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10 frequently asked questions about mutual funds

May 25, 2012

10 frequently asked questions about mutual funds

  1. What is a mutual fund?

A mutual (or investment) fund is a corporation or trust which accepts money from public investors and employs a professional investment management team to place that money in investments that will meet the mutual fund’s objective (i.e. produce the kind of return that the fund has stated as its aim).

A mutual fund therefore is simply a co-operative means for many people to pool their savings together and have their investment professionally managed in the type of investment they choose. This pooled concept is one that allows numerous investors to put relatively small amounts of money into investments that are professionally managed. Those many small sums add to a large amount of available dollars with which the mutual fund manager can use to choose and diversify the investments represented in a specific fund. The mutual fund also offers not only professional money management, but provides full administrative and accounting services for the investor.

  1. Are mutual funds risky?

It’s impossible to compare mutual funds “across the board”. Mutual funds not only differ in their financial objectives but also invest in different kind of securities that reflect the ultimate objective of the fund. Thus, depending on the securities the fund is investing in, or the mix of securities chosen for a specific investment fund, the element of ‘risk’ varies substantially.

The mutual fund’s objective is what the fund seeks to achieve by investing. This will determine what kind of securities the investment will buy, and in what economic sectors or countries.

For example, a mutual fund seeking the highest possible return on capital may invest in more speculative common stocks than one seeking maximum income from dividends. The risk in the first objective is much higher than in the second.

You can see, therefore, that the amount of risk involved is directly related to the mutual fund’s objective. Generally speaking, it can be assumed that the higher the return, the higher the risk involved.

However, mutual funds remove much of the risk from investing because they are professionally managed by fund managers with many years experience in portfolio management. For example, in common stock funds, professional managers select the investments and monitor them carefully and
constantly. In addition, because of the ‘pooled’ concept inherent in mutual funds, the element of risk is spread, thereby making funds less vulnerable to market fluctuations.

It should also be remembered that while it may be considered ‘safe’ to keep one’s savings in cash, there is always the risk that inflation will, over time, erode the value of those savings.

  1. How do the rates of return offered in mutual funds compare with savings accounts?

Generally speaking, savings accounts are the means by which banks and trust companies borrow money from the public and lend it to companies and individuals at higher rates. The financial institution makes money on the spread or the difference between the rate it pays on savings accounts and the rate it charges borrowers. A money market mutual fund, for example, lends money directly to governments, corporations, and financial institutions and all people who invest through such funds earn the higher rate. There is no middle man.

The rates of return for “non-guaranteed” investments, such as common stock funds have, over time, historically been much superior to that of a savings account with a financial institution. This is because, in a free enterprise system, investors who choose to “share” ownership of a public business by purchasing common shares are sharing in the fortunes of the business. If it does well, they share profits – if it does badly there are little or no profits to share. They therefore expect, and get, a higher return for taking this risk. However, it must be borne in mind that the return on a common stock fund would not necessarily be consistent from year to year as companies do better in some periods than others.

  1. What is the minimum amount of money that I can invest in a mutual fund?

This varies between one fund and another but the minimum is quite low for most mutual funds – somewhere in the region of $500 would be fairly common. In addition, it is possible with many mutual funds to start at a much lower level if the investor is prepared to make a regular savings commitment and invest in a fixed amount per month. In such cases the minimum may be as low as $50.00 monthly.

  1. How can I compare the rates of return between different groups of mutual funds?

Before specifically answering this question, it should be clearly understood that one should only compare mutual funds of similar types to get an accurate picture of relative performances. You cannot compare the rates of return between different types or categories of funds – you have to compare apples to apples, oranges to oranges.

For example, it is pointless to compare the results of a fund that invests in oil and gas exploration companies with one that invests in well-established companies. The risks are quite different, as are the possible returns on the investments.

Fortunately, the financial press regularly reports the performance of Canadian mutual funds by type. These reports contain average results over a 1, 3, 5 or 10-year period and are categorized by the investment objective of the fund. This makes it very simple for the investor who is considering, say, a growth fund, to compare all similar mutual funds.

  1. How easy is it to liquidate funds?

Most mutual funds have their shares or units valued daily. This means that investors may purchase shares or units on any business day, and in most cases, may redeem or sell those units or shares back to the fund on any business day.

  1. What types of mutual funds are available?

There are hundreds of mutual funds available in Canada offering a broad range of investment objectives and investing in a variety of securities and in a variety of geographical locations. For example, there are mutual funds that invest in Canadian common stocks, US common stocks and international common stocks. There are also funds that invest in the stocks of specific industries, such as natural resources or oil and gas stocks. Some mutual funds invest only in gold or other precious commodities.

There are dividend mutual funds which aim to maximize dividend income. In addition, there are bond funds and mortgage funds. There are also various types of money market or savings funds based on fixed income or guaranteed investment. Real estate mutual funds invest in real estate. There are balanced funds which balance their holdings between bonds and stocks, depending on how the manager perceives economic conditions at that time. Most of the mutual funds available in Canada are open-end funds, meaning that they issue a continually increasing number of shares and subsequently purchase these shares back from investors on demand.

  1. Are funds covered under the Canada Deposit Insurance Corporation?

The Canada Deposit Insurance Corporation insures the money a financial institution borrows from you in much the same way as you can insure repayment of your mortgage loan or consumer loan.

When you invest in a fund, however, you actually own a piece of the fund’s investments. It’s more like owning a home or other asset you expect will fluctuate in value. There is no loan, or promise to repay it, that needs to be insured when you invest in a mutual fund. Funds only promise to manage your investment, keep it safely while they have it and to pay you its value when you want it back. They are a different type of investment vehicle to bank and trust company accounts covered by insurance. Fund managers and the mutual funds themselves operate under securities regulations, not banking or trust regulations. The assets of the funds are owned by the investors and held on their behalf by a custodian bank or trust company separate from the fund manager.

  1. How are mutual funds suitable for retired people – and where can one get advice on investing and buying into funds?

Mutual funds are suitable for retired people provided there is careful selection of the fund’s investment objectives. A conservative approach to the preservation of capital may be desirable as one reaches more mature years. There may also be increased emphasis on the income needed for retirement. Funds can provide the means to reach both these objectives.

Information can be obtained from the funds’ management or from The Investment Funds Institute of Canada. Advice on investing, financial planning and arrangements to purchase fund shares can be obtained from mutual fund dealers, financial planners, stock brokers and investment dealers. Mutual funds are also available from some banks, individual fund management companies, trust companies and life insurance companies.

  1. What does it cost to invest in a mutual fund – and do I need to understand stock, bond or money markets before I invest?

Basically, all mutual funds charge a management fee which is a percentage of the value of the assets of the fund. On average it is an annual percentage of between 1 and 2 percent. There are also the expenses of administering the fund, which is typically charged to the fund. Together these form the management expense ratio of the mutual fund. In addition, there may be sales commissions charged on the purchase or redemption of shares that are paid to the distributing agency. Remember that commission is paid for the value-added service of investment planning provided by salespeople. The amount of commission will depend upon the size of the purchase. If you understand investment, risk factors and tax considerations, funds without sales commissions (no-load funds) may be investigated.

It is our strong belief that to be successful in reaching your goals it is necessary to have a plan in place and to follow a process. That is, to make your life and financial decisions not by accident but by design.

Remember, successful people ACT towards the future they want!

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