Mutual Funds

A mutual fund is an investment company that purchases bonds, stocks or other securities and sells shares to the public. They are popular because they provide two benefits that few individual investors can achieve on their own. First, because fund shares represent investments in many different companies, shareholders are able to achieve diversification and therefore reduce their risk. Second, mutual funds provide professional management of your money. In effect, you’re hiring a portfolio manager to use your money - and that of other shareholders — to buy a portfolio of stocks, bonds or other investments. Financial advisors recommend further diversifying your nest egg by investing in funds of varying kinds. Mutual funds enable individuals (even those who have very modest amounts to invest) to invest in the categories that provide portfolio diversification (foreign stocks and bonds, US. small and large cap stocks, U.S. bonds, money market securities, gold and even real estate).

Stock Fund Types

  • Small cap – Invests in companies with total outstanding stock worth less than $1 billion.
  • Mid cap – Invests in companies with total outstanding stock worth $1 billion to $5 billion.
  • Large cap – Invests in companies with total outstanding stock worth over $5 billion.
  • Value fund – Invests in out-of-favor companies with stock prices that do not fully reflect their earning potential or asset value. The stock price of these companies is relatively low in relation to what fund managers believe is the company’s true value, because of corporate restructuring or disappointing earnings.
  • Aggressive growth – Invests in companies with rapidly growing earnings; seeks only capital gains.
  • Growth – Seeks capital gains but not as aggressively.
  • Blend – A combination of growth and value funds.
  • Growth and Income – Seeks long term capital growth from stocks that have consistent dividend payouts.
  • Equity Income – Aims for a high level of current income from dividend-paying stocks (growth and capital gains are not the focus).
  • Global – Invests in stocks of foreign countries as well as the U.S.
  • International – Invests only in stocks of foreign countries.
  • Balanced – Invests in stocks and bonds (usually holds at least 25% of each).
  • Index – Buys stocks in the companies included in a specific market average, or index, like Standard & Poor’s 500-stock average of large companies. The fund mirrors the movements of the index, going up and down as it does.
  • Sector – Focuses on particular industries like biomedical, electronics, or energy.

Bond Fund Types

  • High-quality corporate bond funds stick to purchasing the bonds of top-rated companies.
  • High-yield bond funds seek higher yields by owning lower-rated corporate and municipal bonds.
  • U.S. government bond funds hold Treasury securities or those of federal agencies.
  • Ginnie May funds own mortgage-backed securities such as those issued by the Government National Mortgage Association.
  • Global bond funds hold either U.S. or foreign bonds.
  • Municipal bond (Tax-Free) funds buy tax-free bonds issued by state and local governments.
  • High-yield muni funds seek higher yields by owning mostly lower-rated municipal bonds.

Other Types of Funds

  • Closed-end funds pool investors’ capital, but don’t sell new shares once the offering is sold out. Shares are bought and sold on one of the stock exchanges, where they often trade at a discount or premium to the value of the underlying portfolio.
  • Unit trusts are fixed portfolios of securities, usually bonds, with a set number of participation interests sold to investors. Unit trusts provide a way to lock in high yields and are popular with people seeking an above average income with minimum risk. If interest rates rise, however, the value of the units drop. When the securities are redeemed or called, investors get their original outlay back and the trust is dissolved.

The Prospectus

  • When contacting a mutual fund, you will be mailed a publication called a prospectus. There is valuable information you should examine in the first few pages of any prospectus.
  • Investment Objectives - The statement of objectives and policy will tell you how the fund makes its money, and whether it is a growth or income fund. From this section, you will learn if the investment philosophy matches yours.
  • General Description - This section in the prospectus explains how the fund invests: whether it is a stock or bond fund. If the fund invests mainly in stocks, there will be a statement on the types of companies in its portfolio. If the fund invests mostly in bonds, there will be an explanation of the types of bonds purchased.
  • Fund Expenses - It's not enough to just review a fund’s investment strategy, you must also look at what it is going to cost you. A fund’s expense section lets you learn all about the fees of the fund you are examining.
  • Financial Information - The prospectus will have tables showing annual income, expenses and the fund's annual performance. Some of the information on the year-by-year tables are dividends, interest and capital gains paid out per share; total returns per year; yield by year; and the expense ratio - showing "the total percent of charges taken out of the fund."
  • Risks & Investment Restrictions - This section explains any risky investment strategy the fund may practice, as well as how the fund can lose money and if there are any "federally imposed restrictions" on the fund.
  • Officers - It is always important to know who is running the fund and what type of experience he or she has. This section in the prospectus examines who the fund manager is and his or her background. It also lists the members of the board of directors and its officers.
  • Trading - How do you set up an account? Can you trade by telephone or do you need to submit a notarized document explaining your trade? These are the types of questions that will be answered in this section of the prospectus.
  • Reinvestment - If the fund you are interested in offers automatic reinvesting or withdrawal or works with a savings program, it will be listed in the section on reinvesting.
  • Taxes - Look for the distribution date of capital gains and dividends. If the fund is ready to distribute, and you want to invest, you might consider holding off until after the distribution of dividends and gains. Otherwise, there will be additional taxes for you.

Bond Ratings & Terms

  • High Quality: ratings AA or better
  • Medium Quality: ratings AA- to BBB
  • Low Quality: ratings BB or lower
  • Short term: maturities of under 4 years
  • Intermediate term: maturities of 4 to 10 years
  • Long term: maturities of 10 years or more

Resources
The following publications are reliable sources of background and performance information:

  • Kiplinger's Personal Finance Magazine
  • The Individual Investor's Guide to Low-Load Mutual Funds
  • Investor's Guide to Low-Cost Mutual Funds

 

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