A mutual fund is a collection of investments such as stocks, bonds, or other funds that is professionally managed. A mutual fund might benefit your investment portfolio, but like any investment there are also risks. There are pros and cons, and questions you could consider before buying a mutual fund.
On this page you’ll find
- Why do some investors choose mutual funds?
- What questions should you ask before buying mutual funds?
- What are the risks of investing in mutual funds?
- How is your mutual fund investment protected?
- What happens to your mutual fund if a firm goes bankrupt?
- How can you research the mutual funds you invest in?
Why do some investors choose mutual funds?
There are a range of reasons why adding mutual funds may make sense for your portfolio. Four main reasons are:
1.Built-in diversification
When you buy a mutual fund, your money is combined with the money from other investors. This allows you to buy part of a pool of investments. A mutual fund holds a variety of investments which can make it easier for investors to diversify than through ownership of individual stocks or bonds.
Not all investments perform well at the same time. Holding a variety of investments may help offset the impact of poor performers, while taking advantage of the earning potential of the rest. This is known as diversification.
2. Professional management
You may not have the skills and knowledge to manage your own investments, or you may not want to spend the time. Mutual funds allow you to pool your money with other investors and leave specific investment decisions to a portfolio manager. Portfolio managers decide where to invest the money in the fund, and when to buy and sell investments.
3. Ease of buying and selling
Mutual funds are widely available through banks, financial planning firms, investment firms, credit unions and trust companies. You can sell your fund units or shares at almost any time if you need to get access to your money. However, keep in mind you may get back less than you invested if you sell when the fund is at a lower value than when you first invested.
4. There are a wide range of funds to choose from
Mutual funds can be used to meet a variety of financial goals. For example:
- A young investor with a stable income and many years to invest may feel comfortable taking more risk to achieve greater potential return. They may invest in an equity fund.
- A mid-career investor trying to balance risk and return more moderately could invest in a balanced mutual fund that buys a mix of stocks and bonds.
- An investor approaching retirement might be less comfortable with risk and more interested in fixed income investments. They may invest in a bond fund.
Why might mutual funds not be right for you?
- Fees
Investments typically have fees associated with them. Mutual funds include fees for things such as sales charges, fees, and expenses, regardless of how the fund performs, even if the fund has negative returns.
- Transparency
Mutual funds have different compositions according to their investment objectives and strategies. Different mutual funds will also have different levels of risk exposure. This type of information can typically be found in the Fund Facts and other documents about the fund. fund’s However, specific details of a mutual fund’s holdings are only known to investors at certain points in time, and you don’t have any influence over investment decisions made by the portfolio manager.
- Pricing
The price to buy or redeem your shares usually depends on the fund’s net asset value (NAV), which is generally calculated only once every business day. This is different from buying individual stocks, whose prices are monitored throughout the day.
What questions should you ask before buying mutual funds?
You can find out information about a mutual fund from your investment broker or the financial institution selling the fund. Some information is also in the Fund Facts and other documents describing the fund. It’s a good idea to find out answers to the five questions before you buy.
1. What is the mutual fund’s goal?
Make sure the fund’s goal fits with your investment goals. For example: Does the fund provide regular income? Does it fit with the length of time you plan to invest, and your personal goals? Does it work with your other investments?
2. How risky is the fund?
You can make or lose money on a mutual fund. Does the fund’s level of risk fit with your tolerance for risk? Do you find it difficult to handle price fluctuations? If a fund’s returns vary a lot from year to year, it may be considered higher risk because its performance can change quickly in either direction.
3. How has the mutual fund performed?
It’s true that past performance isn’t necessarily a guarantee of how a mutual fund will perform in the future. But it can give you an idea of how the fund compares to other funds with the same investment objective. Don’t just look at how the fund performed last year. How consistent has it been over the long term? How has it performed in different market conditions? If the fund’s investment objective has changed in recent years, its past performance will be even less of a reliable predictor of its future performance.
4. What are the mutual fund’s costs?
All funds must disclose their fees and expenses in their Fund Facts document and simplified prospectus. Consider all of the costs. For example, a fund with a low management expense ratio (MER) could have very high sales charges, and vice versa. Understand what you’ll pay when you buy or sell units of the fund. Also consider what you’re getting for your money. What level of service and advice will you receive?
