirement and other financial goals. As with other investment choices, investing in variable funds involves risk. It pays to understand how to choose products that match goals and tolerance for risk.

Introduction

This Financial Awareness Bulletin reviews the bewildering array of investment fund categories. Investors need to understand the different level of risk they are willing to bear and match it to their investments.

RISK TOLERANCE

Each investor has to determine his/her own risk tolerance. Risk tolerance relates to the level of yield and volatility with which one is comfortable based on personal investment goals. For example, an investor who is close to retirement may not want to risk the possibility of a poor or negative investment return just before it is time to withdraw funds. On the other hand, a younger investor who can afford the ups and downs of the stock market may decide to invest in a stock fund with the hope of obtaining the highest return over the long term. A better option for most individuals, however, would probably be dividing the investment between several fund objectives with varying levels of risk and volatility. Using asset diversification, an investor can take advantage of potentially higher yields while simultaneously protecting himself/herself against higher risk and potentially significant losses.

Once the investor has decided upon a suitable investment approach, he or she must first decide upon investment objectives and then look at comparable asset categories that are likely to meet those objectives. When comparing categories, the investor needs to consider both performance and volatility, keeping in mind that a fund's past performance record is no guarantee of future performance.

Risk, Yield and Volatility

Over the long-term, investment performance is, by far, the most important factor in determining the ultimate value of the assets. An understanding of risk and yield and their relationship to each other is very important.

Yield. Yield means the total return, including income as well as realized and unrealized gains and losses. Investment yields vary for different types of investments. Bank savings accounts are at the low end of the yield spectrum. Common stocks are often at the high end, with yields sometimes in excess of 30%.
Risk. Although yield is an important factor, the investor must also consider the issue of risk. The term risk means that the yield on the investment changes from one period to the next (i.e., that the investment yield is volatile).
Volatility. For the long-term investor, volatility should not be a major concern, since the investment will be held through one or more market cycles. Investments with higher volatility will tend to have higher returns during the upward swings of the cycle and lower or even negative returns during the downward swings. The expectation (but not guaranteed) is that, over the complete cycle, total return on a higher volatility investment will be higher than that of a lower volatility investment during the same period.

The hierarchy of investment types ranges from the lowest yield and volatility to the highest yield and volatility in this order: bank savings accounts, certificates of deposit, money market funds, corporate bonds, preferred stocks, and common stocks. It is important to remember that this hierarchy will not necessarily hold for every single year or even for a given period of time.

INVESTMENT FUND CATEGORIES

Most funds fall into one of three main categories — money market funds, bond funds (also called "fixed income" funds), and stock funds (also called "equity" funds). Each category has different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss.

Money Market Funds

Money market funds have relatively low risks compared to other mutual funds (and most other investments). By law, they can invest in only certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments. Money market funds try to keep their net asset value (NAV) — which represents the value of one share in a fund — at a stable $1.00 per share. But the NAV may fall below $1.00 if the fund's investments perform poorly.

Bond Funds

Bond funds generally have higher risks than money market funds, largely because they typically pursue strategies aimed at producing higher yields. Unlike money market funds, the U.S. Securities and Exchange Commission rules do not restrict bond funds to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.

Stock Funds

Although a stock fund's value can rise and fall quickly (and dramatically) over the short term, historically stocks have performed better over the long term than other types of investments — including corporate bonds, government bonds, and treasury securities. Overall "market risk" poses the greatest potential danger for investors in stock funds. Stock prices can fluctuate for a broad range of reasons, such as the overall strength of the economy, current inflation, balance of trade, corporate earnings, or demand for particular products or services.

Fund Investment Objectives

A fund's investment objective will define what type of investments the fund manager(s) will make. This, in turn, determines its potential yield and risk level. Listed below are classifications of investment objectives used by Lipper Analytical Services, Inc., a well respected firm in the business of analyzing investments.

Money Market Funds

MM-MM: Money Market Instrument Funds. Invests in high-quality financial instruments with average maturities of less than 90 days. No investments with maturities exceeding one year. These funds intend to keep a constant net asset value.

