What is a mutual fund?

A mutual fund is simply a pool of money from a number of individuals which is turned over to a professional manager to invest on their behalf…

Mutual funds invest in a wide range of securities. Some focus exclusively on the stock market but there are many funds that own no stocks at all…

A mutual fund will earn profits or suffer losses on the basis of how well the investments in the portfolio perform…

What’s a mutual fund? Good question. And if you don’t know the answer, don’t feel badly. A lot of other people are in the same boat – including some who actually own mutual fund investments.

Here’s how I explain the concept when I’m giving a seminar on mutual fund investing. Pretend for a moment that you’re sitting in a room with 1,000 other people listening to me discuss the subject.

Let’s start by supposing each of you had to pay $10 to attend this seminar. That’s a total of $10,000 collected at the door. Now I surprise you by saying that I’m not going to keep that money as my fee. Instead, I’m going to invest it on your behalf in Canadian stocks. In its simplest form, I’m going to create a Canadian equity mutual fund, with me as the manager and theeminar attendees as the unit holders.

Your $10 buys you one share in this new venture – there are 1,000 shares in all, one for each person at the meeting. I ask you all to reconvene at the same place in exactly one year and I’ll tell you how your investment has done. That will be our annual meeting.

The next day, I choose some stocks for the fund and purchase them on behalf of you and the others who attended the seminar. They become the fund’s investment portfolio. Over the year, I buy and sell some stocks, hopefully producing some profits along the way. For my services, I withdraw $25 from the fund’s assets each month. That’s my management fee. Of course, that amount seems ridiculously small. But if the fund were to grow in time to $1 million, the fee would increase 100 times to $2,500 a month. When you consider that a number of mutual funds in this country have assets in excess of $1 billion, you begin to appreciate the profit potential for good money managers.

The fund also incurs some other expenses, such as brokerage commissions for the shares purchased. These costs are paid out of the cash remaining in the fund.

At the end of the year, we reconvene and I tell you what has happened over the past 12 months. If the news is good and your original $10 stake is now worth $15, I might ask for a performance bonus. Since presumably you’d all be feeling pretty happy about a 50 percent increase in your money, you’d probably vote to grant it.

But suppose the news was bad. It turned out I was a lousy money manager and your original $10 was now worth only $5. Chances are your immediate reaction would be to get out – to sell your unit, even if it meant locking in the loss of half your stake, and escaping while there was still something left.

If this were a true, open-end fund, the only way to do that would be to have me redeem the unit and pay you the cash from the fund’s assets. You couldn’t sell your share directly to another investor.

If you decided to hang in, despite the rotten results, your alternative might be to demand that I quit as manager. Get someone else who can invest the money more effectively or we’ll all pull out our cash – that might be the consensus of the meeting. This rarely happens in the real world, but it’s theoretically possible if unit holders get angry enough.

There, in a microcosm, is the world of mutual funds. A fund is simply a pool of money put up by a number of individuals and handed over to a professional money manager to invest on their behalf. Certain criteria will govern the operation of the fund – what it can invest in, what fees it can charge, what kinds of risks it can take. All these will be spelled out in detail in a simplified prospectus – a document you must be provided with before any order can be finalized.

In this illustration, I’ve used a Canadian stock fund as an example. But a fund may invest in a wide range of other securities, from government bonds to gold bullion. One of the most common false assumptions made by beginning investors is that mutual funds and the stock market are one and the same thing. I’ve had people say to me: “I won’t invest any money in mutual funds because stocks are too risky”.

In fact, there are hundreds of mutual funds that don’t own a single stock, and never will. Money market funds, for example, invest mainly in short-term notes issued by governments, banks and large corporations. These funds would never hold a single share of stock.

Mutual funds come in a great variety of shapes and sizes. Some funds may have only a few hundred thousand dollars in assets; some have grown to over $10 billion in size. So there’s plenty of variety.

There are over 2,000 mutual funds in Canada now and the number is increasing every year. This is both a curse and a blessing.

The curse is the confusion created by such a dazzling choice of investment options. With so many funds from which to select, some people become paralyzed with inertia, unable to make up their minds which way to go.

The blessing comes from the fact that this wide choice translates into greater profit potential and reduced risk. In the old days, there were few safe havens to turn to when the investment seas became rough. Today there are many funds that offer calm waters in which to ride out the storms that occasionally hit the real estate, stock and bond markets.

Choosing the right funds from this rapidly expanding universe isn’t easy – and will be less so in future, as even more new entries appear. But it’s well worth making the effort, for reasons I’ll explain in subsequent articles.