Mutual Funds 101

Mutual Funds – Introduction

When you invest in mutual funds you are putting your money together with many other people and asking a professional money manager to invest it on your behalf. The fund manager invests it for the whole group into a variety of investments, which suit the fund’s specific investment objectives. Each fund has its own investment objectives. Funds can invest in stocks, bonds, cash or other securities or combinations of these types of securities. If the fund manager’s choices of investments make a profit, you share that profit along with everyone else in the group. If the investments lose money, everyone shares in the loss.

When you put money into a fund, you receive in exchange units or shares of that fund. A mutual fund’s unit value is described as the net asset value per share (NAVPS). The NAVPS is calculated by taking the total value of the fund if everything was sold on that day, less its any outstanding debts it owes, and dividing by the number of units held by all the fund’s investors. For example, if a fund is worth $10 million (value less what it owes) and has one million units outstanding the NAVPS will be $10. If you own 10 units your investment is worth $100.

Mutual Funds – Categories

Equity funds invest primarily in stocks of companies, generally common shares. When you buy a stock of a company you are buying a piece of the ownership of that company. Some equity funds invest strictly in Canadian companies and others may invest in companies in other countries.

Equity funds are riskier than money market or bond funds, but they also can offer the highest potential returns. A stock’s value can rise and fall quickly over a short period of time, but historically stocks have performed better over the long term than other types of investments, such as bonds and money market instruments. Equity funds are often best used as long term investments.

Bond funds invest primarily in bonds. When you buy a bond, the company selling it to you is promising to pay you your money back on a certain date with interest. Bond funds have a higher risk (especially interest rate risk) than money market funds, but result in higher returns. Unlike money market funds, bond funds are not restricted to investments with short time frames. Some bonds come due in 20 years. There are many different kinds of bond funds and as a result they vary in their risks and returns.

Money market funds invest in good quality government guaranteed investments with very short time frames. These investments pay interest to investors. They are most appropriate for short term investment and savings goals or in situations where you want to safeguard the value of your investment while still being paid interest. Money market funds have relatively low risk compared to other mutual funds but they also have low returns. However, they do usually pay higher interest than a savings account or short term deposit.

Mutual Funds – Costs or Fees

As a mutual fund investor, you hire a group of people to manage your money, account for it and keep you informed. You pay their salaries and expenses through various fees.

Some of those fees are paid directly. Others are paid indirectly through deductions from the mutual fund. You’ll find all fees – direct and indirect -detailed at the front of the fund’s Simplified Prospectus – the document you should receive when you buy mutual funds outlining the fund’s goals, objectives, risks, managers and other key information.

There are three broad categories of fees:

  • Management expenses (to pay for the management of the fund)
  • Sales fees (to pay for buying or selling the fund’s units)
  • Special fees (for special administrative costs)

Generally all mutual funds have management expenses. You are not billed directly. These expenses are deducted from the fund.

The “management fee” is the biggest element. It pays for such things as the mutual fund company’s investment management, marketing and administrative costs. Each fund also pays its own operating costs such as brokerage fees on securities trading, audit fees and unit holder communications.

The fund reports the management fee and direct costs it pays each year as a “management expense ratio.” This MER relates those costs to the fund’s value. If a $100 million fund has $2 million in costs, its MER is 2%. The costs are deducted before the fund’s performance returns are calculated. If your fund made 12% and the MER was 2%, the reported return for the year would be 10%.

Unlike management expenses which apply to all unit holders, special fees apply to individual situations. You pay them directly or through specific deductions. Some examples:

  • Annual RRSP, RRIF or RESP trustee fee. This covers the cost of operating the plan.
  • Account set-up fee. Some dealers levy a one-time charge for new clients.
  • Short-term trading fee. Mutual fund companies are allowed to deduct an amount, generally 2% from any redemption that occurs within 90 days of purchase. Many don’t.
  • Transfer fee. At the discretion of the individual advisor, dealers can levy a charge of up to 2% when you switch among funds in the same family.

Processing  fees. Your fund company may levy a fee if you close an RRSP account, have money wired to your bank account or other transactions that require special processing.

Sales fees compensate financial advisors and dealers who sell funds on behalf of mutual fund companies. There are two types: commissions and service fees. Some mutual funds carry both. Some carry just service fees. Some carry none at all.

 

Commissions are paid at the time of sale, or shortly after, to the advisor or dealer who takes your order. There are two formats:

  • Front-load. You pay this directly. For example, the advisor might have 4% deducted from your money and the remaining balance is what is invested. Front loads are negotiable. Some advisors and dealers now offer these funds with a 0% front load. Their compensation comes entirely from service fees.
  • Deferred sales charge (DSC). The mutual fund company pays the dealer a commission, often about 5%. All of your money is invested, but you face a redemption fee if you sell your units within a set time. That fee often declines to zero over six or seven years. Normally, you can switch among funds in the same family without facing a redemption fee. Usually you can redeem up to 10% a year without paying any fees, but fund companies calculate the 10% using different methods i.e. book value, market value.

Some funds – called “no-loads” – have no front loads or redemption fees (except a short-term trading fee, in some cases). Most are sold by financial institutions and mutual fund companies that deal directly with the public or with certain occupational groups. No-load funds may or may not have lower management expense ratios than similar funds that carry commissions. Compare each fund’s management fee.

Service fees – also called “trailers” – are on-going commissions intended to pay advisors and dealers for on-going service. Each year the advisor or dealer gets an amount that equals a certain percentage of your account’s value. That’s often about 1% on front-load accounts and ½% on DSC accounts. No-load companies may also pay trailers to dealers. Dealers disburse the fees to their sales force including financial planners, sales reps, and bank employees of a financial institution.

You do not pay service fees directly. They’re paid by the mutual fund company – in most cases from its management fee. As with commissions, funds that carry low trailers or none at all may or may not have lower management expense ratios.

Mutual Funds – Risks

Mutual funds have different investment objectives and invest in different types of securities or investments. The element of risk varies depending on the types of investments in the funds. For example, a fund seeking to grow in value over the long term may invest in the stocks of more risky companies. Generally speaking, it can be assumed that the higher the risk, the better the investment should do for you. Risky investments have to pay off for investors or no one would buy them.

However, mutual funds control risk to some extent because they are diversified. That means they invest in a large number of investments at the same time spreading out the impact if any one of the investments should lose money. For example, if the fund held stocks in 30 companies and one company went out of business, the loss of the value of that stock would not make the fund collapse as there are 29 other companies that are still doing fine and growing.

You must also realize there is the risk of taking no risk. If you invest in cash, inflation can eat away at your purchasing power. Inflation is how much the cost of goods increases over time. For example, if you hold cash and the cost of goods rises by 3%, the jeans you want to buy will cost you $103 now while you only hold $100.

What is the minimum amount that can be invested in a mutual fund?

This varies between funds but the general minimum is about $50 a month or a lump sum of about $500.

Mutual Funds – Canadian Depository Insurance Corporation (CDIC)

The CDIC insures money deposited into a financial institution. Mutual funds are not deposits. Funds promise investors to manage your investment, keep it safely while they have it and to pay you its value when you want it back. There are no guarantees to the value and therefore no insurance. Banks can use your deposits to lend to other people. Mutual fund companies cannot. Because of the government oversight of how mutual funds operate and the rules they must follow, the money you invest is relatively safe. No one can guarantee protection from market ups and downs.

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