This investment product is very popular in North America. But what is a mutual fund and how does it work?
A mutual fund is a pool of money collected from many investors and used to buy securities such as stocks, bonds, money market instruments and other similar assets.
The securities in the fund are known as the portfolio.
As an investor, you own units, which represent a portion of the holdings of the fund.
A mutual fund is professionally and actively managed. The funds are invested to generate capital gains and income for investors.
Most mutual funds are open-end, meaning you can buy and sell units at any time, without any restriction. You can purchase units by lump-sum or regular contributions.
The unit value is called NAVPU or Net Asset Value per Unit. It is calculated daily, at the end of business day. The formula is:
(Assets- liabilities) / Outstanding # of units
A capital gain is triggered when the fund sells some of its securities at a higher price than purchased. Income is earned from interests on bonds and dividends on stocks.
Both are distributed to investors throughout the year. A lot of mutual funds automatically reinvest these earnings and investors receive more units.
If the securities increase in value and the fund doesn’t sell them, the unit value increases and investors can sell for a profit.
A mutual fund will usually earn you more than a plain savings account at your bank. OK, during a recession, you will probably lose money, but quite frankly who won’t?
The main disadvantage of a mutual fund is its cost, and particularly in Canada. It is said the costs of mutual funds here are amongst the highest in the world.
As stated above, mutual funds are professionally and actively managed. This results in a myriad of expenses. These expenses are paid from the fund, regardless of its performance.
They impact the fund’s returns to the investors. They are called MER, or Management Expense Ratio.
Let’s assume a fund returns 6%, excluding MER. Let’s assume the MER is 3%. The fund’s return to the investors will then only be 3%.
You have to carefully look at both the fund’s performance and the MER when purchasing.
There are also additional charges that you could pay out of your own pocket as an investor:
- Sale charges or loads: amount paid when buying or selling
- Other transactions and administrative fees: switch or redemption fees, account fees
There are thousands of mutual funds available in Canada. There are also websites that compile data and info on them, such as Fund Data Canada or The Fund Library.
Great article! Clear and simple explanations. A change from the super technical jargon on some other sites.
Thanks Alice! I aim to write in simple terms.