Mutual funds are an investment vehicle that’s been around for nearly 200 years and have gained immense popularity, especially in recent decades. In the 1960s, Canada had only 30 mutual funds with a total managed capital of $560 million. Fast forward to 2018, and that number soared to over $1,400 billion.
These funds pool money from numerous investors to invest in a variety of securities—like stocks, bonds, and real estate—at the discretion of professional managers. Each investor shares in the profits or losses based on their contribution to the fund. This setup is ideal for those who lack the time or expertise to manage their investments directly. The investor simply buys shares in the fund and receives returns accordingly. In essence, mutual funds allow a group of investors to entrust their money to experts for management.
Currently, Canada boasts over 4,000 different mutual funds operated by more than 140 companies, each varying in risk levels and potential for growth. Despite their diversity, mutual funds come with their own set of advantages and disadvantages.
Advantages of Mutual Funds
Professional Management: Entering the investment market solo can be challenging, requiring knowledge, experience, and time. Knowing when to buy or sell investments adds another layer of complexity. Hiring a financial expert can be costly, especially for someone with limited funds. For a low income individual, hiring a financial expert may not be feasible, as their fees could outweigh potential gains.
Mutual funds solve this dilemma by pooling funds from many investors—sometimes billions of dollars—allowing individuals to access professional management for a cost.
Investment Diversification and Risk Reduction
Diversification is crucial for mitigating risk in modern investing. Mutual funds typically invest in a mix of securities, bank deposits, stocks, and bonds, helping to create a well-rounded portfolio for investors. This strategy ensures that you’re not putting all your eggs in one basket, significantly lowering your investment risk.
For instance, if you invest $100 million in a single high-rise building, a disaster could wipe out your entire investment. However, if you spread that same $100 million across 100 different buildings across country, any loss from one would only affect a small portion of your capital.
Similarly, consider investing $100 million in Bombardier’s stock. If that company fails, you risk losing everything. On the other hand, if you invest in several companies—like the five major Canadian banks, Bombardier, energy firms, and retailers—you can cushion any losses from underperforming stocks with gains from others.
Similarly, if you allocate funds to various industries—like technology, energy, and retail—you can mitigate the risk of underperformance in any single sector. However, for those without substantial funds, achieving diversification can be challenging. A well-rounded investment portfolio may require purchasing shares across several industries, which can be costly and may necessitate a significant initial investment.
Mutual funds offer individuals the chance to diversify their investments, even with a small amount of capital. By purchasing a share of a fund that has substantial resources for diversification, you gain access to a broad range of assets. For example, a mutual fund worth billions might include various stocks from different industries and countries, government bonds, and treasury bills. When you invest in a mutual fund, you buy shares that represent a mix of these diverse investments, allowing you to participate in a well-rounded portfolio with amounts as low as $500 lump sum or even $25 a month.
Different Types of Mutual Funds Correspond to Different Risk Profiles
Are you someone who embraces risk for the chance of higher returns, or do you prefer a more cautious approach with steady, modest growth? Perhaps you’re nearing retirement and prioritize preserving your principal investment over capital appreciation?
Investment perspectives vary widely, shaped by individual circumstances, income levels, and goals. A young adult’s investment strategy is likely to differ significantly from that of a 65-year-old retiree. Risk tolerance also plays a critical role in these choices. Generally, younger investors may opt for high-growth assets, while older individuals tend to favor stability with guaranteed returns.
Mutual funds cater to these varying risk profiles. Some funds focus exclusively on low-risk investments, like government bonds, while others may target equities from established companies or higher-risk, high-growth startups.
With various types of mutual funds available, you can choose according to your preferences. For those seeking regular income, fixed-income funds may be suitable. Conversely, aggressive investors might opt for funds aiming for significant capital appreciation. Additionally, there are funds that invest in commodities like gold and agricultural products, allowing indirect participation in these markets. Ultimately, there is a mutual fund for every investment style and risk tolerance, providing a diverse array of options for investors.
Some Advantages of Mutual Funds:
Easy Process to Purchase and Redeem
Mutual funds offer a variety of purchasing options, including lump-sum investments and instalment payments made monthly or weekly. Selling your mutual fund shares is just as straightforward; mutual fund companies must process redemption requests and deposit funds into your account within 24 hours.
Flexibility After an Investor’s Death
One of the benefits of mutual funds is that they are professionally managed, even if the investor passes away. This means that the capital remains under management until legal processes for asset distribution are finalized, avoiding potential losses that could occur if the investor had managed individual stocks during a market downturn.
Accepted as Collateral
Your mutual fund investments may be used as collateral for loans or lines of credit, although the acceptable percentage will vary based on the fund’s market value.
Transparency
Mutual funds must provide regular reports on transactions and investment performance, adhering to stringent regulations from the Securities Commission. Investors can easily access this information on mutual fund providers’ websites, ensuring informed decisions. Before selling a fund, sellers must present comprehensive details, including a document known as Fund Facts, which outlines essential information in clear, accessible language. Furthermore, those selling mutual funds in Canada are required to be registered and licensed professionals.
Disadvantages of Mutual Funds
Cost: While mutual funds offer various advantages, they also come with costs. Most funds charge a fee based on a percentage of your investment, typically ranging from just under 1% to several percent, depending on the fund type.
Unsuitable for Short-term Investments: Investing in mutual funds often requires a longer time horizon—generally at least three years—because short-term price fluctuations can negatively impact your capital. For instance, you might aim for an 8% annual return but experience fluctuations like -10% in the first year, 0% in the second, and +30% in the third. While it’s possible to profit, mutual funds may not be the best choice for those needing quick access to funds.
