An investor should be familiar with the different classifications of mutual funds before investing in one. A mutual fund can invest in a group of stocks, bonds, money market instruments, securities of a specialized market sector, securities of a market index, or a combination of any securities. Mutual funds that invest in company stocks are often classified by company size and investment strategy.
Mutual funds use the term “market capitalization” to refer to the size of a company. Market capitalization, abbreviated as “market cap”, is the total value of a company, or total value of all of the outstanding shares of a company’s stock. Market cap is most often split into three categories: large-cap, mid-cap, and small-cap. Large-cap companies have a value of above $10 billion. Mid-cap companies have a value between $2 billion and $10 billion. Small-cap companies have a value below $2 billion. These value parameters can vary by source and can include additional categories such as mega-cap (over $200 billion) and micro-cap (under $300 million), but the large-cap, mid-cap, and small-cap classifications are the most commonly used.
Mutual funds also pursue an investment strategy by investing in growth stocks, value stocks, or a combination of the two. The primary goal of growth stocks is capital appreciation. Growth stocks trade at a high price relative to the company’s current value or earnings and can be considered currently over-valued. The expectation is that the company’s future value or earnings will be high enough to justify the currently high price. When investing in value stocks, the goal is to find currently under-valued stocks. Value stocks trade at a low price relative to the company’s current value or earnings. While the company’s stock may be currently valued low, the expectation is that the future value will be greater so as to match the not-yet-realized high value of the company. Many mutual funds invest in a blend of growth stocks and value stocks. Mutual funds that seek a combination of both the growth and value investment strategies are described as blended mutual funds.
Considering three choices for market cap and three choices for investment strategy, an investor has nine possible choices when selecting a type of mutual fund. Mutual fund companies like to represent these choices using a style box like the one shown below. Morningstar is credited with inventing the style box.
The mutual fund company will shade in the box that represents the style of the mutual fund. Some mutual funds may not be limited to one investment style. For example, some mutual funds can invest in small-cap and mid-cap blended stocks. Total stock market mutual funds will invest in stocks of all nine styles. A mutual fund must indicate in its prospectus which style it is primarily invested in and cannot change the investment style without a majority approval from the mutual fund’s investors.
Investors must decide which style agrees with their investment goals. Investment suitability varies by investor, so investors should not accept any universal recommendations. When investors research and compare the various investment styles, they should remember that historical returns represent historical performance only and provide no guarantee of future returns or performance. Investors should evaluate the fees, loads, and expense ratios of the mutual funds, as these all affect the total returns of the mutual funds. Before investing in a mutual fund, investors should know their investment goals, know the investment goals of the mutual funds, and select an appropriate mutual fund that agrees with their investment goals.