Stock (Equity) Funds

CA: Capital Appreciation Fund. Aims at maximum capital appreciation, frequently by means of 100% or more portfolio turnover, leveraging, purchasing unregistered securities, purchasing options, etc. The fund may take large cash positions.
SG: Small-Company Growth Fund. By prospectus or portfolio practice, limits its investments to companies on the basis of the size of the company.
G: Growth Fund. Normally invests in companies whose long-term earnings are expected to grow significantly faster than the earnings of the stocks represented in the major unmanaged stock indices.
GI: Growth & Income Fund. Combines a growth of earnings orientation and an income requirement for level and/or rising dividends. Includes index funds.
EI: Equity Income Fund. Seeks relatively high current income and growth of income through investing 60% or more of its portfolio in equities.
IE (or IF): International Equity Fund. Invests its assets in securities whose primary trading markets are outside the U.S.

Balanced Funds

These funds maintain portfolios of both stocks and bonds. The following three Lipper investment objectives meet these criteria and give additional detail. The general investment objective BA is shown with the more detailed Lipper investment objective in parentheses. Note that Lipper gives a more specific definition for balanced funds.

BA(B): Balanced Fund. Primary objective is to conserve principal by maintaining at all times a balanced portfolio of both stocks and bonds. Typically, the stock/bond ratio ranges around 60% / 40%.
BA(FX): Flexible Portfolio Fund. Allocates its investments across various asset classes, including domestic common stocks, bonds, and money market instruments, with a focus on total return.
BA(I): Income Fund. A fund which normally seeks a high level of current income through investing in income producing stocks, bonds, and money market instruments, with some emphasis on net asset value protection.

High-Yield Funds

HY(FI-HY): High Current-Yield Fund. Aims at high (relative) current-yield from fixed income securities. No quality or maturity restrictions. Tends to invest in lower-grade bonds.

Fixed Income Funds

These funds have the large majority of their assets in bonds and have income as their primary objective. The following Lipper Investment objectives add detail to this general definition. The general investment objective FI is shown with the more detailed Lipper investment objective in parentheses.

FI(FI-A): Corporate Bond Fund. Invests 65% or more of assets in corporate debt issues rated AAA or better, or in governments.
FI(FI-BBB): Corporate Bond Fund. Invests at least 65% in corporate and government debt issues rated in the top four grades.
FI(FI-GB): General Bond Fund. Does not have any quality or maturity restrictions.
FI(FI-GNM): GNMA Fund. Invests a minimum of 65% of assets in Government National Mortgage Association securities.
FI(FI-GUS): U.S. Government Fund. Invests at least 65% of assets in U.S. Treasury and Agency issues.
FI(FI-SID): Short (1-5) Investment Grade Debt Fund. Invests at least 65% of assets in investment grade debt issues (rated in top four grades) with average maturities of five years or less.
FI(GI): Global Income Fund. Invests primarily in U.S. dollar and non-U.S. dollar debt instruments with unspecified maturities or duration, or other income-producing securities.

Other Investment Objectives

These are less common investment objectives (not assigned a relative volatility).

GL: Global Fund. Invests at least 25% of its portfolio in securities traded outside of the U.S. and may own U.S. securities as well.
GX: Global Flexible Portfolio Fund. Allocates its investments across various asset classes, including both domestic and foreign stocks, bonds, and money market instruments, with a focus on total return. At least 25% of its portfolio is invested in securities traded outside of the U.S.
S: Specialty & Miscellaneous Fund. A fund which limits its investments to a specific industry (e.g., health, financial, technology, transportation, retailing, etc.) or one that has not been classified into an existing investment objective. Includes funds with social or environmental objectives or criteria.

NEA MEMBER BENEFITS

NEA members can learn more about investing through free online financial planning and investing seminars. The Investing in Your Future program provides members access to quality investment education in a convenient, on-demand format. Register here or call toll free at 1-800-637-4636, Monday – Friday, 8 a.m. to 8 p.m. (or Saturday, 9 a.m. to 1 p.m.) ET. The seminars are provided by NEA Member Benefits and BetterInvesting (the National Association of Investors Corporation) through a grant from the NASD Investor Education Foundation.

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Vol. XV, No. 6 August 2007

Investment Fund Categories

Vol. XV, No. 6
August 2007