The differences between investment instruments

Oran A. Hall, Contributor

QUESTION: I would like to know the differences between mutual funds, stocks, unit trusts, and bonds.

- Tasha

PFA: The marketable investment instruments you have asked about differ in several ways including whether they are debt or equity, their level of price variation, security of principal, how they generate income to the investor, whether they have a maturity date, the level of diversification they offer, and the ease of managing them.

Mutual funds are investment companies that invest in corporate and government securities and in other assets such as real estate.

The term mutual fund is generally used to refer to an open-end investment company, which issues and sells its own shares to the public when there is a demand for them and buys them back when their owners wish to sell them.

The value of each share is determined by subtracting the liabilities of the fund from the market value of the securities it owns and then dividing the result — called the net asset value — by the amount of shares outstanding. As such, prices fluctuate, depending on the value of the securities.

In some cases, the shares are sold at their net asset value. In other cases, they are sold at a higher price due to the addition of a sales charge known as the load. Investors desiring to liquidate their mutual fund investment must sell back to the company.

The investment objective of a fund - for example, growth, income — is often reflected in its name but sometimes it is described by the primary type of investments that it makes, so there are money-market funds and equity funds. Balanced funds invest in several different types of investment instruments.

Money-market funds do not generally lose value as the income earned is generally reinvested. On the other hand, funds that invest for growth — in stocks, for example — also reinvest income but their values fluctuate with the prices of the securities, so it is possible to lose capital on such an investment.

Mutual funds provide much scope for diversification, some types more than others, and where the investor is concerned, are generally easy to oversee because it is the mutual fund's fund managers who engage in the day-to-day management of the portfolio.

Unit trusts are quite similar to mutual funds. The primary difference is that whereas the latter is an investment company, the former is an investment trust set up under and managed according to the terms of the trust deed. And whereas investors buy shares in a mutual fund, they buy units in a unit trust.

Only unit trusts are allowed by law to operate in Jamaica, but investors may buy and sell mutual funds through several financial institutions which market overseas-based mutual funds here. Mutual funds and unit trusts, even if diversified, may not necessarily meet the objectives of the investor, so it may be necessary to invest in more than one of them to satisfy the investor's objectives.

issuer's commitment

Bonds are debt instruments representing a commitment by the issuer to pay a specified amount of interest to the lender for a specified length of time and to repay the principal on a stated date, the maturity date. Bonds are secured by assets pledged by the borrower but government debt issues tend to be called bonds though they are not secured.

The price of fixed rate bonds tends to change when interest rates do but in the opposite direction; they decline when interest rates increase and rise when they fall. It is thus possible to lose or gain capital on a bond if it is sold before its maturity date. Bonds generally mature at their face value.

An investor who buys a bond at a premium, that is, for more than its face value, will, at maturity, receive less than he or she invested, but this should not necessarily affect the yield of the instrument when the interest is factored in because bonds of a similar quality and maturity tend to have similar yields. Investors who wish to diversify their bond portfolio may do so by investing in the bonds of several issuers, bonds with different maturities, or bonds issued in different countries or in more than one currency.

To the extent that an investor is content with holding a bond to maturity, there should be no problems with managing that investment.

Stocks, or ordinary shares, represent a share in the ownership of a company and entitle the shareholder to dividends paid out of profit and the right to participate in the decision-making process by voting at shareholders' meetings.

Stock prices are influenced by the performance of the company, the outlook for the economy, and investor perception of the company, and may vary significantly, sometimes in a short space of time. While there is potential for capital gains, there is a real risk of incurring a capital loss.

Ordinary shares do not mature so investors must sell them, usually through a stockbroker, if they wish to convert their investment to cash. Managing a stock portfolio is time-consuming and diversification may be achieved by several means such as buying stock in different sectors of the economy and in different markets.

Though so different, all may have a place in the same portfolio.

Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers free counsel and advice on personal financial planning.finviser.jm@gmail.com