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What are Mutual Funds?

Back to basics: Why people buy them and why fees are key 

Ruth Saldanha 14 July, 2020 | 2:55PM
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A mutual fund is an investment vehicle that allows a group of people to pool money together to invest in a range of different securities such as stocks, bonds, property or commodities.

You’re Not Buying Stocks
It is important to remember that as a mutual fund investor, you do now own the actual stock, or bond, or commodity, in which the fund invests; you won only the shares of the fund itself.

For example, if you were to buy units of Mawer Canadian Equity A. The fund’s top holding is Canadian Pacific Railway (CP). You, as an investor in Mawer Canadian Equity A, do not hold Canadian Pacific Railway, are not a shareholder of the company, and cannot vote at Canadian Pacific Railway’s annual general meeting. You do, however, own shares of the Mawer Canadian Equity Fund A. This said, investors will find that the price of a mutual fund moves largely in tandem with the fund’s stock holdings.

Mawer Canadian Equity A is a Canadian equity fund, which means it invests in Canadian stocks. Each mutual fund has an underlying asset or security, like stocks, or bonds, or commodities, and each fund also has an objective. Some funds aim to deliver a regular income. Others provide investors with capital growth. Still, others offer investors access to specific sectors or commodities. Funds are grouped into categories determined by their objectives or aims, and by where in the world their underlying assets are from.

Managed for You
In most cases, mutual funds are actively managed, where an appointed individual (or a fund manager) picks which securities or assets to invest in from a larger pool, assisted by a research team. The underlying holdings of a fund are known as its portfolio.

The decisions of which securities to buy and sell, and perhaps as importantly, WHEN to buy or sell, are made by the fund manager. Often, funds have more than one manager. Most managers have teams of researchers to help with the process.

A fund manager’s job is to find securities that will help the fund do better, or outperform, its benchmark. A fund’s benchmark is usually an index. One way to tell if a fund is performing well is to see how it does relative to its index. You might also consider comparing the fund’s performance against its peers, which can be defined by the category to which it belongs.  However, it is vital to remember that past performance is no guarantee of future returns

Prices
Every mutual fund quote page on Morningstar.com begins with a quoted net asset value, NAV, for the fund.  At the most basic level, net asset value is the current price for one unit of a fund.

Net asset value, as the name suggests, reflects the value of the fund's net assets (assets minus liabilities, such as the cost to operate the fund) divided by the number of shares. This price, or NAV, fluctuates each day, based on the value of the underlying holdings in the portfolio at the end of each business day. Next to the fund's closing price (NAV) you'll find the amount and percentage by which its NAV changed relative to the previous trading day.

The Fine Print
When you sell a mutual fund, you’re not selling stocks (or any other assets) directly either. You’re selling your piece of the fund, minus expenses... Mutual funds all have a variety of fees. There are costs to buy and sell. Some funds charge you a penalty if you sell a fund too soon – this is called a ‘redemption charge’. Still, others have upfront commissions or ‘loads’ paid to the salesperson selling you the fund. Plus, investors also pay ongoing operating expenses.

These fees are expressed on an annual basis but are typically charged monthly or quarterly. For most funds, fees are charged regardless of how the investment manager performs. As Morningstar’s director of investment research Ian Tam explains, let’s assume an overall cost of 2% to own a fund, if in one year a fund returns 6%, you’ll receive roughly 4% for that year. However, if the fund loses 6%, you lose 8% after fees. So you will probably pay the same fee this year as you did last year on the same fund that in all likelihood is showing losses on a year-to-date basis. 

Put in percentage terms, after 10 years, the impact of a 2% fee results in a difference of 18% less wealth when compared to no fees. After 20 years, that gap balloons to 33% So you need to be diligent in monitoring the fees you’re being charged because the fees you pay are detrimental to the amount of wealth you will end up with. 

Should I Buy a Mutual Fund?

The answer is rarely ‘Yes’ or ‘No’. Most of the time, the answer is, ‘It depends’.

Before you decide WHERE to invest, you need to know WHY you’re investing. Is it for retirement? To buy a home? A car? For your child’s education? When will you need the money? These questions will help you determine your investment time horizon, which is tied directly to your risk appetite. The longer your time horizon, the more risk you can afford to take.

Once you know why you want to invest, you could consider where to invest. Mutual funds are suitable for investors who do not have the time or expertise to construct and monitor a portfolio themselves and would rather have this done by a team of professionals. They require a smaller investment than picking individual stocks or bonds allowing the investor to gain access to a far greater number and variety of securities which decreases risk through diversification.

However, fees should always play a part in your decision-making process. Is there a cheaper way to get the benefits of mutual funds in almost all cases? The answer is yes – with exchange-traded funds or ETFs. Here’s how to find out more about ETFs.

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About Author

Ruth Saldanha

Ruth Saldanha  is Senior Editor at Morningstar.ca. Follow her on Twitter @KarishmaRuth.

 
 
 

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