What Are Mutual Funds?

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Mutual funds are an enduringly popular way to invest. They’ve been around in Canada since the 1930s and at the end of 2019 Canadian mutual fund assets totalled $1.6 trillion. Mutual funds pool money from a large group of people to invest in a variety of different securities chosen by a professional fund manager. For the average investor, it’s a way to automatically buy into a more diversified portfolio of stocks, bonds, cash and commodities.

here are thousands of different mutual funds that target specific industries, asset classes, currencies, investing strategies and risk levels. Before investing, make sure to compare fees—professional management comes at a cost, and higher fees will take away from your investment returns.

How do mutual funds work?

Buying a mutual fund is different than buying an individual stock. Instead of directly owning shares in a company, you buy shares of the mutual fund itself, which are called units. Your money is pooled with the contributions of other unitholders, and invested by a professional manager who makes all the decisions around research and analysis, picking investments, asset allocation and rebalancing.

The type of investments a mutual fund holds depends on the fund’s management style and investment objectives, such as income, growth or preservation of capital. For example, a fund focusing on lower risk and more reliable returns might hold fixed-income securities such as government bonds and guaranteed income certificates (GICs). A fund that takes more risks in a bid for potentially higher returns will hold more equities.

Some mutual funds require a minimum investment to buy in—for example, anywhere from $1,000 to $5,000. Most mutual funds are open-ended, and issue new units whenever new investors buy into the fund.

Unlike stocks, which fluctuate in price and can be bought and sold throughout the trading day, mutual fund units are priced at the end of the day and can only be traded after the markets close. In North America, markets trade on weekdays between 9:30 a.m. and 4 p.m. EST.

Can you make money from mutual funds?

Your return is based on how well the fund’s underlying investments perform, and the proportion of fund units you own. If the fund’s investments perform well and you sell your units for more than you paid, you make money (also called a capital gain). If the fund’s investments lose value and you sell your units for less than you paid, you lose money (also called a capital loss). You should also factor in fees and commissions to determine whether you made or lost money.

Depending on the type of fund, you might receive interest or dividend payments on a monthly, quarterly or annual basis. Investment income may be paid in cash or reinvested back into the fund.

The pros and cons of mutual funds

As a way to invest money for savings goals such as retirement, buying a home or university tuition, mutual funds have a few pros and cons.

Mutual fund advantages

Diversification: Mutual funds benefit from economies of scale. This means they increase buying power by pooling the resources of thousands of individuals, while spreading out risk across a wide variety of investments. When you buy into a mutual fund, you can instantly access a diverse portfolio of investments instead of trying to assemble one on your own.

Professional management: Mutual funds employ professionals to handle the minutiae of the markets. This might be appealing if you don’t have the time, knowledge or interest in meticulously choosing your own investments. You can learn about a mutual fund’s objectives and strategies, investment mix, top investments, risk rating, historical performance and returns by reading its fund facts and simplified prospectus.

Mutual funds disadvantages

Higher fees: Canadians pay some of the highest mutual fund fees in the world, with the average management expense ration (MER) coming in at about 2.5%. MER is the total cost of the fund’s management fees and operating expenses, expressed as a percentage of the fund’s assets. Over the long term, higher MERs can eat into your investment gains. Fund managers get paid regardless of how the fund performs, so it’s up to you to decide whether the fund’s performance is worth the fees.

No control over investments: When you invest in a mutual fund, you’re putting your faith in the skills and expertise of the fund manager. You can target certain sectors or research the fund’s strategy and see where your money is invested, but you ultimately have no say over how that manager invests your money.

Types of mutual funds

There are many different types of mutual funds to choose from, depending on your risk tolerance, time horizon and investing goals. Here are a few of the most common ones.

Money market funds

A safer investment with minimal risk, but lower potential returns. These funds invest in preferred shares of stock that generate interest income and short-term, fixed-income securities such as government bonds, treasury bills and guaranteed income certificates (GICs).

Fixed income funds

Focused on stability and regular cash flow, these funds invest in mortgage-backed securities, government bonds and corporate bonds. These funds are generally more conservative investments than equity mutual funds, but their risk-return profiles can can vary widely depending on the quality of the underlying bonds. (A fund that holds non-investment grade corporate bonds, for instance, can be riskier to hold than some equity investments.)

Equity funds

These funds invest in publicly traded stocks. While the return potential may be greater in these funds than in fixed-income ones, they can also carry more risk because they’re subject to equity market fluctuates. Stock-holding funds can focus on companies of a certain size (small, mid and large market capitalization), investment objectives (value, growth or income-producing stocks), a particular sector (health care, telecommunications, energy, real estate, precious metals, etc.), or a specific country or region.

Balanced funds

A combination of equities, fixed income and money market securities that balance safety with the pursuit of higher returns. Most balanced funds invest contributions according to a formula: funds that take more risks hold a higher proportion of equities, while conservative funds hold more bonds.

Index funds

A fund that tracks and mimics a market benchmark or index with the goal of producing similar returns. Index funds have managers that pick stocks and build portfolios, but they’re still considered a passive investment. Since index funds don’t require as much research or analysis, they have lower operating expenses and portfolio turnover.

Fund-of-funds

A fund that invests in a basket of other mutual funds with the goal of providing diversification. It’s similar to a balanced fund, and may also be called a “portfolio fund.” Management expenses and fees for fund-of-funds can be higher than regular mutual funds.

