Mutual Fund Basics
Mutual funds are the investing equivalent of a shopping cart full of fruit: you’ve got your apples — both red and green — watermelon, oranges, honey dew, and maybe some papaya. You may even have a few exotic fruits from another country that somehow made their way into your local Superstore or Metro. Now, in this analogy, you really got to love fruit. If you do and then dig in, you have a pretty delicious snack. It doesn’t matter if two of those fruits are rotten — you still have enough good stuff to eat.
With mutual funds, you’re not owning a variety of fruits, but rather you’re holding a bunch of different stocks and bonds — companies headquartered in Canada, the U.S., Europe, and a few places in Asia. You have businesses in the tech sector, but also in energy, financials, healthcare, and more. If a few of those companies end up giving you a bad taste in your mouth, the others should still produce tasty returns.
People love mutual funds, because, on the surface, they’re super easy to understand — every fund holds a bunch of investments, usually chosen by a professional stock picker, named a fund manager. When the stocks in the fund do well, you do well and vice versa.
Now, funds aren’t quite as simple as a basket of fruit. Many funds come with high fees that can eat into your overall returns. The way they’re sold and how the person who sells you those funds are compensated can be extremely confusing. And plenty of options sound interesting but should be nowhere near the average investor’s portfolio.
At the same time, those professional managers often have trouble generating returns above standard benchmarks. That’s why index funds and exchange-traded funds – mutual fund-like securities that simply hold all the same stocks in an index, such as the S&P 500 or S&P/TSX Composite Index — have become so popular over the years.
Mutual funds are by no means perfect, but they’re still wildly popular in Canada, and ultimately, give investors all they need to grow their wealth.
Mutual Fund Investing Do’s and Don’ts
Do:
- Invest now. You’re not going to win the lottery.
- Buy a bond fund. Over the last decade, you did well by simply owning equity. But stocks can be volatile beasts, as we are reminded in recent years. Holding bonds as well as stocks in your portfolio provides the diversification needed to smooth out your long-term investment ride.
- Own index funds. Even better, own exchange traded funds that mindlessly track the Canadian, U.S., and international stock markets, plus a couple of regular Canadian and global equity funds. That way, if some of your funds go into a slump, you’ll probably still have some winners.
- Get your money into a registered retirement savings plan (RRSP) or tax-free savings account (TFSA) as soon as possible. And then leave it there. (Which one you choose to use depends on your savings’ objectives and how much you have to invest.)
- Ask to see a sample account statement when buying a fund. If you can’t understand it, or if they don’t have one to show you, then shop elsewhere. If you can’t tell how much your funds are earning for you, how do you know if they’re doing their job?
- Look for funds with low and easy-to-understand annual expenses, top-quality holdings, and a broad mix of investments.
Don’t:
- Invest in a hot opportunity you heard about. If you already heard about a hot investment opportunity, it’s too late.
- Invest in commodities you don’t understand. Pretty well everything that’s worth investing in is also easy to explain and understand. That’s why tech stocks have been such a great way to lose money in the past.
- Buy funds purely because of a star manager. Star fund managers almost invariably go into a slump and either drop back into the pack or even become underperformers.
- Buy complicated funds. The more bells and whistles attached to the fund, or the fancier the concept, the higher the expenses — and that reduces your return.
Types of Mutual Funds Defined
There are many many (and many) different types of mutual funds. What you choose will depend on your financial goals, risk tolerance levels and more. Here are the key kinds of funds you’ll want to consider adding to your portfolio.
Balanced funds: These funds have a little bit of everything — but in particular, a mix of stocks and bonds in one place — for bone-lazy mutual fund customers. Just dump your money in and let someone else worry about how to invest it but beware of high costs and returns that can be hard to judge.
Fixed-income funds: An essential ingredient in just about anyone’s fund arsenal, these funds usually hold longer-term government and corporate bonds. You earn plenty of interest and a steady return.
Dividend funds: A collection of high-quality conservative shares that produce a stream of lighter taxed payments, ideal for investors who want to get regular income from their funds.
Equity funds: These funds give you a tiny stake — in the form of stocks and shares — in lots of companies. They’re available in a vast array of flavours, from sensible to downright silly.
Fund packages: Nourishing stews of funds (if a little dull) with impressive-sounding names and, often, complicated rules. Typically referred to as wraps or managed portfolios, they are a useful solution if you want to just buy a grab-bag of investments and forget about them. But, as ever, watch out for those sneaky annual fees.
Index and exchange-traded funds: The elegant kings and queens of funds — and something that every investor should own. These beauties simply give you a return that’s in line with the entire stock and bond market by holding just about every share and bond that matters. No muss, no fuss, and nice low annual expenses for you, especially when it comes to ETFs. They’ll never top any performance leagues, but they won’t crash and burn in a plume of black acrid oily smoke, either. (Well, unless the entire market goes bust.)
Money market funds: Almost as dull as that hilarious story you tell about your cute kid. Buy one of these and you’re lending money for short periods to the government or to big companies. Park your money in one and watch it grow slowly. Your savings aren’t at risk — as long as a giant meteor doesn’t land on our nation’s capital.
Segregated funds: Mutual funds with belt, braces, and a parachute strapped on. This gang guarantees to at least refund your investment if you hang onto the fund for years — or to pay the cash to your heirs if your die. Sounds like a great deal but watch out for high annual fees and complicated rules.