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Focused Mutual Funds

These days, stock-based funds are still the largest category of mutual funds. But as the market for different types of mutual funds has expanded, fund companies have responded to investor demand by creating products tailored to the needs of investors with specific goals.

A caveat: you're never guaranteed that a fund will meet its objective, or keep the same investment objective forever.

Bond Funds

You can buy shares in a bond mutual fund, just as you do with a stock fund. Bond mutual funds invest in portfolios of individual bonds, while stock funds invest in individual companies and group them together into a basket of securities.

Like stock funds, bond funds are available in many varieties and each fund has an investment objective and a strategy for achieving it. For example, you can buy corporate bond funds, US Treasury funds, or municipal bond funds (which invest in bonds issued by state and local governments). Some funds focus on bonds with longer durations and others focus on those with shorter terms. Some purchase highly rated bonds that may pay the fund a lower interest rate but are considered less risky, while others focus on lower-quality, higher-yield bonds.

Bond mutual funds aim to pay out interest income to investors. And if the fund sells bonds in its portfolio at a profit, it pays capital gains distributions to shareholders. Unlike old-school bonds, bond funds have no maturity date. Similar to bonds, they won't guarantee repayment of principal, or to return the original amount you invested. The dollar amount (known as net asset value) you receive by selling your shares back to the mutual fund will depend on market conditions.

Another difference between bond funds and individual bonds is that if the fund pays distributions, you can reinvest your distributions to buy additional shares. What's more, you can buy shares in a diversified bond fund for much less than it would cost you to buy just a single individual bond.

Tax-free Bonds

Most mutual fund earnings are taxable if you own the fund in a taxable account. The exception is when you invest in mutual funds that pay tax-free distributions. Tax-free income is particularly appealing to people in higher tax brackets, since they may benefit at tax time despite the fact that tax-free funds typically pay interest at a lower rate than taxable funds of the same creditworthiness. The other side of that is that it may not make sense for investors in lower tax brackets.

The biggest tax savings occur when a person who lives in a high-tax state, such as New York or California, buys shares of a fund that owns bonds issued in that state. When this happens, no state or federal income tax is due on the interest the fund pays (but you may be responsible for taxes on any capital gains).

The dilemma that many tax-free funds face is finding enough high-quality investments to meet investor demands. In some cases, they also buy bonds from other municipalities. This means the investor will owe tax in his or her home state on the portion of earnings that comes from other states' bonds.

Sector Funds

Sector funds focus on the stocks of a particular part of the economy, such as energy, pharmaceuticals, or telecommunications. In that sense, they provide less diversification than funds that invest across multiple sectors. Although you may be better off when you own a sector fund versus a single stock in that sector, you still have a lot of potential risk if that sector as a whole takes a hit.

Some sectors are highly volatile, so they may provide larger gains to investors willing to take on risk and who buy shares at the right time. Typically, though, one year's hot sector is flat the next. Many investors make the mistake of buying too late, after all of the potential gains have already been realized.

Market Neutral Funds

Some mutual funds participate in market neutral investing. This is also known as zero beta or long/short portfolio investing.

Market neutral funds don't want to beat the market, as most actively managed funds do. Rather, they seek to provide stability with an average annual return that's a few points higher than the return on three-month US Treasury bills, independent of whether the market is going up or down.

These funds evaluate and rank possible investments using quantitative research, analyzing factors such as price/earnings ratios, yield, volatility, and earnings growth. The funds then buy the top-ranking stocks and sell short the ones ranked at the bottom.

Since meeting the fund's goals depends so heavily on accurate assessments of future market movements, a fund manager's decision-making skills may even be more crucial to overall return than if the fund were following a more conventional trading approach. For that reason, some market neutral funds use multiple managers to diversify risk.

Socially Responsible Funds

Mutual fund companies have also created funds to attract investors who want to use their money in ways that are consistent with their beliefs or values. A socially responsible fund might avoid companies with poor environmental records, those with certain employment policies, or those that manufacture or sell specific products.

You can read a fund's prospectus to the find the criteria, called screens, it uses to identify acceptable socially responsible investments.

Funds of all types, including stock funds, bond funds, and index funds, can be socially responsible. They may also be identified as green funds or conscience funds.