Professional Fund Management Does Not Guarantee Profit: Although mutual fund management is a key advantage, it’s important to remember that no one can predict market movements with certainty. Even top managers may underperform in certain years due to market conditions or their own decisions. While professional management can enhance your chances of capital growth, it doesn’t guarantee it.
Classification of Mutual Funds
Mutual funds cater to various investor profiles, from those willing to take on risk for high returns to more conservative investors seeking safer, smaller profits. To facilitate decision-making for potential investors unfamiliar with the underlying securities, mutual funds are categorized based on risk levels, growth potential, and asset types. This classification includes standard definitions and terms to help investors choose wisely.
Money Market Mutual Funds
Money market mutual funds are defined as funds that invest at least 95% of their capital in money market securities. These are short-term, fixed-income securities (maturing in less than 364 days) that can be easily converted to cash, with government treasury bonds being a prime example. Essentially, these funds allocate investors’ money to short-term bonds, primarily government-issued, which carry minimal risk.
As a result, the returns from these funds are relatively low and fluctuate slightly based on bank interest rates, similar to Guaranteed Investment Certificates (GICs). The yield increases when government interest rates rise and decreases when they fall. It’s important to note that you, as an investor, can keep your money in these funds for years; the fund management team is responsible for replacing maturing bonds with new ones as needed. Many banks and investment firms offer this type of fund for those seeking low-risk investment options.
Mortgage Mutual Funds
Mortgage mutual funds primarily invest in high-quality mortgages. They acquire large numbers of mortgages from banks or financial institutions, which issue loans to individuals. Instead of maintaining these loans on their balance sheets for decades, banks bundle them together and sell them to mutual funds. This arrangement benefits both parties: the fund gains a source of income for its investors, while the bank frees up capital to issue more loans.
Typically, mortgage mutual funds allocate most of their capital to mortgages, with a smaller portion in cash, bonds, and mortgage-backed securities. They are classified as “fixed income” mutual funds because the mortgage rates are generally predetermined. Unlike money market mutual funds, which provide fixed returns, mortgage mutual funds can experience increases in value over time.
Mortgage Mutual Funds
Bond mutual funds primarily invest in a diverse range of bonds, generating income mainly from the interest on these securities. While the funds can appreciate or depreciate in value, they are sensitive to changes in interest rates: rising rates typically lead to declining fund values, while falling rates can boost them. Additionally, there’s a risk of default if a bond issuer fails to repay. The level of risk varies among bond funds, with those focusing on government bonds being less risky compared to those investing in corporate bonds. As an investor, you can choose a bond mutual fund that aligns with your risk tolerance.
Equity Mutual Funds
Equity mutual funds primarily invest in common or preferred shares of publicly traded companies. This category encompasses a wide range of investments, each with varying objectives and risk profiles. For instance, one fund may aim for steady income with minimal capital growth, while another might focus on maximizing long-term capital appreciation without prioritizing short-term income. As a result, equity mutual funds can cater to diverse investment strategies and goals.
Mutual funds offer a diverse range of investment options, catering to various financial goals and risk tolerances. From equity mutual funds that focus on stocks to balanced funds that combine bonds and equities, each type has its unique characteristics. Understanding these categories can help investors make informed decisions that align with their objectives. Below, we explore different types of mutual funds, including their investment strategies and potential benefits.
Standard Equity Mutual Funds: While the term “standard” isn’t officially defined, it refers to the most common type of equity mutual fund. These funds aim to enhance value and profitability through a combination of dividend income and capital appreciation, investing in both high-growth potential companies and stable corporations that offer consistent profits.
Equity Growth Funds: These funds prioritize capital growth, investing in stocks with significant long-term price appreciation potential. While they may provide little short- to mid-term income, they are designed to achieve substantial growth over time, focusing on smaller, developing companies rather than large, stable corporations.
Equity Index Funds: Rather than selecting individual stocks, these funds invest in a stock index, reflecting the performance of a broad range of companies, such as the S&P/TSX60, which comprises 60 major Canadian corporations. This approach ties the fund’s performance to the overall market or a specific market segment.
Balanced Mutual Funds: These funds allocate capital between stocks and bonds, blending the characteristics of equity and bond funds. The ratio of bonds to stocks determines the fund’s risk level: a higher bond allocation suggests a more conservative approach, while a higher stock allocation indicates a willingness to take on more risk for potential higher returns. Fund providers offer various balanced options to cater to different investor preferences.
Target-Date Funds: Distinguished by their expiration date and glide path strategy, these funds are designed for specific financial goals. Investors choose a target date, and fund managers adjust the investment strategy over time, starting with higher-risk assets and gradually shifting to lower-risk investments as the target date approaches.
Global Mutual Funds: These funds invest in securities from various countries rather than focusing solely on Canadian assets. Although all types of mutual funds can be global, they often take the form of equity funds investing in international stocks. Global mutual funds can help mitigate market risk and currency risk by diversifying across different economies.
Specialty Mutual Funds: Investing in a specific niche, such as precious metals or natural resources, these funds typically have limited diversification compared to broader mutual funds. For example, a gold-focused fund might invest in several companies in the gold sector but will remain highly sensitive to gold market fluctuations.
Fund Wraps: This program curates a selection of existing mutual funds tailored to an investor’s specific conditions and goals. A fund wrap involves a mix of different mutual funds allocated in prescribed percentages, allowing for a diversified investment strategy managed by a fund professional.
