What you need to know about mutual funds

The essential aspect of a mutual fund is that it provides access to markets that were previously only accessible to seasoned investors.

A mutual fund is a company or trust that raises funds by selling fund shares or units to many investors. Mutual funds are managed by specialists who are equipped with tools for optimizing returns that are not available to the average investor. In exchange for this expertise, investors pay management fees.

Over 5,000 mutual funds are available in Canada. They're classified into more than 30 categories: bond funds, equity funds, sector funds, specialty funds, regional funds, diversified funds, balanced funds, index funds, etc. In short, the funds meet specific objectives and needs.

Mutual funds are also known as mutual investment funds. The official term, which is rarely used, is investment company.

Pros and cons of mutual funds

Pros

• Affordable investment in a diversified portfolio.
• Management handled by specialists.
• Units that are easy to buy and sell.

Cons

• Management fees reduce the return. In Canada, these fees are much higher than they are elsewhere.
• Even specialists are fallible.

Also note that, like all securities, mutual funds are not protected by the Canada Deposit Insurance Corporation or the Autorité des marchés financiers deposit insurance fund (Quebec).

Before choosing a mutual fund

Every investment decision requires a thorough understanding of your financial situation. Draw up your balance sheet, and make sure you have paid off your debts and set aside an emergency fund before you contemplate making an investment.

Then, determine your tolerance for risk and pinpoint your investment goals (buying a house, children's education, retirement, etc.). These steps will help you decide which funds match your needs.

You can also turn to a financial planner for help with your choices.

How to choose a mutual fund

Once you know what kinds of funds suit your needs and goals, you have a wide array of choices.

A number of criteria can guide your "shopping": return, quartile, management fees, ethics and management style. Most of this information appears on the simplified prospectus, a document provided by fund managers.

You can also search in the System for Electronic Document Analysis and Retrieval (SEDAR). External link It contains many information documents on the funds you're interested in: financial statements, annual information form, annual report, prospectus, simplified prospectus, etc.

Returns

This is the most commonly used criterion for comparing funds. In most cases, it's the long-term return that must be considered, i.e., return over at least 3 years.

Consider the concept of risk as well, and make sure the fund you choose is in line with your personal tolerance level.

Quartile rankings

Quartile rankings allow you to compare a fund's results with the results of funds in the same category. These rankings are widely published in newspapers and on a number of financial sites.

Mutual funds are classified into more than 30 categories. The Mutual Funds Standards Committee (MFSC) establishes the classification, which makes it easy to compare funds with similar characteristics.

Each category is broken down into 4 equal parts or quartiles. For instance, if a given fund category contained 100 funds, each quartile would contain 25 funds. The 25 funds with the highest returns will belong in the first quartile; the next best 25 funds would go into the second quartile, and so on.

The quartile rankings are usually compiled for the following return periods: 6 months, 1 year, 3 years, 5 years and 10 years.

The quartile rankings for 3 or more years are the most reliable indicators.

Management fees

Mutual fund managers receive annual fees for their research, analysis, security selection and portfolio monitoring services. The fees represent a percentage of fund assets and generally vary between 1% and 3%.

Among other things, the percentage depends on the complexity of the portfolio as well as the market in which the asset is invested. For example, management fees for an equity fund are higher than those of a money market fund.

Also, among equity funds, specialized funds and international funds generally charge higher management fees than traditional Canadian or North American equity funds.

With index funds, where the portfolio fully replicates the make-up of the benchmark index, management fees are lower. In fact, they are managed passively, that is, the manager does not do any research and does few transactions.

Management style

Management style varies from fund to fund and manager to manager. Management style determines how securities are chosen and day-to-day investment decisions are made.

You need to know the approach a manager uses to make sure it suits your investment goals.

Under specific conditions, one style could stand out for its results. For instance, a growth style may do better under certain conditions, while the value style may do worse. It's best to hold funds that are managed using different strategies in order to optimize overall potential return.

Ethical investments

If you want your investments to make a profit and be socially responsible too, you can invest in ethical funds.

These funds usually exclude the tobacco, arms and nuclear sectors from their portfolio.

The negative or exclusion filters are usually associated with positive or inclusion filters. Managers of ethical funds select businesses with the best environmental, social impact and governance practices in their sector. These are the ESG factors.

While ethical investments currently represent less than 1% of Canadian mutual funds, investors are increasingly turning to them.

For more information on ethical funds in Canada, go to the Social Investment Organization website.

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