Mutual Funds

Mutual funds have become extremely popular over the last 20 years. More than 80 million people, or one half of the households in America, invest in mutual funds. It is common knowledge that investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a savings account, but, for most people, that's where the understanding of mutual funds ends.

Originally, mutual funds were heralded as a way for the little guy to get a piece of the market, all you had to do was buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, not all mutual funds are created equal, and investing in mutual funds isn't as easy as giving your money to the first salesperson who solicits your business.

A mutual fund is nothing more than a collection of securities such as stocks, bonds, money market securities and similar asset. A mutual fund brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares of the mutual fund, which represent your portion of the holdings of the fund. Mutual funds are operated by money mangers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus

You can make money from a mutual fund in three ways:

1. Income that is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2. If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3. If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit.

Advantages of Mutual Funds:

• Professional Management - The primary advantage of funds (at least theoretically) is the full-time investment management of your money by portfolio managers. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
• Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money.
• Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. These savings are then passed down to you, the investor.
• Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time.
• Simplicity - Buying a mutual fund is easy and the minimum investment is small!

No matter what type of investor you are, there is bound to be a mutual fund that fits your style! It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk - it's never possible to remove all risk.

Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds:

1. Equity funds (stocks)
2. Fixed-income funds (bonds)
3. Money market funds

All mutual funds are variations of these three asset classes.

Money Market Mutual Funds

These consist of short-term debt instruments, mostly Treasury bills and commercial paper and are considered to be the lowest risk of all mutual funds. You won't get great returns, but you won't have to worry about losing your original investment. A typical return is twice the amount you would earn in a regular chequing/savings account.

Fixed-income Mutual Funds

Fixed-income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. These terms denote funds that invest primarily in loner-term government bonds (never Canada Savings Bonds), corporate bonds, mortgages, or preferred shares. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees.

Bond funds are likely to pay higher returns Money Market Mutual Funds, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down.

Balanced Mutual Funds

The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A similar type of fund is known as an asset allocation fund which Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle.

Equity Mutual Funds

Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities.

The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favour with the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.

For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in start-up technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth).

International or Global Mutual Funds

An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country.

It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification. Although the world's economies are becoming more inter-related, it is likely that another economy somewhere is outperforming the economy of your home country.

Specialty Mutual Funds

This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don't necessarily belong to the categories we've described so far. This type of mutual fund forgoes broad diversification to concentrate on a certain segment of the economy.

Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc. Sector funds are extremely volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank.

Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession.

Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience.

Index Mutual Funds

The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An investor in an index fund figures that most managers can't beat the market. An index fund merely replicates the market return and benefits investors in the form of low fees.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments.  Please read the prospectus before investing.  Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.