Mutual funds 101
What is a mutual fund?
Simply put, a mutual fund is a financial product that individuals can buy into alongside other investors. The pooled money is then invested in securities like stocks, money market funds, bonds, real estate funds and other assets. The funds are operated by professional managers that direct the funds resources and are successful if they return value to the investors in the form of capital gains or income via dividends for the investors.
Unlike a specific security, mutual funds are usually fairly well diversified, having been invested in a vast number of securities.
What are the benefits of a mutual fund?
Mutual funds are great for a variety of reasons. The first and foremost being that they give the individual access to an almost limitless variety of securities and financial products through a professional manager. The economies of scale offered by pooling assets with other investors gains mutual fund owners the opportunity to participate in securities that might otherwise be too pricey for them.
Another great perk is that, unlike individual investment products, mutual funds routinely hold at least 100 different securities, which reduces risk through diversity. Diversified portfolios are the key to successful long term investing.
The three ways most investors earn money from their mutual funds are as follows:
- Selling the funds for a profit, ie: capital gains.
- Income earned through dividends from stocks owned within the fund. Usually distributed annually to fund owners.
- Similar to #2, if the fund sells it's position in a specific security which it realized a profit, or capital gain on, those gains are passed onto investors in the form of a dividend distribution.
- Funds will usually provide owners with the option of receiving their distributions in the form of a cheque or having them reinvested in the fund in the form of more shares.
Are there any risks to a mutual fund?
As with any investment vehicle, there is almost always risk. If the balance of securities in the fund lose money, so will the fund. This risk is usually mitigated by the diversity of the securities held within the fund.
Another thing to keep an eye on is the fees associated with the fund. Depending on the rate of return, the fees, or MERS (management expense ratio), can erode your gains over time. All funds charge a fee. Wealth advisors are required by law to disclose any and all fees that are involved in management.
One of the upsides to working with a professional advisor is that they can help you educate yourself on the what your appetite for risk is and what a reasonable amount of risk is given your circumstances and goals.
As technology and prosumer culture becomes more prevalent in finance, options for online, self managed portfolios in the form of exchange traded funds (ETFs) are becoming more plentiful. While the fees associated with online trading platforms (QTrade) tend to be less than those associated with actively managed portfolio, you do lose the benefit of professional advice, personalized service and a computer will rarely act as the voice of reason. Self managed online portfolios can be both enriching and empowering for the right investor type, but most people choose to stay with
Types of funds:
- Equity funds: the biggest and most popular category of funds. Equity funds tend to focus primarily on stocks. The type of and risk profile of equity funds vary tremendously.
- Fixed-income funds: These funds are geared towards lower risk profile investments that pay a stable and predictable return over time. Examples of the investments you'd find in a fixed-income equity fund include: government and corporate bonds, and other debt instruments.
- Index funds: These funds are exactly what the name suggests, indexed to the market. While not as aggressive as equity funds, these funds usually have a lower fee associated because tying the fund to the market tends to require less research and active management.
- Balanced funds: Are funds that seek to spread risk across the broadest exposure to all asset classes. Similar in principle to Index funds, but tending to be more dynamic and involve more active management.
- Money market funds: Is made up of almost risk-free, short-term debt instruments consisting primarily of government treasury bills. Money market funds are among the safest places to store you money. Over the long term, you will be unlikely to see any substantial returns, but your principal is more or less safe.
- Income funds: The primary goal of income funds is to provide a steady flow of cash to owners, not to necessarily appreciate in value. This is done by investing in high quality government and corporate debt.
- International/Global funds: Another valuable tool for diversifying your portfolio, these funds tend to invest the majority of their capital outside your home country.
- Specialty funds: These funds focus on a certain segment of the economy or commercial activity. While specialty funds can be a valuable part of a well diversified portfolio, they can be volatile, so they are best balanced with more conventional funds.
- Socially responsible funds: These funds invest only in companies that meet certain ethical criteria. Some funds forgo certain industries they classify as unethical or direct the majority of their funds towards causes they deem particularly virtuous.
- Mutual funds are baskets of securities that may contain bonds, stocks or other investable assets lime money or real estate market products which are curated by a professional fund manager.
- In most cases, funds invested in your mutual funds can be redeemed and exchanged for other mutual funds at any time.
- Mutual funds are geared towards a variety of needs and can be catered to suit different risk profiles, industry preferences or investment
- Money invested is combined with other investors and the economies of scale allow access to investments that an individual investor might not otherwise be able to access on their own.
- There are a veritable smorgasbord of funds available, and while there is guaranteed to be something to fit your needs and goals, this variety can be somewhat daunting to wade through.
- A professional fund managers is a definite benefit, but as with most things in life, the quality ones come at a cost.
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