Mutual funds are essentially a basket of securities and when you buy a mutual fund, you’re buying a share of that basket. Many investors choose to invest in mutual funds because they’re managed by professional portfolio managers. This gives the investor a piece of mind when it comes to investing as they don’t have to worry about watching the market or monitoring their portfolios. For this peace of mind, the manager charges a fee known as the Management Expense Ratio (MER). There are a wide variety of funds to choose from and they have different risk profiles.
Management Expense Ratio
Many people think that investing in mutual funds is free. That is not the case. Mutual funds have a management expense ratio known as the MER which is total annual expenses relative to the fund’s assets. The MER is the cost of investing in the mutual fund and is usually expressed as a percentage.
An example of the MER breakdown is below:
- Portfolio Management Fees
- The portfolio management fee is the portion that is paid to the fund company and portfolio managers managing the fund. This fee covers research, compliance, trading and other events that may go into managing the day to day activities of the fund.
- Trailer Fees
- The trailer is paid to the investment dealer who sold the mutual fund. The investment dealer then may pay a portion of the trailer to the advisor who recommended the mutual fund to the client. The trailer is typically 1%.
- Operating Costs
- Operating costs cover custodian fees, accounting fees, auditing, record keeping and much more.
- GST/HST
- Mutual funds include GST/HST in their management fees.
Example of MER: Fund ABC has an MER of 0.80%. If an investor has $10,000 in the fund, their annual cost would be $80.
Types of Mutual Funds
There are over 5,000 different types of funds, each different than the other. The most common types of mutual funds have a combination of equities and fixed income. Below we’ll go over the most common types of funds that you might run into during your course of investing.
- Money Market Funds – Money market mutual funds allow Canadians to earn a higher rate of interest from their cash balances. These are low risk investments that allow you to earn interest and access your money fairly quickly, typically a one day settlement. These money market funds invest in short term high quality debt instruments such as treasury bills with the primary goal to preserve your capital.
- Fixed Income Funds – Fixed income mutual funds invest in short term and long term debt securities such as government bonds, treasury bills, corporate bonds etc. These type of funds aim to preserve your capital while provide you with a regular monthly distributions. In addition, fixed income funds are sensitive to interest rates and may differ by geographic location, credit quality, term to maturity, investment strategies and so on.
- Equity Funds – Equity mutual funds invest in a basket of stocks. These funds may differ by the type of companies that they purchase. Equity fund categories could include small, mid and large cap funds. Cap refers to the capitalization and size of the companies in the basket of stock purchases. These funds may pay a monthly dividend distribution.
- Balanced Funds– Balanced funds have an equal combination of stocks and fixed income. Typically, these funds have 50% of the assets in bonds and the other 50% in stocks, however, this can deviate depending on the portfolio mandate. The goal of these mutual funds is to preserve your capital while giving you the opportunity for growth.
- Alternative Funds – Alternative mutual funds have more freedom to take on risk. These funds typically, hedge funds, are allowed to invest in physical commodities, take position in derivatives such as options and engage in short selling. These types of strategies are typically not permitted in regular funds.
- Funds of Funds – Funds of funds are mutual funds that invest in other mutual funds. These type of funds are typically very diversified often holding over 10 different funds in their portfolio. These types of funds are also known as multi-manager investments.
Advantages of Mutual Funds
- Convenience
- Affordability
- Access to your money
- Professional management
- Diversification
- Access to markets
Mutual funds are typically recommended to individuals who are not comfortable in investing in stocks or bonds by themselves. Mutual funds have continuous oversight that might make a novice investor comfortable knowing that their money is managed by a professional portfolio manager.
Every mutual fund provides a document called Fund Facts for investors. This includes the fund’s risk rating, based on the past volatility of the fund’s returns. Make sure that you always review a mutual funds fund facts before investing.