Investing in a mutual fund is a bit like buying a fruit salad. Instantly, you have access to a variety of fruits, each of which can satisfy your appetite. If strawberries aren’t fresh enough for your taste, opt for a juicy watermelon and honeydew melon instead.
The approach is the same for a mutual fund. This basket of securities includes stocks and bonds, each of which can grow your savings. This diversity of assets can help reduce the risk of loss; even if one investment’s performance disappoints you, others may exceed your expectations.
Instant diversification is why mutual funds are so popular around the world. Highly versatile, they can be used for both short-term and long-term savings, and with the wide range available in the market, a single fund can cover the entire world, niche technology companies and everything in between.
Here’s what you need to know about mutual funds.
What is a mutual fund, in simple terms?
A mutual fund holds a variety of securities, typically stocks and bonds, but can also include real estate investment trusts, cryptocurrencies, derivatives—like options or futures—and more. Investors buy shares (similar to shares in a company). Pooling their money allows the fund manager—the person or team that chooses the asset mix—to purchase securities for the portfolio.
Types of Mutual Funds
Investors have a wide range of mutual funds to choose from: more than 140 companies in Canada offer over 4,000 funds. Here are some of the types of mutual funds available.
Money Market Funds
Money market funds are short-term, low-risk investments that primarily hold Government of Canada Treasury bills and other corporate securities. Investment growth in these funds may not be rapid, but you will receive monthly distributions with minimal risk, making them ideal for saving for short-term financial goals.
Fixed Income Funds
Bond funds are plentiful and contain different types of fixed-income securities. The range is broad: government bonds, corporate bonds, high-yield bonds, foreign bonds, short-term bonds, long-term bonds, etc. While some funds hold only one type of bond, others offer them all. In general, fixed-income funds provide a steady stream of income and act as a balance to the riskier stocks in the portfolio.
Equity funds
These funds pool stocks of public companies and are often divided into subcategories based on various factors, such as size and industry, geographic region (a U.S. stock fund will only hold U.S. companies), or whether they are growth stocks or more stable, established ones.
Balanced Funds and Portfolio Solutions
The balanced fund is one of the most popular on the market. By combining stocks, fixed income and money market investments, it reduces risk. A typical balanced fund holds 60% stocks and 40% bonds, but there are other possible asset allocations (such as 50/50 or 70/30).
How do mutual funds work?
It’s simple. You and other investors buy shares, and the fund manager uses that money to buy securities. If the value of the fund’s assets increases, so does the price of your shares. Things can get complicated when it comes to fees and taxes; more on that later.
How can a mutual fund make you money?
There are several ways to profit from a mutual fund. Here are the two most common.
Fund shares increase in value
As with any investment, the value of the fund – determined by what is called the net asset value (NAV) – can go up or down. Your fund company calculates the net asset value per share by dividing the total value of the portfolio by the total number of shares outstanding. Typically, when the fund’s securities appreciate, the net asset value also increases.
Dividend, Interest and Gains Income
Many funds also pay distributions—often quarterly or monthly—to unitholders. These typically come from dividends paid by companies the fund owns, income earned on bonds, and gains from selling a share of the fund. Investors often reinvest these distributions to buy more shares of the fund, but some, especially retirees, rely on the money to meet their needs.
When evaluating a mutual fund’s performance, always consider the overall yield. This is the investment’s actual rate of return, including capital gains , interest, dividends and any distributions over a given period.
Mutual Fund Fees
You can’t talk about mutual funds without mentioning fees. Charged by companies to cover the costs of operating the fund, including the portfolio manager’s salary, this amount is usually expressed as a management expense ratio (MER).
If a fund’s MER is 2%, you’ll pay $40 per year for every $2,000 you invest. Fees can be a good thing – your fund manager isn’t working for free – but you may want to compare costs before you invest.
Mutual Funds: Advantages and Disadvantages
Benefits
They are accessible
Investing in mutual funds is easy; they are relatively simple to understand and usually require only a small initial amount.
They are managed by professionals
Busy investors can leave the selection of their investments to professionals, who continually review hundreds, if not thousands, and select the best ones to compose their portfolio.
They are diversified
By their nature, mutual funds provide exposure to a range of securities in an attempt to reduce overall risk. If one investment fails, others can offset the fund’s losses.
Disadvantages
The costs eventually add up
Fees can quickly eat into potential returns, so keep a close eye on the MER and check what you’re getting for your money.
Daily Trading
Mutual fund shares can only be bought or sold at the end of the day, unlike exchange-traded funds (ETFs) , an increasingly popular alternative that can be purchased when the market opens.
There is no guarantee
Paying for a professional fund manager doesn’t guarantee results. In times of volatility, even well-managed funds struggle to match market benchmarks.