Investment funds follow many different types of investment strategies. Income funds focus on stocks with high dividend yields, growth funds invest in stocks that are expected to have high capital appreciation, value funds follow stocks that are
considered to be undervalued, and short funds bet against stocks they consider to be overvalued. What types of investors are likely to be attracted to each of these types of funds? Why?
Income Funds. The main investors in income funds tend to be investors who need a relatively steady stream of income, or those with relatively low tax rates on ordinary income. Retirees and parents financing the educational costs of their children are two common groups that invest in income funds since the companies in the fund pay dividends that provide a relatively predictable stream of income. Investors with low ordinary income tax rates may also own income funds since they can earn higher after-tax returns from these funds relative to other investors. Firms with high dividend to stock price ratios tend to be lower risk firms in mature industries. Excess cash from their operations is returned to stockholders via dividends rather than reinvested in the firm. However, dividend income is not guaranteed which causes income funds to vary in their payouts to investors. Despite the fact that firms try to avoid lowering dividends, firms can and do change their dividend policy depending on their financial condition.
Growth Funds. Investors in growth funds are typically medium to long-term investors who are willing to assume additional risk in hopes of earning higher long-run returns. In addition, investors with high current tax rates may be attracted to growth funds because they typically generate capital gains, which can be deferred, rather than dividends. Firms in growth funds tend to be in new and rapidly expanding industries. Consequently, these firms tend to be riskier than average.
Value Funds. Investors in value funds are often medium to long-term investors who believe that it is possible to find undervalued firms using publicly available information and that any mispricing for undervalued firms is not corrected quickly. Furthermore, they expect the return on value funds to increase as the market begins to reprice undervalued stocks.
Short Funds. The typical investor in a short fund is willing to assume the considerable additional risk and expense related to short sales for the possibility of a higher return. The investment time horizon is typically shorter than those of either growth or value funds. Short fund investors believe it is possible to use publicly available information to find overvalued firms.
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