What are mutual funds?

Imagine a group of investors all want to buy U.S. stocks. A company comes along and says they're going to set up a fund to buy the stocks. Investors can then buy units of the fund in small or large amounts and get a share of the fund's return — after the fund has covered the expenses of buying and selling the stocks, paying the manager and administering the fund. In a nutshell, this is a mutual fund. Here, "mutual" means that the investment company holds a number of U.S. stocks for the mutual benefit of all investors in the fund. This can be simpler and more convenient than each investor trying to select those stocks for themselves.

The mutual fund company employs highly experienced and skilled teams to manage the fund, giving investors access to professional investment management. When investors buy units in a mutual fund, they get a share of the fund's gains, losses and cash distributions. If the investments held by the fund go up in value after expenses, the units go up in value — and investors see a gain. If the investments held by the fund go down in value after expenses, the units go down in value — and investors see a loss.

Equity

Equity investment provides investors with a share of the profits or losses of the businesses held in the fund, and may also offer a share of regular income payments or dividends paid by the businesses. Equity mutual funds typically invest in a wide range of different businesses and offer broader exposure and diversification than an investor picking a few stocks for themselves. This said, investing in equity can be risky, since profits and dividends are not guaranteed but depend on the performance of the business and economy. Equity mutual funds involve a relatively high degree of risk — the possibility of losing money. A typical purpose of investing in equity mutual funds is to seek a higher return than inflation over the long term, which means that the investor is able to buy more goods and services in the future. The ability to buy goods and services, even though prices tend to increase over time, is known as purchasing power. Maintaining or increasing purchasing power is important to fund retirement, education and other long-term goals. This highlights the tradeoff of investing in equity — trying to increase wealth over the long term comes with the risk of losing money.

Fixed income

Fixed income is about investments that pay a fixed rate of return, like government bonds and corporate bonds. Fixed income involves loaning money to governments or large businesses, typically for a period of one year or more — and even for longer periods, like 20 to 30 years. A fixed-income mutual fund provides investors with a share of the regular interest payments that borrowers pay on their loans and a share of the principal that borrowers repay at the end of their loan terms.

In addition, a fixed-income mutual fund provides investors with a share of gains or losses in the value of the bonds. Losses can occur for a number of reasons, including rising interest rates, rising inflation or a decline in the issuer's credit rating. The repayment part of the bonds, both interest and principal, is usually quite stable. Borrowers, whether governments or corporations, don't need to have a tremendous year; just bringing in enough cash to pay interest and repay their loan is good enough for bond investors to get paid. Bond mutual funds typically involve a lower degree of risk than equity mutual funds. A typical purpose of investing in fixed-income mutual funds is to get regular income payments and reduce some of the risk to the portfolio of holding equity.

Money market

Similar to cash, the money market fund involves loaning money to governments or large businesses, typically for a period of up to one year. A money market mutual fund provides investors with a share of the income from its loans. Money market mutual funds involve a lower degree of risk than equity or fixed-income mutual funds. A typical purpose of investing in money market mutual funds is to maintain a stable source of funds for spending or other short-term needs and to reduce some of the risk to the portfolio of holding equity or fixed income.

Asset allocation

So far, we've described mutual funds as if they only hold one type of investment. In contrast, asset allocation funds typically hold a mix of stocks and bonds, providing investors with instant diversification in a single fund. Asset allocation funds come in various types, including balanced, aggressive and conservative. A balanced fund holds a similar weight of stocks and bonds. For investors who want more risk, an aggressive fund holds more stocks than bonds. For investors who want less risk, a conservative fund holds more bonds than stocks. The fund manager keeps the weights of stocks and bonds in line with the fund’s objective. This process, known as rebalancing, saves investors from having to buy and sell investments based on changes in market conditions.

Fund-of-funds

Another type of mutual fund that holds more than one type of investment is a fund-of-funds. As its name suggests, this is a fund that holds several other mutual funds in one fund. Similar to asset allocation funds, this can provide ready-made diversification with a single fund. However, the management fees of these funds can be higher than those of an asset allocation fund.

Specialty

While mutual funds often hold stocks, bonds, cash or some mix of these assets, specialty funds hold other types of investments, such as private equity, real estate or commodities. These are known as alternative investments, since they capture a different type of risk than regular assets and it can also take longer to sell the investments. Specialty funds may also hold other investment styles or themes, such as investing based on environmental, social and governance factors, known as ESG investing.

Mutual funds, including all the types mentioned above, can be actively or passively managed. With passive management in equity, for example, the manager simply buys the stocks in a popular market index, like the S&P 500 for U.S. stocks, and tries to match the performance of the index. These funds are known as index funds. With active management in equity, for example, the manager selects stocks with the goal of beating the performance of the index. Some of the common approaches to making these decisions are growth — investing in companies with fast-growing profits or sales — and value — investing in companies that appear to be undervalued. Active management is appropriate for investors who believe that skilled investment managers can do better than investing in an index fund. Passive management is appropriate for investors who want to accept the overall risk and return of investing in an index fund, usually at a lower cost than active management.

How do mutual funds work? Investors buy units in a fund, where the minimum initial investment might be $500 and the minimum follow-on investment might be $100 — these amounts are examples and vary by fund. The price is based on the fund's net asset value (NAV) — the value of the investments in the fund minus its liabilities. The NAV is set daily by the fund manager, at the close of each trading day.

Mutual funds charge a management fee, known as the Management Expense Ratio (MER). This can be more than 2% for actively managed funds or less than 1% for index funds. The fee is deducted from the net asset value of the fund. For example, an investor holding an average balance of $100,000 in mutual funds would pay $2,000 per year with a 2% fee or $1,000 per year with a 1% fee.

Investors also have to consider trading costs. Full-service dealers typically don't apply a charge for mutual fund purchases and sales, since they receive a sales commission from the fund manager. Order execution-only dealers like CIBC Investor’s Edge charge a commission to buy or sell mutual funds, since they don’t receive a sales commission from the fund manager. Some order execution-only dealers like CIBC Investor’s Edge don’t charge a commission for pre-authorized, recurring mutual fund purchases such as Regular Investment Plans, which can make mutual funds cost-effective for investors making regular contributions.

Mutual funds other than money market funds are not intended for short-term trading; mutual fund companies may charge a short-term redemption fee if units are sold within 30 days of purchase. This time period can vary by fund company.

Mutual funds come in different series or classes that provide different payment structures for the advisors selling the fund, which impacts the fund's performance results. An advisor series of funds might charge a higher fee for investors who obtain financial and investment advice from an advisor, while another series of funds might charge a lower fee for self-directed investors because there is no advisor commission.

Last but not least, capital gains and distributions from mutual funds are subject to taxation. This explains why investors often choose to hold mutual funds in a tax-deferred account like the RRSP (Registered Retirement Savings Plan) or a tax-exempt account like the TFSA (Tax-Free Savings Account).

In a separate article, we compare mutual funds and ETFs (exchange-traded funds). Below is a quick summary of two key points about cost and selection. Mutual funds typically come with higher fees than ETFs. For example, the Management Expense Ratio for an index mutual fund might be 1%, compared to 0.20% or less for an index ETF. Mutual funds may also offer less selection than ETFs. The Investment Funds Institute of Canada shows 3,409 mutual funds and 1,056 ETFs registered in Canada as of 2022, but this does not include 3,030 ETFs registered in the U.S. as of September 2022. By including ETFs in their investment toolbox, Canadians may have access to a wider selection of funds.