Types of funds

There are three main categories of mutual funds: cash, fixed income, and growth.

1. Cash funds are lowest risk, but provide the lowest return as well.
2. Bond funds aren’t as safe as many people think, but they can produce above-average profits under the right conditions.
3. Growth funds offer the biggest gains but be prepared to take more chances.

A few years ago, a woman came up to me after a seminar and asked if it was “too late” for her to start investing in mutual funds. She was 70 years old, she explained (she didn’t look it). Were funds too risky for her at that age?

Her question reflects one of the most common misconception about mutual funds. That’s the strong tendency to assume that mutual funds and the stock market are one and the same thing.

I can’t tell you how many times I’ve heard people say that they won’t invest in mutual funds because they’re nervous about stocks.

Well, if that’s all that’s holding you back, let me lay that false impression to rest once and for all.

There are funds that invest in stocks, of course — lots of them. But there are also funds that invest in things that have nothinwhatsoever to do with the stock market: mortgages, bonds, Treasury bills, real estate, commodities, index futures, gold, and a whole variety of other securities.

In fact, if it’s a legitimate investment, you’ll probably find a mutual fund that specializes in it.

So even if you’re scared to death of the stock market, that’s no reason to pass up mutual funds. In fact, a fund may be an excellent option for you in that situation.

But you have to know which type of fund is right. The lady who asked if she was too old to buy funds was obviously not a candidate for high-risk ventures. But there are plenty of conservative, income-generating funds that would be ideal for her needs — some of which have never had a losing year since they were launched.

So let’s take a look at the various groups and sub-groups of mutual funds currently being offered in Canada. You can then decide which ones are right for you.

Cash-type Funds

Money Market Funds (Canadian): These invest in a variety of short-term securities including federal and provincial Treasury bills, certificates of deposit, short-term corporate notes, bankers’ acceptances and term deposits. A few offer limited chequing privileges. The unit value of these funds is fixed, usually at $10. 

Money Market Funds (U.S.): As the name indicates, these invest in short-term U.S. dollar securities, such as federal Treasury bills. The rate of return will usually be lower than that paid on Canadian money market funds because of the interest rate differential between the two countries. These funds are best suited for those looking for a safe hedge against a drop in the Canadian dollar or who require frequent access to U.S. cash.

T-Bill Funds: These are similar to money market funds, but hold only government Treasury bills. This gives them added safety, but the return is usually a bit less than from standard money market funds.

International Money Market Funds: The weakness of the Canadian dollar in the ’90s created a demand for money market funds that provided some currency protection but offered potentially better returns than U.S. dollar funds. International money market funds are the answer. These invest in short-term securities denominated in a range of currencies. Unlike other money funds, the unit value is not fixed so these funds are subject to bigger gains and losses than other choices in this group.

Premium Money Market Funds: Some fund companies, notably the big banks, offer special money market funds for those with a lot of cash to invest (the minimum entry fee is usually at least $100,000). The attraction is a lower management fee, which translates into higher returns.

Fixed Income Funds

Mortgage Funds: These specialize in residential first mortgages, although they may hold other assets as well, such as short-term bonds or commercial mortgages. These are the one of the lowest-risk type of fixed-income fund you can buy. The mortgages held in the portfolio will normally all mature within five years. This makes them less vulnerable to loss when interest rates rise (the longer the term of a fixed-income security, the more its price will be affected by interest rate movements). Mortgage funds are best-suited for highly conservative investors looking for slightly better returns than are offered by GICs. Your profits are usually in the form of interest income; capital gains potential is low.

Canadian Bond Funds: These invest in bonds issued by various levels of government, Crown corporations, municipalities, or major companies. They are somewhat higher risk than mortgage funds because the bonds in the portfolio will usually have a longer period until they mature than mortgages will. However, that higher risk is compensated for by higher returns — bond funds can be expected to generate 1 to 2 percentage points more each year. For example, over the five-year period to Jan. 31, 2000, the average Canadian mortgage fund had an annual return of 6.2 percent, according to figures published by The Globe and Mail. The average Canadian bond fund produced 7.9 percent. Bond funds generate interest income but also have the potential to produce capital gains if interest rates drop, as they did for much of the ‘90s. But most people buy bond funds for the interest they produce, not for capital gains.

Short-Term Bond Funds. These represent a cross between a regular bond fund and a money market fund. The managers invest in bonds with relatively short maturity dates. In some cases, three years is the maximum allowed; other funds will hold bonds with maturities up to five years. The goal is to create a defensive portfolio that will provide better returns than a money fund but will carry less risk than a standard bond fund. These funds will usually outperform regular bond funds when interest rates are rising, as happened in 1999, but they won’t experience the good gains normally associated with declining rates. 

High-Yield Bond Funds. Relatively new on the scene, these funds invest mainly in corporate bonds issued by companies with a lower credit rating. They have been called “junk bond funds”, but that’s too harsh a description. Essentially, when you invest here you’re accepting a higher degree of credit risk in exchange for potentially higher returns. In fact, high-yield bond funds as a group significantly outperformed regular Canadian bond funds in 1999.

