The growth in the number of mutual funds is, in part, a
reflection of the variety of investment styles employed by fund
managers. The following is an overview of some of the key spectrums
of investment style.
Active vs. Passive
Active investors believe in their ability to outperform the
overall market by picking stocks they think will perform well.
Passive investors, on the other hand, feel that simply investing in
a market index fund will produce higher long-term results. Passive
investors believe this is due to market efficiency. In other words,
they feel that all information available about a company is
reflected in that company's current stock price, and it's
impossible to predict and profit on future stock prices. Rather
than trying to second-guess the market, passive investors buy the
entire market via index funds.
Active investors counter that the market is not always efficient
and that through research, active fund managers may be able to
uncover information not already reflected in a security's price and
potentially profit by it. For example, some active investors feel
that the small-cap market is less efficient than the large-cap
market since smaller companies are not followed as closely as
larger blue-chip firms. A less efficient market could potentially
favor active stock selection, they reason.
Growth vs. Value
Some stock fund managers can be divided into growth and value
seekers. Proponents of growth seek companies they expect (on
average) to increase earnings by 15% to 25%. Stocks in these
companies tend to have high price to earnings ratios (P/E) since
investors pay a premium for higher potential returns. They also
usually pay little or no dividends. The result is that growth
stocks tend to be more volatile, and therefore more risky.
Value investors look for bargains -- stocks perceived to be
undervalued that are often out of favor, such as cyclical stocks
that are at the low end of their business cycle. A value investor
is primarily attracted by asset-oriented stocks with low prices
compared to underlying book, replacement, or liquidation values.
Value stocks also tend to have lower P/E ratios and higher dividend
yields. These higher yields tend to cushion value stocks in down
markets while certain cyclical stocks will lead the market
following a recession.
Other investors choose not to lock themselves into either
investment style. Returns on growth stocks and value stocks may not
be correlated. This means that an increase or decrease in one
style's returns may occur independently of the other. By
diversifying between growth and value, investors can reduce some
risk and still enjoy long-term return potential.1
Mutual Fund Investment Styles
Active -- Strives to outperform the market by
actively picking out the stocks.
Passive -- Believes that investing in a market
index will produce better long-term results.
Growth -- Seeks out growth stocks with high P/E
Value -- Picks asset-oriented "cheap" stocks
with lower P/E ratios.
Small Cap -- Prefers small-cap stocks for their
higher potential for growth.
Large Cap -- Believes that large-cap stocks
provide less volatility and can still outperform small-cap
Target Date -- Automatically rebalances asset
allocation over the years.
Sector -- Focuses on industry sectors such as
utilities, financial services, technology, or health care.
Some investors use the size of a company as the basis for
investing. At times, the highest returns -- on average -- have come
from stocks with the lowest market capitalization (common shares
outstanding multiplied by share price). But since returns tend to
run in cycles, there have also been periods when large-cap stocks
have outperformed smaller stocks. Small-cap stocks also tend to
have higher price volatility, which translates into higher risk.
Some investors choose the middle ground and invest in midcap stocks
-- seeking a trade-off between volatility and return.
With target-date funds, your portfolio's asset allocation is
automatically rebalanced on your behalf over the years by the
fund's managers, typically growing more conservative as the
identified target date approaches. Generally speaking, the name of
each target-date fund includes a specific year, such as "2020" or
"2030." All you need to do is choose a fund named for the year
closest to the year of your goal. From that point on, professional
investment managers make all the investment decisions.
Sector funds are mutual funds that invest in sectors such as
utilities, financial services, technology, or health care, to name
a few. They target specific industries and economic niches to seek
above-average returns. Although these funds may reduce individual
security risk, some may fluctuate in value more than diversified,
multi-sector funds. These funds may also include a greater
percentage of small-cap stocks, which may offer greater opportunity
for growth but at the expense of potentially greater risk.
Don't Judge a Fund by Its Cover
With such a wide variety of investment styles, individual fund
investors may be confused as to which is the best. In order to
reduce volatility, many experts encourage diversifying or spreading
money around among different investment styles. Fund investors need
to ask questions, carefully read the fund prospectus, and consult
fund rating services to make sure they are buying a style that is
right for them.