What is a Mutual Fund? Everything you need to know

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Have you ever wondered what is a mutual fund? It’s easily the most popular type of investment product, yet many people have no idea what they are and how they work. While that may sound surprising, it shouldn’t be since most people let their financial advisor or financial institution make investment decisions on their behalf. Owning mutual funds is just one product that you can own. Understanding how they work is vital since there are thousands of mutual funds available and you’ll likely only own a few.

What is a mutual fund?

What is a mutual fund?

To simply put it, a mutual fund is an investment product that consists of stocks, bonds, and other investments that are chosen by a professional fund manager. The money you put into this fund is pooled with other investors (hence the term mutual). With this strategy, you’re able to buy a mix of investments that you may not normally have been able to do on your own.

As you can imagine, the goal of mutual funds is to make money. That could be from capital gains or dividends. Since mutual funds buy stocks and bonds from many different organizations, you’re essentially a part-owner of every single company. This is appealing to many investors since owning mutual funds gives you a diverse portfolio. You’re not invested in just a few stocks, you’ll own hundreds.

How to invest in mutual funds

Investing in mutual funds is easy since you can purchase them from a bank, investment firm or robo advisor. They can also be purchased within your different investment accounts such as your RRSP, TFSA, RESP, LIRA, etc. Selecting the mutual fund can be the tricky part. You basically want a fund that matches your risk tolerance and your timeline.

For example, if you’re in your 20’s, investing in a mutual fund that has more equities (riskier investments, but bigger potential return) probably makes sense. Now, if you’re someone in your 50’s, having a fund that has more fixed income investments (safer assets) is likely the best choice.

Mutual funds are a hands off type of product. Once you’re invested, there’s not much to do. All of the rebalancing is done by the portfolio managers, so you don’t need to do anything. While this is convenient, it also shows why you need to make sure you know what is a mutual fund. When I first started investing, my advisor at the bank put me in a few mutual funds that didn’t make much sense for my profile. It didn’t hurt me much, but I’ve heard horror stories from other people.

What are examples of mutual funds?

I’ve sort of touched on the basics of mutual funds, so now I’m going to go into a bit more details about the different types of mutual funds. The idea here is to educate yourself so when you’re ready to invest, you know what type of funds you’re buying. Keep in mind that there are more than 10,000 mutual funds out there so I can’t comment on the best mutual funds. You should also understand that past performance is not indicative of future results so it’s not realistic to expect a fund that has performed well in the past to continue to do so in the future.

Equity Funds

Many investors wonder what are equity funds? Equity funds consist of shares in publicly traded companies and are focused on growth. They’re attractive to investors who are willing to take more risks in their portfolio. While most investors prefer to have a balanced portfolio, equity funds are attractive to those who are willing to take on more risk.

Equity funds may appear to be risky since they’re 100% invested in stocks, but you can still diversify. As mentioned, all mutual funds invest in a variety of companies, so you’ll always on a basket of stocks. You can even purchase equity funds that are diversified around the world which would give you a global portfolio.

Fixed income funds

For those looking for investments that are safe and pay out a defined amount, then fixed income funds will appeal to you. Generally speaking, fixed income funds are aimed at older investors who are looking for less risk or need to balance out their portfolio. For example, an investor that’s nearing retirement may want to have more of their portfolio dedicated to fixed income as they may not be able to afford any sudden market drops. Alternatively, a young couple about to buy a home may also consider fixed income mutual funds as a place to park their down payment.

A fixed-income fund will consist of investments such as government and corporate bonds of a high grade, so there’s no real worry that your money will go down in value. That said, your money won’t really grow either. Fixed income fund buys you security and peace of mind, but your returns may not even beat inflation.

Money-market funds

Money-market funds are similar to fixed-income funds in the sense that they invest in fixed-income investments. I’m talking things such as certificates of deposits (known as CDs), short-term debt from corporations and the government, and even commercial paper which is sold by large corporations to meet short-term debt. 

If you’re looking for the safest investment possible, then money-market funds are the way to go, but to be realistic, you should only be using them to park your cash until you figure out what you want to do with your money.

Balanced funds

For most people, balanced funds are the way to go since they mix equities with fixed income. The ratio of equities vs. fixed income varies by the fund. As you can imagine, mutual funds with more equities are riskier compared to those with more fixed income. This mixture of equities and fixed income is known as asset allocation which may be a term you’ve heard of before.

Target funds for Registered Education Savings Plans are a type of balanced fund which is incredibly popular since you’re basically picking the year where you need the money and the fund balances itself (well, the fund manager does it).

Index funds

When it comes to mutual funds, index funds are my favourite since their fees are quite low compared to mutual funds. You can purchase them yourself, through a robo advisor or even via a bank such as Tangerine.

Basically, index funds are built to track a specific index such as the S&P 500 whereas fund managers pick individual stocks for say equity funds. Since they track an index, you’ll get average returns, but history shows that index funds outperform mutual funds 90% of the time so getting the average is a good thing. 

Specialty funds

Specialty funds have been around ever since mutual funds were invented. Instead of focusing on equities or fixed income, they typically focus on a sector such as real estate or energy. If you wanted more exposure to a certain sector, then purchasing a specialty mutual fund would be the way to go. In recent years, socially responsible mutual funds have become popular specialty funds as it allows you to invest in companies who are trying to reduce their impact on the environment.

Specialty funds can also focus on specific countries or regions. For example, in my early years of investing, BRIC funds were all the rage. They focused on companies located in Brazil, Russia, India, and China. The idea was that these markets were emerging so there was potential for huge gains. I don’t think BRIC funds took off in the end, so don’t assume specialty funds will guarantee you a higher return.

Mutual fund fees

Although mutual funds can help you diversify your investments, they can be quite costly. Every fund has a management expense ratio known as the MER which is paid to the fund manager/firm regardless if your investments go up or down in value. With mutual funds, the average MER can range from 2%-2.5%. While that fee may not sound like a lot to have a professional manage your money, you need to think big picture.

Let’s say you have a portfolio with a value of $100,000 and you’re invested in mutual funds that charge you a fee of 2.5%. That means you’re paying $2,500 a year to the fund managers. Now think about a portfolio that’s worth $1,000,000. You’d be paying $25,000 a year. If you’re paying that much in fees, you better be getting more than one call a year from your financial advisor/institution.

It should come as no surprise that there’s been a bit of a revolution in the last few years when it comes to fees. Investors are tired of paying so much for very little effort and advice. Switching to low cost mutual funds could easily save you tens, or possibly, hundreds of thousands of dollars over your lifetime. That’s why robo advisors such as RBC InvestEase, Justwealth and Wealthsimple have become so popular. They use exchange traded funds (a type of index fund) to invest which have low fees. Sure, robo advisors still charge an additional management fee, but overall, you’d be paying less than 1% to have your money managed.

Which mutual fund should you choose?

I can’t tell you what specific funds to invest in since there are so many variables to consider. That said, I can tell you that I started with Tangerine index funds before I switched to TD e-Series funds. I eventually moved my portfolio to all-in-one ETFs. Investing on your own may sound complicated, but if you’ve taken the time to read this article, you’re oviously interested.

I personally recommend new investors start with a robo advisor these days as you can get a balanced portfolio at a low cost right away. If you’re interested in managing things on your own, then switch to ETFs in a discount brokerage. There are multiple all-in-one ETFs that are suitable for every type of investor.

Mutual funds will continue to be popular, but it’s up to you as an investor to educate yourself about them. Not every financial advisor will put your best interests first. Since this is your money and your future, you should put in a little effort to learn about mutual funds and investing.

About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

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