5. Who manages the mutual fund?
Much of the success of a mutual fund depends on the portfolio manager’s skill at choosing investments and knowing when to buy and sell them. Consider questions such as: What kind of education and experience does the portfolio manager have? Does the manager run other funds? How successful have they been? What is their investment style?
Find out how stable the fund’s management has been over the years. High turnover can be a warning sign.
What are the risks of investing in mutual funds?
Like most investments, mutual funds have risks. Your investment may go up in value, but it may also go down. The value of most mutual funds will change as the value of their investments goes up and down, so you could lose money on your investment if you sell when the value is lower than when you first bought the fund.
The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be. For example, stocks are generally riskier than bonds, so an equity fund tends to be riskier than a fixed income fund.
Some specialty mutual funds focus on certain kinds of investments, such as emerging markets, to try to earn a higher return. These kinds of funds also tend to have a greater risk of a larger drop in value.
Six common types of risks associated with mutual funds
| Type of risk | Type of investment affected | How the fund could lose money |
|---|---|---|
| 1. Market risk | All types | The value of its investments decline because of unavoidable risks that affect the entire market. |
| 2. Liquidity risk | All types | The fund can’t sell an investment that’s declining in value because there are no buyers. |
| Credit risk | Fixed income securities | If a bond issuer can’t repay a bond, it may end up being a worthless investment. |
| Interest rate risk | Fixed income securities | The value of fixed income securities generally falls when interest rates rise. |
| Country risk | Foreign investments | The value of a foreign investment declines because of political changes or instability in the country where the investment was issued. |
| Currency risk | Investments denominated in a currency other than the Canadian dollar | If the other currency declines against the Canadian the investment will lose value. |
Assessing riskOne way to assess a fund’s level of risk is to look at how much its returns change from year to year. If the fund’s returns vary a lot, it may be considered higher risk because its performance can change quickly in either direction.
How is your mutual fund investment protected?
Because mutual funds are securities, not deposits, they’re not protected by the Canada Deposit Insurance Corporation (CDIC) or other deposit insurance. But other safeguards are in place to protect investors:
- Third-party custodian – holds the assets of a mutual fund. This is usually a trust company or chartered bank
- Independent auditor – reviews and reports on the fund’s financial statements each year.
What happens to your mutual fund if a firm goes bankrupt?
Your mutual funds may be covered by the Canadian Investor Protection Fund (CIPF) if the firm declares bankruptcy. The fund does not cover losses from other causes, such as changing market values of securities, unsuitable investments, or the default of an issuer of securities.
Canadian Investor Protection Fund (CIPF) is a not-for-profit organization. CIPF can return assets to you or compensate you when your assets are not available because a member firm has become insolvent.
Learn more about how your investments are protected.
Remember
The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be. Minimize your overall risk by holding a variety of investments. Before you decide on a mutual fund, figure out how it fits with the rest of the investments you own.
How can you research the mutual funds you invest in?
Find out as much as you can about a mutual fund before you buy. A good place to start is with the disclosure documents that a mutual fund company is required by law to file with securities regulators. You can find these on the mutual fund company’s website, the System for Electronic Document Analysis and Retrieval (SEDAR), or you can ask your adviser.
Disclosure documents include:
- Fund Facts – A plain language summary of key information about the fund, such as performance, risk and costs. Mutual fund companies are required to give investors a copy of Fund Facts before they decide to purchase a conventional mutual fund.
- Simplified prospectus – Detailed information on things like investment objectives and strategies, fees and expenses, risks, tax considerations and distributions. The simplified prospectus is available to investors from the mutual fund company upon request.
- Management reports of fund performance – Report of the fund’s returns for various periods and a discussion about what affected the fund’s performance in the past year.
Summary
Many Canadians hold mutual funds as part of their investment portfolio. They can add diversification to your portfolio and allow you to invest based on specific objectives. They also come with risks. Take time to ask questions and learn more about how the fund is managed before you buy.
- Mutual funds offer investors built-in diversification, professional management, an easy way to buy and sell investments, and a wide range of different funds.
- Find out the fund’s level of risk and whether it fits with your own tolerance for risk. Usually, the higher the potential returns, the higher the risk will be.
- Consider how the mutual fund will fit within your portfolio and your overall financial goals.
- Compare the fund’s costs and performance against similar funds to see what kind of value you’re getting.
- Consider how the fund is managed, including the experience and success of the fund’s manager, and how well it has performed in the past.
- Mutual funds are not protected by CIDC as they are not deposits. There may be some protection if the firm goes bankrupt.
