Here at Young and Thrifty, we’re all about saving money, which is why we continue to beat the drum about investing in low-fee exchange-traded funds (ETFs) through online discount brokers and robo-advisors.
And while ETFs are certainly becoming mainstream—total Canadian assets invested in ETFs increased by 25% in 2020 to a total of $257 billion—mutual funds are still the country’s investment of choice with assets of a whopping $1.78 trillion at the end of last year. So, what’s the deal?
Can mutual funds be a profitable part of your portfolio? The short answer is yes — if you choose carefully and go about it in the right way. Read on to find out how to invest in mutual funds.
Why Invest in Mutual Funds
The advantage of investing in mutual funds — especially if you contribute small amounts frequently — is there’s no cost to buy or sell the funds. Whereas investors typically pay $9.95 per trade to buy and sell stocks and ETFs at big bank discount brokerages.
You can also set up automated monthly mutual fund purchases so that a given amount is withdrawn from your bank account each month and divvied up into your chosen allocation of mutual fund purchases.
Mutual funds don’t trade during the day like stocks and ETFs so your order won’t fill until the end of the day. They are like a basket of investments that can be bought and sold as a unit.
The idea is that instead of selecting individual stocks, bonds or other assets one by one—you get a collection of investments all at once which simplifies the process and may also reduce your exposure to risk. If some of the investments in the fund perform poorly, others will hopefully do better and you’ll still come out ahead.
READ MORE: Mutual Fund Basics
How to Invest in Mutual Funds
If you’re gung-ho about investing in mutual funds, here’s how to do it like a boss.
Determine your risk tolerance
Start with a risk tolerance assessment to determine how comfortable you are with risk. Would you rather have the potential for higher returns, even if there’s an equal chance of losing money in the short term? If so, you’d want to focus on mutual funds made up of growth stocks.
On the other hand, if you’d rather opt for smaller returns and less volatility in your investments, you’d look toward mutual funds that are designed to be more conservative. Balanced funds, as the name implies, hold a combination of aggressive and conservative investments.
Selecting the right type of mutual fund(s)
With thousands of mutual funds in Canada, this is no small task. But here’s the low-down on the type of mutual funds available in Canada:
- Equity mutual funds: Gives you exposure to stocks. Depending on the mandate of the fund, you can invest in global stocks, country-specific stocks, or drill down into sector-specific stocks (i.e. renewable energy or oil & gas). Equity mutual funds come with the highest risk-to-reward trade-off.
- Bond mutual funds – Gives you fixed-income exposure through federal government bonds, provincial government bonds, municipal bonds, and corporate bonds. Bond funds are less risky than equity funds but also come with lower expected returns.
- Balanced mutual funds: A combination of equities (stocks) and bonds to give investors an optimal asset mix with just a single fund. The classic balanced fund holds 60% stocks and 40% bonds. A balanced fund offers middle-of-the-road risk and returns.
- Money market mutual funds: The safest and most liquid fund type. That’s because they primarily hold cash and cash-like products such as 30 and 60-day T-bills. Money market funds are for investors who need a safe place to park cash for the short term.
Research, research, research
Once you know how risky you want to get with your investments, compare the particulars of funds that match your risk tolerance. It’s easy: just look up their fact sheets online and study ‘em!
If you’ve never done this before, start with Morningstar — a research firm that analyzes mutual funds. It’s a great go-to source to look at a fund’s returns and fees, and compare it against other funds in its category.
Looking at the below example, here are a few details to scrutinize during your search:
- Identify the type of investments included in the fund. Remember, you want to diversify over different sectors in both domestic and global markets.
- Previous performance over the short and long term. Keep in mind, however, that past performance is no guarantee of future returns.
- The fund’s rating.
- The fee structure.
Get finicky about mutual fund fees
There are two main types of fees that mutual funds charge: management expense ratio (MERs) and sales charges.
- MERs: This fee covers the fund’s operating costs, including compensation for the fund manager (the professional who selects and manages the investments in the fund). The MER also usually includes a trailing commission that’s paid to your investment firm/advisor. The MER is taken off the top of the fund’s earnings. So, for example, if a fund gained 8.5% last year and its MER is 2.5%, the reported return would be 6%.
