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How do mutual funds work?

22 November 2015 by National Bank
mutual funds

Want to invest, but not experienced enough to put together your own portfolio? A mutual fund might be a good solution for you.

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A mutual fund is a pool of money from a number of people that is invested in products like stocks, bonds, Treasury bills, etc. and handled by a fund manager. “A mutual fund is simply a vehicle whose contents are selected based on investor goals, profile, and risk tolerance,” explains Annamaria Testani, Vice President of National Sales at National Bank Investments.

Mutual funds are perfect for small investors, who benefit from the leverage effect of pooling money from many different sources. Such funds also give small investors access to a range of investments that would otherwise be out of their reach.

A broad variety of mutual funds

When you put your money into a mutual fund, you’re buying a share in it. Each fund has its own goal, strategy, composition, and level of risk. So it’s important to read the prospectus of the fund you're interested in to clearly understand its specific characteristics.

Whether they focus on income, security, or growth, all mutual funds are aimed at diversifying your portfolio.

There are several different types of mutual funds. As their name indicates, stock or equity funds are made up of stocks. There are Canadian equity funds composed of common and preferred shares in Canadian companies. Other funds are made up of shares in well-established or fast-growing U.S. companies.

International equity funds comprise shares in publicly traded companies in the main industrialized countries and certain emerging countries. In the last two cases, exchange rates can have an effect on yield.

As a general rule, equity funds are best suited to investors with a higher risk tolerance. However, their inherent diversification gives investors exposure to various markets, especially U.S. and emerging country equity funds.

Fixed income funds provide regular income from interest or dividends, while preserving invested capital. They’re generally made up of debt securities such as bonds or debentures, or preferred shares in companies that issue regular dividends. Returns are relatively modest, but fixed income funds provide a stable income at low to moderate risk.

Balanced funds combine common and preferred shares in Canadian and international companies, debt securities, and money market instruments. Diversification ensures fairly stable returns and moderate risk.

Money market funds are composed of short-term bonds and short-term debt securities issued either by governments (Treasury bills, for example) or by companies. They generate a fixed income that is safe but quite low. They are used to secure capital or store cash slated for another type of investment.

Specialized funds invest in specific economic sectors such as precious metals or technology or in certain geographic regions through company shares. They present a relatively high level of risk from market or currency fluctuations. A lack of geographical or sectoral diversification and political disturbances can also negatively affect their performance.

Index funds track the performance of specific indices, such as a market index, and fluctuate accordingly. Risk levels and returns depend on the index used.

The pros and cons of mutual funds

Mutual funds are very popular with investors and offer a number of advantages. They provide access to the professional expertise of seasoned fund managers, offer a high level of diversification, and come in a variety of forms. They allow you to invest in different economic sectors and types of securities, which helps you manage overall risk and choose the type of investment product that best suits your needs. They also permit small investors to target markets that would otherwise be hard for them to access, especially overseas markets.

They are flexible and investments can be transferred to other funds in the same family and with the same fee structure free of charge at any time. It is also possible to make regular deposits or withdrawals. And lastly, mutual funds are easily bought and sold if you need cash at any time.

One of the main disadvantages of mutual funds is their management fees, which can be as high as 2.25% to 2.50%, although fees have been coming down in recent years, notes Annamaria Testani.

Management fees depend on a number of factors, particularly the type of fund: Equity funds cost more to manage because fund managers spend considerable time on analysis. The fund manager’s management style can also affect fees, for example, active management aims to beat market performance and passive management simply seeks to track it. Active managers buy and sell securities more often, which has an impact on fees. Passive management involves fewer transactions and so fees will be lower.

When you buy shares in a fund, you should consider the management expense ratio (MER). This ratio represents the percentage that will be directly skimmed off your fund’s net return and indicates the cost of administering the fund. So the higher the ratio, the lower your return. A fund’s prospectus will provide details on the various fees involved.

Types of returns mutual funds provide

Mutual funds offer two types of returns: capital gains and dividends or interest.

You earn capital gains when you sell your shares in a fund at a profit. Of course, it’s also possible to suffer a capital loss.

A mutual fund can also generate dividends, interest, and other types of income. These returns can be either withdrawn or reinvested in the fund.

Specific tax rules apply to mutual funds. Selling shares in a fund leads to a capital gain or loss, which may be taxed or be deductible, depending on the tax laws in effect.

With all these choices, everyone can find the investment vehicle that best suits their needs based on their risk tolerance and investor profile.

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