Most people understand the basics of investing. If you take the money you have saved and invest it in the markets, it’ll hopefully grow to a larger sum when you need it.
The issue is that with so many different products available, potential investors may become overwhelmed because there’s too much choice. One product that tends to appeal to new investors is mutual funds, as they’re a simple way to get started without much effort. If you’re not sure exactly what a mutual fund is or how a mutual fund works, we’ve got you covered.
What is a mutual fund?
A mutual fund is an investment vehicle that pools money from numerous investors. That money is used to purchase stocks, bonds, or other assets based on the goal of the mutual fund. This type of product is appealing to investors because they don’t need to worry about picking individual investments. They get access to a diversified portfolio immediately.
Management of the mutual fund is left up to a professional fund manager. Some mutual funds are actively managed, where the fund manager makes purchasing decisions based on experience and market opportunities.
Types of mutual funds
While there are thousands of mutual funds available, they can be broadly broken down into four categories:
● Equity Funds: These primarily invest in stocks, aiming for higher returns, but they come with greater risk. They’re ideal for long-term investors pursuing growth since they can weather short-term market fluctuations. Some equity funds focus on specific sectors - such as tech, healthcare, or energy - or geographic regions to maximize potential gains.
● Bond Funds: Since bond funds focus on fixed-income securities, such as government or corporate bonds, they're low risk. That said, in exchange for this stability, your return won't be as high compared to equity funds. They're conservative investors or those who may need to withdraw their money soon.
● Index Funds: These track a specific stock market index - such as the S&P/TSX Composite Index, S&P 500, and the Dow Jones Industrial Average - giving you broad market exposure. They’re great for passive investors. Since they aim to mirror the market's performance, they don’t require frequent trading, which may help reduce management fees.
● Balanced Funds: With a combination of equities and fixed-income securities, these funds aim to balance risk and reward, thereby assisting with volatility. There are many balanced funds available, allowing you to choose one based on your risk tolerance.
Costs & risks of mutual funds
There’s no immediate fee for purchasing a mutual fund. However, all shareholders must pay a management expense ratio (MER), which covers management fees and operational expenses. This annual fee is deducted as a percentage of the fund’s total assets, regardless of whether the fund has increased in value or not.
The MER for mutual funds typically ranges from 2% to 2.5%. While this may seem like a small price to pay for access to experts, when factoring in compounding, the fees can become significant compared to other investment products. To find the MER of any fund, you should read the fund’s prospectus.
Regardless of which fund you’re invested in, there will always be market risks to consider. For example, a downturn in the economy will likely reduce the value of an equities fund. Similarly, a cut to interest rates by the Bank of Canada could impact bond funds.
Investors should always choose a fund that aligns with their risk tolerance. If you’re unsure where you stand, just about every mutual fund dealer will have a questionnaire to help you determine your risk tolerance.
Choosing the right mutual fund
With so many mutual funds available, it can be overwhelming. Fortunately, you can narrow down your choices by following a few steps.
- Define your goals: Are you saving for retirement or a down payment for your first home? Your goals will determine whether you should invest in equity funds, bond funds, or balanced funds.
- Consider your risk tolerance: If you can manage market fluctuations - where the value of your portfolio might increase or decrease - an equity or balanced fund is often recommended. However, a bond fund with lower risk may be more appropriate if you're frequently anxious about money.
- Check the fund’s strategy: Some funds focus on growth, regions, or providing dividends. Choose one that aligns with your financial goals.
- Check past performance: Past performance doesn’t guarantee future results, but seeing how the fund performed compared to similar funds over the last few years can give you an idea of how it’s run.
- Check the fees: Lower-cost funds like index funds typically charge lower fees, which can help maximize returns over time.
Final thoughts
Mutual funds provide a straightforward and accessible way for investors to create a diversified portfolio without requiring extensive market knowledge or active management. Although they tend to be more expensive than other investment options, they are appropriate for anyone looking to start investing now – and the payoff could definitely be worth it in the long run.
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. As a completely self-taught, do-it-yourself investor with no formal training, he makes money easy to understand for all Canadians. His specialties include personal finance, budget travel, millennial money, credit cards, and trending destinations.