Mutual funds can be either passively managed or actively managed. Passive mutual funds, also known as index funds, invest in every company in an index that a fund follows. Index fund managers do not select stocks. The managers of active mutual funds pick stocks based on a fund's investment goals. While passive funds seek to match performance of the broad market, active funds seek to outperform the market. The higher expected return comes with potentially higher risk because managers' stock picks can go wrong from time to time.
Undervalued Stocks
Mutual fund managers who actively pick stocks do not believe that the stock market is entirely efficient, meaning that from time to time certain stocks are not correctly priced -- they are either undervalued or overvalued. One way to achieve higher returns is to find and buy undervalued stocks that will generate outsized returns once they are fairly valued by the market.
Growth Stocks
Some active mutual fund managers select growth stocks. The better a stock's growth prospects, the higher its potential investment returns. But stocks with significant growth prospects inevitably have higher risks, as growth stocks are often smaller companies without proven track records.
Quality Stocks
Some mutual fund managers may focus on picking primarily high-quality stocks. Investing in high-quality stocks is a lower-risk approach, as stocks with steady returns can accumulate in value over time. These stocks tend to be from well-known and large companies, also called blue chip stocks.
Sector Stocks
A disadvantage of index investing is that it ignores changing market and economic conditions. Different sectors tend to perform differently as they respond to various stages of a business cycle. Managers who pick stocks may add sector bias as an additional screening criterion. By eliminating under-performing sectors, fund managers try to maximize returns based on current market conditions.
Effects of Stock Picking
Because of the increased risk associated with picking stocks, actively managed mutual funds may earn lower returns than the market as a whole in certain years. Management fees are usually higher than those of passively managed index funds. In addition, buying and selling stocks frequently can lead to higher transaction costs, which are passed along to fund shareholders. Each stock sale also has tax implications. Frequent trading can result in short-term capital gains, which are subject to the higher ordinary income tax rate.
