Funds focused on stocks, for example, are generally split between growth and value profiles which both seek capital appreciation. Growth funds invest heavier in large and reliable companies that are expected to gain in their share prices due to strong financial fundamentals. Value funds, on the other hand, look for companies that are expected to gain in share price because they are trading at a discount. Funds are additionally available, blended anywhere between growth and value.
Mutual funds weighted towards stocks may focus on companies with either large or small market capitalizations affecting risk levels and returns. Small market capitalization companies, or “small caps,” experience higher volatility while large market capitalization companies, or “large caps,” enjoy more stability. Small caps will rise quicker and fall quicker relative to their large cap counterparts. Thus, risk levels and investment goals heavily implicate whether small or large cap funds are better investments for the individual investor. Investors seeking larger returns and are willing to take on greater risk may prefer small caps. To the contrary, investors who prefer stability and less risk may look towards large cap mutual funds.
Additionally, mutual funds often target specific goals. These funds may invest geographically, focusing on companies from particular areas around the world to take advantage of emerging markets. Funds also target particular years for retirement. Investors who seek to invest for retirement can find mutual funds targeting their expected retirement year.
Many mutual funds are weighted towards bonds rather than stocks. Investors may choose from funds focusing on municipal bonds, state-specific bonds, treasury bonds, corporate bonds, high or low yields (correlating with risk), long or short maturities, among others.
Given the wide variety of mutual funds, investors should work closely with their investment advisors to choose funds that match the investor’s goals and risk appetite. Investment advisors have a duty to understand the funds they recommend and to understand which mutual funds are suitable for their clients. This is a fiduciary relationship subject to FINRA and SEC regulation. Factors required for consideration into a client’s suitability for investment recommendations include the investment objectives, investor’s financial situation and needs, investor’s experience, investment time horizon, investor’s age, investor’s other investments, tax status, liquidity needs, and risk tolerance. FINRA Rule 2111.
Furthermore, suitability is not judged by ultimate profitability of the investment but is rather based on the reasonableness of the advisor’s recommendation in light of the factors listed above. In the Matter of the Arb. Between: Michael F. Zinn As Co-Tr. & Beneficiary of the Zinn Fam. Charitable Tr., (Claimant ), No. 02-00366, 2003 WL 21262095, at *6 (May 21, 2003). Suitability is judged at the time the investments were made. In the Matter of the Arb. Between: Claimant, Robert Anthony Daly , No. 19-02983, 2020 WL 4217489, at *4 (July 27, 2020). However, investors and investment advisors should continue to mind investments relative to changes to the factors considered for suitability.
Importantly, the suitability requirement does not apply to investments executed based on investor’s directions, although this exception mainly applies to sophisticated investors. Sheldon Co. Profit Sharing Plan and Trust v. Smith , 828 F. Supp. 1262, Fed. Sec. L. Rep. (CCH) ¶ 98081 (W.D. Mich. 1993). The SEC defines a sophisticated investor as one who has “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.” Securities and Exchange Commission Rule 506 of Regulation D. The suitability requirement does apply, as well, to fees associated with mutual funds. Benzon v. Morgan Stanley Distributors, Inc. , 420 F.3d 598, Fed. Sec. L. Rep. (CCH) ¶ 93,332, 2005 FED App. 0362P (6th Cir. 2005).