Specialty funds

A niche type of fund that narrows its view to stocks and other securities from a specific geographic region, sector, industry or asset class. Specialty funds may also focus on alternative or specialized investment strategies, such as socially responsible investing. Specialty funds also tend to have higher MERs.

Mutual funds vs. ETFs

An exchange traded fund (ETF) is a type of investment that holds a basket of different securities with the purchase of a single share. ETFs generally track and mimic the investment holdings of an index, so they’re more low-cost and more passive option than most mutual funds. In fact, ETFs were created in the 1990s in response to the high costs associated with mutual funds.

Just like mutual funds, there are dozens of different types of ETFs that invest in different sectors of the market. Mutual funds and ETFs are often compared, but there are a few key differences.

Buying and selling

Like stocks, ETFs are sold in shares and can be bought and sold at any time during the trading day. You buy into a mutual fund by investing a flat dollar amount, and can only trade mutual fund units at the end of the day, after the markets close.

Pricing

Mutual funds are priced based on their net asset value (NAV), which is the total value of the fund’s underlying assets and cash divided by the number outstanding shares. ETF shares have two prices: net asset value and market price, which is based on the bid (what buyers are willing to pay) and the ask (what sellers are willing to take for it).

Transparency

ETFs are more transparent than mutual funds, and publish a daily list of their full holdings on publicly accessible websites. Mutual funds are less transparent, and generally only disclose their general asset mix and top 10 holdings to investors.

Commissions and fees

Most ETFs have much cheaper management expense ratios compared to mutual funds. Since they track an index, the fund company doesn’t have to pay a manager to research, implement, manage and rebalance a portfolio.

How to invest in mutual funds

Mutual funds are widely available through banks, credit unions, caisse populaires, financial planning firms, brokerage firms, trust companies and other investment firms. If you’re ready to invest, here’s how to do it.

1. Choose how you want to invest

You can buy and sell your own mutual funds by setting up a trading account through a robo-advisor or discount brokerage, or get investment advice from a financial advisor. Here’s what you should know about the costs associated with trading, advising and managing your account.

Automated: Robo-advisors offer a set-it-and-forget-it approach by asking you a few questions, assessing your risk profile and using algorithms to appropriately invest your money. You’re normally invested in a broad section of the market, such as in Canada, the U.S. and internationally. Robo-advisors have low opening balance requirements and are inexpensive, with fees much lower than the cost of a financial advisor (0.4%-1% of your investments).

DIY: A discount brokerage is much more hands-on. You can pick your own stocks, bonds or funds and, as the name suggests, trading fees are low (from between $0-$10 per trade depending on the institution). They can be a good fit for investors who want to trade frequently, though trading fees can add up. Discount brokerages don’t offer any financial advice.

Financial advisor: A financial advisor is someone who provides financial planning advice and can, in many cases, invest money on your behalf. Financial advisor fees are generally higher than a robo-advisor or a discount brokerage–often 1% to 2% of the assets they manage.

2. Choose your mutual fund

The type of mutual fund you choose depends on your reason for investing. Do you want to invest in a particular sector, industry, index, country or asset class? Are you investing to generate income, grow your capital or preserve it? Consider your risk tolerance, and how long you have to invest (time horizon). Do your due diligence on management fees, commissions, and how the fund works (who runs it, investment objective, strategy, fund performance).

3. Watch out for fees

Besides MER fees that cover the cost of managing and operating the fund, there are other types of sales fees associated with mutual funds.

Front-end load: A commission or fee charged upfront when you buy the investment. For example, if you have $1,000 and a fund charges a 5% front-end fee, you’ll be charged $50 and have $950 leftover to invest. This type of charge can be negotiated with your advisor.

Back-end load: You don’t pay any fees up front, but must keep your money in the fund for a predetermined period of time or pay a redemption fee. The most common type is a deferred sales charge, where you pay a smaller redemption fee the longer you stay in the fund. So if you invest $1,000 in a fund with a deferred sales charge of 5% that drops by a percentage point every year, you would have to wait five years to redeem without paying a fee.

No-load fund: Investors can buy and sell at any time without paying a commission or sales charge. Instead of sales charges, no-load funds often have higher expense ratios and compensate by charging other fees such as redemption fees, exchange fees and miscellaneous account fees.

How are mutual funds taxed?

How investments are taxed depends on what kind of account they’re held in. If you hold mutual funds in a registered account, your investments receive special tax-sheltered or tax-deferred status. Types of registered accounts include registered retirement savings plans (RRSPs), tax free savings accounts (TFSAs) and registered education savings plans (RESPs). Each has its own rules around deposits, withdrawals and taxes.

For non-registered investment accounts, you’re liable for taxes on capital gains, interest income, dividends and foreign income whenever the mutual fund sells its investments and distributes income to fund investors. Whether you receive your distributions in cash or reinvest them back into the fund, distributions are taxable in the year you receive them.

When you sell your mutual fund units, the issuer redeems them back into the fund. This triggers a capital gain or capital loss on your end, depending on whether you sold your units for more or less than you paid. In Canada, 50% of capital gains are taxable, while capital losses can be declared to offset gains. You can use capital losses in the current year to reduce gains in any three preceding years or future years.

Mutual funds are plentiful in Canada, and investing in them is one way to build a diversified, professionally managed portfolio. When deciding which type of fund to invest in, it’s important to understand your personal profile and risk tolerance. Look for a fund with the right asset allocation, investing objectives and management style for your goals. And don’t forget to double-check fees and MERs, which, depending on what you’re charged, could have a significant impact on your savings over the long-term.