Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks

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Management of Financial Institutions - MGT 604

Lecture # 24

Mutual Funds

Balanced Funds

The basic objectives of balanced funds are to generate income as well as long-term growth

of principal. These funds generally have portfolios consisting of bonds, preferred stocks,

and common stocks. They have fairly limited price rise potential, but do have a high degree

of safety, and moderate to high income potential.

Investors who desire a fund with a combination of securities in a single portfolio, and who

seek some current income and moderate growth with low-level risk, would do well to invest

in balanced mutual funds. Balanced funds, by and large, do not differ greatly from the

growth and income funds described above.

Growth Funds

Growth funds are offered by every investment company. The primary objective of such

funds is to seek long-term appreciation (growth of capital). The secondary objective is to

make one's capital investment grow faster than the rate of inflation. Dividend income is

considered an incidental objective of growth funds.

Growth funds are best suited for investors interested primarily in seeing their principal grow

and are therefore to be considered as long-term investments - held for at least three to five

years. Jumping in and out of growth funds tends to defeat their purpose. However, if the

fund has not shown substantial growth over a three - to five-year period, sell it (redeem your

shares) and seek a growth fund with another investment company. Candidates likely to

participate in growth funds are those willing to accept moderate to high risk in order to

attain growth of their capital and those investors who characterize their investment

temperament as "fairly aggressive.

Index Funds

The intent of an index fund is basically to track the performance of the stock market. If the

overall market advances, a good index fund follows the rise. When the market declines, so

will the index fund. Index funds' portfolios consist of securities listed on the popular stock

market indices.

It is also the intent of an index fund to materially reduce expenses by eliminating the fund

portfolio manager. Instead, the fund merely purchases a group of stocks that make up the

particular index it deems the best to follow. The stocks in an index fund portfolio rarely

change and are weighted the same way as its particular market index. Thus, there is no need

for a portfolio manager. The securities in an index mutual fund are identical to those listed

by the index it tracks, thus, there is little or no need for any great turnover of the portfolio of

securities. The funds are "passively managed" in a fairly static portfolio. An index fund is

always fully invested in the securities of the index it tracks.

An index mutual fund may never outperform the market but it should not lag far behind it

either. The reduction of administrative cost in the management of an index fund also adds to

its profitability

Sector Funds

As was discussed earlier, most mutual funds have fairly broad-based, diversified portfolios.

In the case of sector funds, however, the portfolios consist of investment from only one

Management of Financial Institutions - MGT 604

sector of the economy. Sector funds concentrate in one specific market segment; for

example, energy, transportation, precious metals, health sciences, utilities, leisure industries,

etc. In other words, they are very narrowly based.

Investors in sector funds must be prepared to accept the rather high level of risk inherent in

funds that are not particularly diversified. Any measure of diversification that may exist in

sector funds is attained through a variety of securities, albeit in the same market sector.

Substantial profits are attainable by investors astute enough to identify which market sector

is ripe for growth - not always an easy task.

Specialized Funds

Specialized funds resemble sector funds in most respects. The major difference is the type

of securities that make up the fund's portfolio. For example, the portfolio may consist of

common stocks only, foreign securities only, bonds only, new stock issues only, over - the -

counter securities only, and so on.

Those who are still novices in the investment arena should avoid both specialized and sector

funds or the time being and concentrate on the more traditional, diversified mutual funds

instead

Islamic Funds

In case of Islamic Funds, the investment made in different instruments is to be in line with

the Islamic Shairah Rules. The Fund is generally to be governed by an Islamic Shariah

Board. And then there is a purification process that needs to be followed, as some of the

money lying in reserve may gain interest, which is not desirable in case of Islamic

investments.

Risks in Mutual Fund Investing

There is some degree of risk in every investment. Although it is reduced considerably in

mutual fund investing. Do not let the specter of risk stop you from becoming a mutual fund

investor. However, it behaves all investors to determine for them the degree of risk they are

willing to accept in order to meet their objectives before making a purchase. Knowing of

potential risks in advance will help you avoid situations in which you would not be

comfortable. Understanding the risk levels of the various types of mutual funds at the outset

will help you avoid the stress that might result from a thoughtless or a hasty purchase.

Let us now examine the risk levels of the various types of mutual funds.

Low Level Risks

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Moderate level Risks

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High Level Risks

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Measuring Risks

LOW-LEVEL RISKS

Mutual funds characterized as low-level risks fall into here categories

Management of Financial Institutions - MGT 604

1. Money market funds

2. Treasury bill funds

3. Insured bond funds

MODERATE-LEVEL RISKS

Mutual funds considered moderate-risk investments may be found in at least the eight types

categorized below.

1. Income funds

2. Balanced funds

3. Growth and income funds

4. Growth funds

5. Short-term bond funds (taxable and tax-free)

6. Intermediate bond funds (taxable and tax-free)

7. Insured government/municipal bond funds

8. Index funds.

HIGH-LEVEL RISKS

The types of funds listed below have the potential for high gain, but all have high risk levels

as well.

1. Aggressive growth funds

2. International funds

3. Sector funds

4. Specialized funds

5. Precious metals funds

6. high-yield bond funds (taxable and tax-free)

7. Commodity funds

8. Option funds

MEASURING RISK

As you become a more experienced investor, you may want to examine other, more

technical, measures to determine risk factors in your choice of funds.

Beta coefficient is a measure of the fund's risk relative to the overall market. For example,

a fund with a beta coefficient of 2.0 means that it is likely to move twice as fast as the

general market both up and down. High beta coefficients and high risk go hand in hand.

Management of Financial Institutions - MGT 604

Alpha coefficient is a comparison of a fund's risk (beta) to its performance. A positive

alpha is good. For example, an alpha of 10.5 means that the fund manager earned an

average of 10.5% more each year than might be expected, given the fund's beta.

Interest rates and inflation rates are other factors that can be used to measure investment

risks. For instance, when interest rates are going up, bond funds will usually be declining,

and vice versa. The rate of inflation has a decided effect on funds that are sensitive to

inflation factors; for example, funds that have large holdings in automaker stocks, real estate

securities, and the like will be adversely affected by inflationary cycles.

R-Square factor is a measure of the fund's risk as related to its degree of diversification.

The information is supplied here merely to acquaint you with the terminology in the event

you should wish to delve more deeply into complex risk factors. The more common risk

factors previously described are all you really need to know for now, and perhaps for years

to come.

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