Nailing The Basics of Mutual Funds

Nailing the basics of mutual funds

The RRSP season has come and gone ... did you get a call from your bank representative or financial advisor this year?

I can only imagine what percentage of their annual business is completed during the first few months as people are rushing to make their RRSP contribution before the deadline.

The mutual fund industry has done a brilliant job of advertising and convincing people that Registered Retirement Saving Plans (RRSPs) and mutual funds are one and the same.

But that couldn’t be further from the truth.

Quick Recap

Remember, RRSPs are an investment VEHICLE that can be filled with different types of investments, such as:

  • stocks,
  • exchange traded funds (ETFs),
  • mutual funds,
  • bonds,
  • guaranteed investment certificates (GICs), and even…
  • good old cash. (And cash isn’t really an investment at all.)

Ditto with your Tax Free Saving Account (TFSA). Just because you have an RRSP DOES NOT mean you are limited to just mutual funds or even traditional investments.

I think a large percentage of people currently own mutual funds as this is what their bank guy or financial advisor recommended.

“They’re the professionals, right? They know what’s best for me? They definitely know more about investments than me!”

But if I were to ask you what mutual funds are, would you be able to answer?

If you hesitated, don’t feel guilty.

I’m sure plenty of people would be stumped; (at least they are from my experience)...

Yet, we are all rushing to throw hundreds or thousands of dollars to invest in them.

Oh, Mutual Funds are…er… what was the question again?

So, what exactly are they?

A mutual fund is essentially a portfolio (collection) of stocks and/or bonds.

Instead of you going out and buying shares in companies (stock) or bonds (either company bonds or government bonds), mutual funds do that for you.

They collect money from a group of people, and in turn, their professional fund manager buys and sells stocks, bonds and other securities based on the goals of the fund.

As an investor in a mutual fund, you own shares...

And this represents a portion of the holdings of the fund.

In Canada, we are fortunate enough to have access to a large variety of mutual funds!

Unfortunately, we are also subject to some of the highest fees in the world!

There are a lot of types of mutual funds you can buy, but they boil down to three main types:

1) Money Market Funds

These funds usually consist of short-term debt, such as T-bills (also known as Treasury bills, which are kind of like short term loans that are backed by the government). The return is very minimal and it is a relatively safe place to park your money.

Notice that I said PARK your money, not INVEST your money.

The rates that you would receive from these funds are so low that they rarely keep up with inflation. If your intention is to invest your money to earn a reasonable rate of return over time, you should avoid money market funds completely.

But, if you are putting money aside that you will need in the near future, they are an option that earns you slightly more than nothing while you are waiting.

2) Fixed Income (Bond) Funds

The purpose of these funds is to provide regular steady income.

They invest primarily in corporate or government debt. In other words, you are lending money to companies or the government, and they’ll pay you for it.

These funds are riskier than money market funds, especially in a low interest rate environment like the one we are currently in. When interest rates start to increase, you will see that the value of your bond funds will decrease.

Related: Compound Interest Explained

In general, all you need to know is that when interest rates GO UP, bond values (or bond mutual fund values) will GO DOWN. That being said, we have been in a low interest rate environment for years now, so there is always speculation on how soon rates will increase.

When will rates actually start to increase? No one knows for sure! Always be wary of anyone who claims otherwise.

This may seem a bit confusing because bond values are supposed to be guaranteed unless the company or government issued the bond goes out of business or restructures their debt. So how can their value go down?

It is true that bond values are guaranteed if you hold individual bonds for the entire term until maturity. Bond funds are different though because the funds themselves are bought and sold on the open market.

That means if the economy changes and other investments start becoming more desirable, then nobody wants to buy into funds with old low rate bonds in them. That pushes the price of the entire fund down, even though the underlying bonds will still eventually return their full value.

3) Equity Funds

Equity funds hold stocks (company shares).

Different funds have different investing goals, which impacts what types of stocks the fund manager will buy and sell. These are the riskiest types of mutual funds, but also the ones with the potential to provide the most gains.

If you invest with a bank or investment company, they will (hopefully!) go through the exercise of figuring out your asset allocation and your risk tolerance. You will have to sign off on this, which essentially covers their butts if you lose your money and want to sue them.

Given this information, they will proceed to recommend a portfolio to you that contains either one (or a collection) of mutual funds. Not coincidentally, those funds are usually created by either the bank they work for, or a company they are affiliated with to maximize their profits.

Although it may feel like you are handing your money over to a ‘professional,’ do not blindly trust that they have your best interests at heart. Ultimately, their paycheques and bonuses are based on the volume of products (mutual funds) they can sell.

Related: 11 Signs Your Financial Advisor Is Robbing You Blind (And How To Stop It!)

Before purchasing any mutual funds, ask them what the MERs are, and if there are any additional sales charges associated with the recommended funds. As a general rule of thumb, you want to own funds with the LOWEST MERs and do not have any additional sales charges at all. Expect some resistance. After all, higher sales charges = more money for them.

The one exception is if you are looking for a very actively traded fund that is managed by a highly talented fund manager. It still means more money for them, but it also could mean more money for you after the fees are paid.

Those funds don’t come cheap though and finding a talented fund manager is a bit like finding a needle in a haystack or picking the next hot stock - not an easy task.

So Now You Know, But There’s More...

Phew.. there sure is a lot to say about mutual funds.

I wanted to keep this as brief as possible, so stay tuned for the next article where I’ll get into MERs in detail (spoiler alert: it got ugly!).

Then we’ll go over the advantages and disadvantages of mutual funds – and my favourite type of mutual funds: index funds!

Even if all this sounds a little bit scary…don’t let it stop you from starting to invest.

Disclosure: Some links in this article may be affiliate links. We're letting you know because it's the right thing to do. Here’s a more detailed disclosure on how HTS makes money.

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Comments

Cheryl's picture

Seeing as how your first sentence started out mentioning RRSP, it's also important to mention that mutual funds don't have to be purchased as a retirement product. My portfolio is higher than I'd like on mutual funds and that's because about 2/3 of them are not RRSP and their purpose is income and growth.

June 27, 2017 @ 3:58 pm
JOANNE
JOANNE's picture

Hi

I am about to go to our Financial guy at TD tomorrow. We are torn between setting up self-directed Index funds through TD e-series for low MERs and hassle free investing but we do not trust ourselves to rebalance or chose the correct direct investing funds.

Our other option is to ask our financial guy at TD to put us in mutual index funds with low MERs that he invest for us. Basically, our financial guy at TD said to us that if we go self-directed we forego any consulting from him for my husband and I ‘s finances and retirement planning. We are 54 years old and only have about $150K each to invest (so far making little in GICs and balanced mutual)

For both options, could you please advise on your thoughts as well as do you have any Mutual and or index funds through TD that you can recommend?

Thanks so much for your time
Jo

June 29, 2017 @ 11:50 am
Maria Weyman
Maria Weyman's picture

Hi Jo,

Depending on your financial goals, here are some questions to ask your adviser at the very least:

  • What kind of financial planning/consulting advice are you giving up exactly?
  • If he (your adviser) were to put them into mutual index funds with low MERs, how much would the MERs be? (This could give you a comparison of the differential between the cost of e-series vs. the other funds.)
  • How did those funds perform compared to the index?
  • What kind of turnover are on those funds?
  • What kind of asset allocation he is recommending for your situation?
  • What kind of withdrawal strategy does he have for you?

 

June 29, 2017 @ 8:09 pm

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