International Bond Funds: These invest in international fixed-income securities, usually bonds. Some funds specialize in bonds issued by foreign governments and corporations. Others invest in Canadian bond issues denominated in foreign currencies (U.S. dollars, yen, sterling, euros), which makes them fully eligible for RRSPs. These funds are attractive during periods when the Canadian dollar is falling because of the profit potential from the fluctuations in currency exchange rates. For example, a bond denominated in U.S. dollars will be more valuable to a Canadian investor when our dollar is worth US65c than it would be with a US70c dollar. For that reason, this category of fund performed well in 1998, when the loonie was weak, but slipped badly in 1999 as our dollar recovered some ground. International bond funds are somewhat higher risk than Canadian bond funds because of currency movements as well as interest rate exposure.

Dividend Funds: True dividend funds (and many are not) invest in shares that pay a high dividend yield, thus allowing investors to benefit from the dividend tax credit. They’re best suited for conservative investors in high tax brackets who want to improve their after-tax returns by making use of the dividend credit. In the past, the portfolios consisted mainly of preferred shares but now many of these funds concentrate on high-yielding common stocks, such as the utilities and banks, making them nothing more than specialized blue-chip funds. True dividend funds are relatively safe but their growth potential is limited, which is why they’re included in this category.

High-Income Balanced Funds: Another newcomer to the fund scene, these invest in a variety of high-yield securities such as royalty income trusts and real estate investment trusts (REITs). The goal is to produce strong cash flow, much of which will be received on a tax-deferred basis. The trade-off is risk. Royalty trusts have proven themselves to be very volatile and investors in these funds may see their unit values decline sharply in bad markets.

Growth Funds

Canadian Equity Funds: These specialize in publicly traded shares of Canadian companies, although most contain some foreign stocks as well, within the foreign content limit. The degree of risk will depend on a fund’s objectives: some emphasize security of capital by investing mainly in blue-chip stocks while others concentrate on more junior issues in a relentless pursuit of big capital gains. Your choice of which funds are most appropriate should be governed by your personal financial objectives.

Labour-Sponsored Venture Capital Funds: These funds were created to encourage new business development in Canada by investing in small and medium-sized companies, most of which are not publicly traded. They’re high risk by nature, so governments have provided sweeteners in the form of tax credits to encourage people to take a chance. 

U.S. Equity Funds: These invest mainly in American stocks. Some specialize in large, blue-chip issues, some focus on small-cap stocks, but the majority are broadly diversified.

International and Global Funds: These funds invest in stocks of several countries. Some limit themselves geographically to certain areas (Europe, the Pacific Rim, Latin America); others roam the world. International funds do not invest in their home country, global funds do. So a true international fund will not invest in North America. But don’t be guided by the fund name alone; it can be deceptive. There are many funds with the word “international” in their name that actually invest in all parts of the globe.

Country-Specific Funds: These concentrate on stocks of a specific nation. After the U.S.-based funds, Japan funds are the most common type sold in Canada, but you can also buy funds that specialize in China, Germany, and India.

Precious Metals Funds: These invest mainly in gold, either directly by buying bullion or, more commonly, in shares of gold mining companies. Some funds also have holdings in other precious metals, such as platinum and silver. In recent years, shares in companies engaged in diamond exploration in the Northwest Territories have found their way into the portfolio of some of these funds. These funds are typically high risk by nature and will only do well during periods when bullion prices are strong.

Natural Resource Funds: These funds invest in companies that are involved in the resources business in one way or another. They will usually be heavily weighted towards the energy sector but will also provide exposure to mining and forestry stocks. The stocks held by these funds are highly cyclical so performance will vary greatly from year to year.

Real Estate Funds: Here the managers specialize in commercial and industrial real estate. Profits are generated by capital gains and rental income, giving these funds a tax advantage. These funds ran into serious problems when property values in many parts of the country tumbled during the recession of the early ‘90s. As a result, only a handful of pure, open-end real estate funds are available today. However, there are a number of closed-end funds, known as real estate investment trusts (REITs) that trade on the Toronto Stock Exchange.

Derivative Funds: A new category, these have been developed for RRSP/RRIF investors who wish to go beyond the foreign content limit. Most of their assets are in Canadian Treasury bills, which are used as security for the purchase of index futures on international bond and stock exchanges, or on the portfolio of a parent fund.

Index Funds: Growing in popularity, these funds are designed to track the performance of a benchmark stock index such as the TSE 300 or the S&P 500. They are known as “passive” investments because no buy or sell decisions are made by the manager.

Sector Funds: These specialize in a particular segment of the economy such as health services, science and technology, telecommunications and infrastructure companies. They have been growing in popularity and some of these funds scored huge gains in 1999.

Adapted from Making Money in Mutual Funds by Gordon Pape, published by Prentice Hall Canada.