Mutual Funds Explained: A Beginner's Guide to Investing

Mutual Funds are pools of money collected from many investors for the purpose of investing in stocksStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably., bondsBond TranchesBond tranches are usually portions of mortgage-backed-securities that are offered at the same time and that typically carry different risk levels, rewards, and maturities. For example, collateralized mortgage obligations (CMO) are structured with a number of tranches that mature on different dates, carry varying levels of risk, and pay different interest rates., or other securities. Mutual funds are owned by a group of investors and managed by professionals. In other words, a mutual fund is a collection of securitiesAsset ClassAn asset class is a group of similar investment vehicles. They are typically traded in the same financial markets and subject to the same rules and regulations. owned by a group of investors and managed by a fund managerPortfolio ManagerPortfolio managers manage investment portfolios using a six-step portfolio management process. Learn exactly what does a portfolio manager do in this guide. Portfolio managers are professionals who manage investment portfolios, with the goal of achieving their clients’ investment objectives..

Understanding How Mutual Funds Work

When you purchase a mutual fund, you are pooling money with other investors. The money pooled together by you and other investors are managed by a fund manager who invests in financial assets such as stocks, bonds, etc. The mutual fund is managed on a daily basis. Below is a diagram of how mutual funds work:

Common Types of Mutual Funds

There are six common types of mutual funds:

1. Money Market Funds

Money market funds invest in short-term fixed-income securities. Examples of short-term fixed-income securities would be government bonds, Treasury bills, commercial paper, and certificates of deposit. These types of funds are generally a safer investment but with a lower potential return than other mutual funds.

2. Fixed Income Funds

Fixed income funds buy investments that pay a fixed rate of return. This type of mutual fund focuses on getting returns coming into the fund primarily through interest.

3. Equity Funds

Equity funds invest in stocks. Furthermore, there are different types of equity funds such as funds that specialize in growth stocks, value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or a combination of these stocks.

4. Balanced Funds

Balanced funds invest in a mix of equities and fixed-income securities – typically in a 40% equity 60% fixed income ratio. The aim of these funds is to generate higher returns but also mitigate risk through fixed-income securities.

5. Index Funds

Index funds aim to track the performance of a specific index. For example, the S&P, or TSX. Index funds follow the index and go up when the index goes up and goes down when the index goes down. Index funds are popular as they typically require a lower management fee compared to other funds (due to the manager not needing to do as much research).

6. Specialty Funds

Specialty funds focus on a very small part of a market such as energy, telecommunications, healthcare, industrials, etc.

Benefits of Investing in a Mutual Fund

There are several key benefits to investing in a mutual fund:

1. Professional Management

Mutual funds are actively managed by a professional who constantly monitors the fund’s portfolio. In addition, the manager can devote more time selecting investments than a retail investor would.

2. Investment Diversification

Mutual funds allow for investment diversification. A mutual fund invests in several asset classes and not just a single stock or bond.

3. Liquidity

Mutual funds possess high liquidity. In general, you are able to sell your mutual funds within a short period of time if needed.

Disadvantages of a Mutual Fund

There are important disadvantages to consider when investing in a mutual fund:

1. Management Fees and Operating Expenses

Mutual funds typically charge a high MER (management fee and operating expenses). This would lower the overall return. For example, if the mutual fund posted a 1-year return of 10%, the MER would lower this return.

2. Loss of Control

Since mutual funds are managed by a manager, there is a loss of control when investing in a mutual fund. Remember that you are giving someone else your money to manage to when investing in a mutual fund.

3. Poor Performance

Mutual fund returns are not guaranteed. In fact, according to research, a large majority of mutual funds fail to beat major market indexes like the S&P 500. In addition, mutual funds are not insured against losses.

Related Resources

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