Understanding Mutual Funds

The idea behind a mutual fund is simple: it is an investment vehicle that pools the money of many investors — its unitholders — to invest in a variety of different securities (stocks, bonds and money market instruments).

Each unitholder shares proportionately — depending on the portion (or units) of the fund owned by the investor — in the fund's investment returns, which come from two sources:

Income (dividends or interest paid on the fund's securities)
Capital gains or losses (created by sales of securities the fund holds)

Every mutual fund has a manager who buys and sells investments according to the fund's objective, which could be long-term growth, high current income, capital preservation or any combination of the three.

Depending on its objective, a fund may invest in stocks, bonds, money market instruments or a blend of these securities.

Mutual Fund Advantages

Over the past two decades, mutual funds have become popular due to these five advantages:

Diversification. A single mutual fund can hold a number of securities, far more than most investors could afford on their own, helping spread risk and reduce the effects of market ups and downs on returns.
Professional management. Experts manage the money unitholders invest in a mutual fund, making day-to-day investment decisions based on extensive research, sophisticated software, market information and experience.
Choice. Given the wide variety of mutual funds, investors have the flexibility to find those that best meet their investment objectives.
Liquidity. Mutual fund units can generally be bought and sold any business day, so investors have easy access to their money.
Flexibility. Investors can easily move their money from one fund to another as their investment needs and objectives evolve.

Types Of Mutual Funds

Asset Allocation Funds

Asset allocation funds don't invest in just one asset class. For diversification purposes, they hold several asset classes, focusing on stocks, bonds and cash.

The purpose of asset allocation funds is to provide investors with a single mutual fund that combines both growth and income objectives. To achieve this goal, these funds invest in stocks (for growth) in addition to bonds and cash (for income).

Such diversified holdings ensure that asset allocation funds can manage downturns in the stock market with fewer losses, since this approach decreases the reliance on a particular segment of the marketplace, lessening any declines.

Asset allocation funds have high to moderate stability of principal and moderate potential for current income and growth. This makes them suitable for investors who can assume some risk to achieve capital growth but want to maintain a moderate level of current income.

Fixed Income Funds

Fixed income funds invest primarily in bonds and preferred stocks that have a fixed dividend payment. These funds offer a higher level of current income than money market funds, but a lower stability of principal. They are generally steadier in price than funds that invest in stocks.

Within the fixed income category, funds vary greatly in their stability of principal and in their dividend yields. High-yield funds, which seek to maximize yield by investing in lower-rated bonds of longer maturities, offer less stability of principal than fixed income funds that invest in higher-rated but lower-yielding securities.

Some fixed income funds seek to minimize risk by investing exclusively in securities whose timely payment of interest and principal is backed by the full faith and credit of the Canadian Government.

Fixed income funds are suitable for investors who want to maximize current income and can assume a lower degree of capital risk in the process. Capital growth is of secondary importance. Generally, they are popular with retirees and other investors looking for a steady cash flow without assuming high levels of risk.

Canadian Equity Funds

Canadian equity funds buy shares in a wide range of Canadian companies. When investors buy units of an equity mutual fund, they essentially become a part owner of each of the securities in their fund's portfolio.

Some Canadian equity funds invest in companies based on, among other things, market capitalization (the market value of all outstanding company shares). Generally, small-cap Canadian equity funds invest mostly in small or very specialized companies, while large-cap Canadian equity funds hold mostly large corporations. Mid-cap funds cover the ground in between.

Within the Canadian equity fund category, funds also vary greatly in their objectives:

Aggressive growth funds. These funds buy shares in companies that have the potential for explosive growth (for example, the initial public offerings of small companies).
Growth funds. These funds buy shares in companies with a history of solid growth and the potential for share appreciation and capital gains.
Growth and Income funds. These funds buy shares in companies that have a modest prospect for growth and pay healthy dividend yields (for example, a utility company).

The upswings and downturns of the stock market affect equity funds. Despite a history of outperforming other types of securities, there is no guarantee that this historical trend will continue in the short term. That's why Canadian equity funds are best used as part of a long-term investment strategy.

Global Equity Funds

If one of the goals in mutual fund investing is diversification, what better way to achieve that goal than by investing in assets from all over the world? That is the logic behind global equity funds. Global equity funds invest primarily in foreign stocks, but may include some Canadian companies.

While global equity funds can be volatile and involve more risk than Canadian investments — depending on the state of world affairs, currency fluctuations and other economic and political factors — they diversify against any type of country or political risk an investor might encounter.

Global equity funds may invest in large-cap, mid-cap or small-cap stocks or specific industries. There are many variations here. Don't get confused. As a rule of thumb, a "global" fund will likely spread its investments across North American and foreign securities. A fund labeled "international" will buy only foreign securities. A "regional" fund will concentrate on markets in one part of the world. And you might see "emerging" funds, which focus on developing countries and the securities listed on exchanges in those countries.