Understanding the 4 main types of mutual funds is the first step in choosing the right one for you

• Mutual funds fall into four main types: equity funds, bond funds, hybrid funds, and money market funds.
• Equity funds tend to be riskier, while bond funds are generally more risk averse.
• Knowing the different types can help investors find the one that best suits their financial goals.

Mutual funds are among the most popular ways to invest. They pool investors' money to create a large portfolio of stocks and bonds, or even commodities like precious metals or raw materials. Mutual funds do the research and investment for you and are therefore one of the easiest ways to diversify your assets.

Investors looking into mutual funds can be faced with an overwhelming number of choices. Varying investment objectives, management approaches, and target securities account for the biggest difference between the main types of mutual funds. And different types often have very different risk factors and investment outcomes. In the broadest sense, there are four main types of mutual funds: equity funds, bond funds, hybrid funds, and money market (or short-term debt) funds. We'll go over these in detail below.

1. Equity Funds

Equity funds invest in stocks from corporations anywhere in the world. These funds are among the most popular.

Equity funds focus on more aggressive investment growth than other mutual fund types, particularly over the long term. Because equity funds seek high rewards, they are considered higher risk. However, over the long term equity funds can generate a much higher yield than other mutual funds. Though stock investments can be volatile, equity funds offer more portfolio diversity than many of the other mutual fund types and individual stock investments.

When talking about equity funds, they are typically further broken down into various categories depending on their makeup and investment objectives. These include:

Funds based on company size

Equity funds that are based on the market value of the companies they invest in are broken down into three main groups:

• Large-cap — (more than $10 billion)
• Mid-cap — (between $2 billion and $10 billion)
• Small-cap — (between $300 million and $2 billion)

"Remember there are more than 10,000 equity mutual funds, yet there are only 2,800 stocks that trade on the New York Stock Exchange," says Clark Kendall, president and CEO of Kendall Capital. "Equity mutual funds do a great job of slicing and dicing the equity markets however you would like to have your market served to you."

Sector funds

To slice up equity markets into investable pieces, funds may also focus on investing in individual economic sectors and break up larger index funds into smaller investable pieces.

The primary sectors equity investors focus on are:

• Information technology

• Health care

• Financials

• Consumer discretionary

• Communications services

• Industrials

• Consumer staples

• Energy

• Utilities

• Real estate

• Materials

Funds based on investing strategy

Another way funds are categorized is by the investing strategy they use, including two of the most popular: growth and value.

• Growth funds invest in securities that are considered to have high potential to outperform the market and in turn produce high yields.

• Value funds instead invest in companies that are considered to be undervalued on the stock market and thus have a high potential for high return on investment.

Funds that track an index

Index funds invest in the securities found in an underlying index in an attempt to match their market performance. Some of the most popular include the S&P 500 and the Dow Jones Industrial Average. Index funds are managed much less actively than most mutual funds. As such, they often have lower fees while offering higher yields than more conservative options such as money market or fixed-income funds.

"There is no stock picking involved in managing an index fund," says Sam Dogen, author and founder of Financial Samurai. "The fund manager simply buys all of the stocks or bonds in the index it tracks and rebalances accordingly when positions are added or dropped from the index."

Funds based on geographic location

Some equity funds also may invest solely in securities from specific geographic regions, countries, and emerging markets.

Socially and environmentally responsible funds

A more recent trend in mutual funds has been "impact investing." They target companies or projects committed to specific social or environmental causes.

These funds cater to investors who are increasingly looking to direct their money to companies that are making positive social or environmental impacts in the world. While many perform well, the return on impact investments may be lower than more traditional investments.

Quick tip: Over the long term, equity funds can generate a much higher yield than other mutual funds. Though stock investments can be volatile, equity funds offer more portfolio diversity than many of the other mutual fund types and individual stock investments.

2. Bond funds

Bond funds, also known as fixed-income funds, are more conservative than equity funds, and primarily seek to generate income for investors through the collection of interest which is then distributed to the investors in the fund. Though bond funds are more conservative than equity funds, some can be aggressive and seek higher returns, and some can, conservatively, seek consistent income from less volatile and lower yield securities. Fixed-income funds can vary greatly in terms of volatility, risk, and priorities.

Bond funds are further broken out into three main categories of investment:

• Corporate bonds: issued by corporations that mature over a period of time and pay interest if you hold the bond to maturity
• Government bonds: issued by the US government, including Treasury securities, with fully taxable interest from a federal level and tax-free from a state level

• Municipal bonds: issued by local governments and other authorities to pay for projects such as projects such as toll roads, stadiums, and hospitals; interest is exempt from federal taxation and in many cases state and local taxation as well

  Quick tip: If you invest in municipal bonds, the interest you earn is exempt from federal taxation, and if you buy the bonds in the state where you live they are also exempt from state taxation.

3. Hybrid funds

Hybrid funds invest in two or more asset classes whereas other mutual funds tend to invest in a single asset class. Hybrid funds often combine stocks and bonds, but may even include commodities like raw materials or precious metals. The goal of a hybrid fund is to reduce risk by further diversifying the investors' portfolio, even more so than other mutual fund types. Further, hybrid funds can offer an investor a combination of income generation, capital gains, and increased net asset value (NAV).

4. Money market funds

Money market funds invest primarily in cash, short-term debt, and government securities. These funds typically carry the least amount of risk. Money market funds attempt to maintain their NAV and pay investors with any interest generated by the securities they hold.

Money market funds are often used by investors who need their investments to be liquid or have a short time before they need to access their funds for something else like personal purchases. Income generated by some money market funds can be tax-free. The conservative nature and regulation by the Securities and Exchange Commission of these funds make them attractive for the risk-averse investor, but they do not often have high rewards.

Quick tip: Money market funds are typically not a good place to keep your money for very long. Over time the low yield of the fund may not match the rate of inflation, management fees, or tax liabilities.

The financial takeaway

When choosing a mutual fund, an investor must know what they are looking to get out of the investment. Before investing, identify if you are seeking out dividend payments or other forms of income, capital gains, or increased value of the underlying assets, and how averse to the risk you are.

Knowing this, investors can better match themselves with a mutual fund by reading up on the prospectus that lays out the fund's investments, strategy, and other key details. Mutual funds are a great way to increase portfolio diversity, but like all investments have elements of risk to consider before investing.