The ins and outs of mutual funds

Hey there, time traveller!
This article was published 21/09/2022 (1172 days ago), so information in it may no longer be current.

Dear Money Lady,

Can you explain what mutual funds are and which ones I should consider?

Karin B.

Dear Karin,

Let’s start by giving you a general overview of what a mutual fund is and why you should use it when investing. A mutual fund (MF) is just that – a fund of different types of products such as stocks, bonds, and money markets. When you invest in a MF you invest money into the fund with everyone else and, by doing so, your contribution is measured in units. You will be given several units based on the daily market price called a NAV price per share (net asset value) and you will share in the income, gains, losses, and expenses of the fund you now partially own.

MFs are a great way for any investor to take advantage of buying into a fund, managed by a professional investment specialist, whose sole goal is to analyze the financial markets and monitor performance. As well, MFs provide great diversification. A typical fund could have a portfolio consisting of 60 to 100 different securities in 15 to 20 industries. The average investor can’t be expected to hold a stock portfolio of that size. It is not feasible to have the time, knowledge or expertise to monitor such a plan. Therefore, small and large investors choose MFs which now come in varying degrees of security, income and growth potential. Today there are over 135,000 MFs to choose from worldwide, with over $1.7 trillion invested in Canada alone.

Let’s examine the different types you can consider:

• Money market MFs: Canadian or U.S., short term, low risk, variable interest rates;

• Fixed income MFs: Designed to provide a steady stream of income rather than capital appreciation;

• Bond fund MFs Various types with profit through interest income;

• Dividend MFs: Stocks and bonds together in the fund provide a mix of income and growth. You can take advantage of the dividend tax credit;

• Growth/Equity MFs: This is the most popular MF now offered in every sector: U.S., domestic, global, international, plus small-, mid-, and large-cap. This type of MF is designed to provide long-term capital growth and comes with a variety of risk and return features. These are more volatile than the money market, fixed income or bond MFs.

• Balanced MFs: These MFs are designed to provide a balanced mixture of safety, income, and capital appreciation. A typical balanced fund holds 60% equities and 40% fixed income. Good choice for the average investor.

• Index MFs: These would be my recommendation for most people. Index MFs mirrors the performance of a market index; for example, S&P/TSX or DAX. The fees and management expense ratio (MER) are lower, and they are very similar to an exchanged-traded fund (ETF) structure. This is a low-cost way for an investor to pursue a passive investment strategy;

• Closed end MFs: By far these MFs are the riskiest because they only issue a set number of shares traded in the market – often launched through an initial public offering (IPO). This is not the same as the MFs explained above, which are all open-ended, and easily traded on the stock market.

When you choose to invest in mutual funds, take note of the load fees, trailer fees, and management fees. This will be expressed in the management expense ratio (MER), but it is a good idea to review the breakdown. Due to increased competition in the market, there are alternative funds that have less fees and no front-end or deferred sales charges (built-in, back-end sales fees). Do not choose MFs as a short-term investment unless you opt for the money market funds.

And, as a final note, make sure you know when the fund distribution times are so that you can avoid higher pricing or tax implications when you buy into a fund.