Mutual funds vie for your attention

There has been a virtual explosion in the mutual fund business in recent years, as baby boomers put their collective accumulated wealth to work for retirement, or look for ways to invest an inheritance. But people of all ages can benefit from the mutual fund boom, due to the wide variety of mutual funds available, each designed to match an investor’s personal financial objectives, including those of mature Canadians.

Mutual funds are pools of money collected from many different people and placed in a portfolio of investments. Each individual buyer of the fund owns a share of all those investments, in direct proportion to how much they put into the fund. Guided by clearly defined objectives, the funds can be invested in the money markets, bonds, stocks, real estate, precious metals and other securities.

Most mutual funds can be grouped into four broad categories: money market, income, balanced and growth funds. Money market and income funds carry the lowest risk/variability, followed by balanced funds that have moderate risk/variability. Growth funds, consisting mainly of stocks, have the highest risk/variability.

• Money market funds have iestments in government treasury-bills, bank term deposits and high quality corporate borrowings, to offer maximum security and liquidity. These funds provide regular income payments and generate a floating rate of return which rises or falls with short-term interest rates.
• Income funds have investments in bonds, preferred shares and some blue chip stocks. Some income funds invest only in bonds issued by federal and provincial governments, foreign governments and corporations. They may hold one type of bond or a combination of bond types. Mortgage funds, another type of income fund, tend to invest in ‘high-quality’ mortgages, such as first-time residential mortgages. The objective of income funds is to offer a steady stream of interest income, maintain safety of principal and offer some potential for capital gains. These funds can experience significant capital appreciation or loss depending on the trend of interest rates.
• Growth funds have investments in common stocks. Their objective is to provide higher returns through increases in stock prices and some income from dividends. There are also growth funds that have clearly defined niches. These include: Specialty or sector funds focus on shares of a group of companies from one industry (i.e. pharmaceutical or natural resources) or from one specific commodity (i.e. gold); Small cap funds: Investments concentrated in shares of smaller companies;
• Index funds hold the same ‘basket’ of stocks as a specific financial market index, such as the TSE 300; and,
• International funds invest in major and emerging markets outside of Canada.
• Balanced funds have investments in stocks and bonds. The objectives of the balanced approach are long-term growth potential and lower risk. Asset allocation funds are similar.
• Asset allocation funds have investments in stocks, bonds and the money market. The fund manager changes the portfolio mix, shifting money between types of investments, depending on the market outlook.

Most mutual funds are open-end funds, where shares or units are continually sold to the public. As the portfolio earns income and grows – or appreciates in value – the market value of the portfolio increases and the value of each mutual fund unit also increases. Of course, the reverse can also happen.

The performance of a mutual fund depends upon that of the markets and the skill of the people managing it. If the stock or bond market stumbles or the manager makes poor decisions, the fund will suffer. When an investor or shareholder of the fund decides to sell his or her shares (called the right of redemption), the fund manager will buy them back at the current market value, also known as the net asset value per unit.

A second kind of mutual fund, the closed-end fund, offers its shares or units to investors at the time the fund is set up. This is similar to a new issue of stock. The shares then trade the same way as common stocks do in the over-the-counter or stock markets.

There are far fewer closed end funds available than open end funds. In addition, these funds tend to trade at a discount to the net asset value.

The major advantage of mutual funds is that they’re managed by professionals who provide day-to-day supervision of the fund’s investment portfolio and written records of its performance. These managers, not the investors themselves, make decisions about buying and selling the investments in each fund. Mutual funds allow you to diversify in many different kinds of investments, even if you’re a small investor. A typical fund, for example, may have investments in 60 or 100 different securities in 15 or 20 industries.

Mutual funds are also very convenient and cost-effective. They’re easy to buy and sell, contribution and pay-out amount arrangements are flexible, dividends and income can be automatically reinvested into a fund and commission fees are lower than if you were to buy each individual security in the fund separately.

Doubling up

By their very nature, mutual funds allow you to diversify in many different kinds of investments, industries — even countries. Investing all your money in one mutual fund can still be risky, however. For this reason, you may want to invest in several funds, by adding different ones to your portfolio, gradually, over time.

Of course, funds aren’t offered free of charge. The professionals managing them and the people selling them must be paid. Mutual funds charge management fees, annual charges to cover the cost of commissions to sales representatives, as well as legal and audit costs and other administrative expenses. These expenses are charged to each investor, either at the time of purchase or when shares in a mutual fund are redeemed.

Using what’s called the Management Expense Ratio (MER), you can compare the management fees from one fund to another. Funds are required to disclose their MER – which typically ranges from 1.5 per cent to three per cent – in the prospectus. Some people are attracted to “no-load” funds because they don’t want to pay a sales commission. But focussing only on the commission can distort the real value of a well-managed load fund. And some no-load funds come without advice; fine for some investors, but not for all. It’s important to question the load structure of mutual funds, but these and other costs should be measured against a fund’s performance.

Many other questions about mutual funds can be answered by reading the fund’s prospectus or simplified prospectus. By law, mutual fund companies must provide each investor with a prospectus or simplified prospectus – a document that details what the fund is and how it functions. The main points in a prospectus are as follows:

• The investment objectives of the fund
• The name of the company issuing the security as well as its directors and managers
• The commission or “load structure” and other fees and expenses charged
• How, where and by whom the fund is sold
• The risks associated with the fund
• How to purchase and sell/redeem fund units
• The fund’s audited financial statements

Before you buy

You may want to draw on the experience of a financial advisor to help you with your choice. An advisor understands the subtle differences between the myriad of funds available and can help you choose the fund or funds that will best suit your investment objectives. He or she should be knowledgeable about the mutual fund manager’s abilities as well as the fund’s investment philosophy, to ensure it’s a good match with your own. Advisors can also help to interpret the prospectus and show you how to track a fund’s performance.