- Sales charges: Also known as “loads,” these charges come in three varieties. With front-end loads, you pay a sales charge upfront to your investment firm/advisor when you purchase units in a mutual fund. With back-end loads (also called deferred sales charges, or DSCs), you only pay if you sell the fund within a certain time frame (usually seven years from the date of purchase). No-load funds charge no sales charges at all.
Our expert advice: go for lower-fee mutual funds. While you can’t guarantee an investment’s performance, you can guarantee its fee structure. And the research is clear: fees are the biggest predictor of successful investing.
By choosing funds with lower fees, you’ll hold on to more of your investment returns instead of lining the pockets of fund managers and advisors. Often, these lower-fee funds are passive index funds (see the FAQ below for more information on index funds), but not always. Some smaller fund companies have actively managed funds with lower fees and decent performance.
Morningstar famously said that a mutual fund’s expense ratio is the most proven predictor of future fund returns – meaning the lower the fees, the higher the returns.
“That’s not to say investors should only consider cost when selecting a fund. There are many other variables, but investors should make expense ratios their first or second screen.”— Russel Kinnel, Morningstar
Select the right provider to buy mutual funds
You can purchase mutual funds directly from the investment firms that own and operate the funds, or you can open an online brokerage account.
Understand that if you go straight to the source, you will likely have to deal with a representative of the investment firm who has a vested interest in you purchasing their products. A brokerage account, on the other hand, allows you to purchase whatever investments you want from a variety of firms.
A full-service brokerage will provide you with investment and financial planning advice, but you’ll pay a premium for those services in higher transaction fees. If you know already exactly which mutual funds you want to buy, a discount broker like Questrade is probably your best bet in terms of cost savings.
Online discount brokerages not only charge lower transaction fees, but some also provide discount versions of mutual funds (labelled as “D” series) that come with a lower MER because the trailer commission fee has been removed. Some discount brokers even offer rebates on trailer fees if you purchase funds that charge them.
Buying Mutual Funds is Simple — Just Place Your Order!
Buying mutual funds is as simple as online shopping. If you can place an order on Amazon, you can buy mutual funds! All you have to do is:
- Enter the fund code of the mutual fund
- Enter how many units or how much (in dollar terms) you want to invest
- Preview the order
- Click the “buy” button
Rebalance your portfolio
As markets go up and down, the total amount you have in each of those four funds will stray from your original allocation. To make sure you maintain your preferred risk profile, you’ll need to rebalance your portfolio every so often – at least once a year is best.
READ MORE: How and When to Rebalance Your Portfolio
Mutual Fund FAQs
What's the difference between mutual funds and index funds?
Most mutual funds in Canada are actively managed, which means the holdings in those funds are carefully selected by fund managers with the intention of outperforming the market. So, for example, the managers of a U.S. large-cap equities fund would look at all the U.S. large-cap companies listed on the market, and invest only in the ones they think will perform better than average for that category. In exchange for this service, investors pay a fee (called a “management expense ratio” or MER) often between 1% and 3% of their total holdings.
Index funds, on the other hand, are mutual funds that take a passive approach to investing. Rather than paying an expert to pick and choose market “winners,” index funds aim to match a market’s overall performance by holding all (or nearly all) the assets listed on a particular index—say, the S&P 500 in the case of U.S. large-cap equities. Index funds also charge MERs, but they are typically much lower than actively managed funds because there’s no legwork involved in selecting the fund’s assets.
Which is better: mutual funds or index funds?
The research is clear: a risk-appropriate portfolio of low-cost, globally diversified, index funds or ETFs is the best and most reliable way to achieve long-term investment returns. While active investing can outperform the market over shorter periods of time, it is impossible to continue to do so with any long-term consistency and reliability.
The Last Word
Mutual funds get a bad rap in Canada due to their high fees but don’t paint all mutual funds with the same brush. Most new investors are going to start with mutual funds because they’re easily accessible through their bank, cost-effective to set up – often with as little as $25/month, and you don’t pay any trading fees when you buy and sell funds.
The bottom line: mutual funds aren’t for everyone, and there are pros and cons to consider before pulling the trigger. In many cases, the hefty MERs and built-in trailer fees on mutual funds come without any added service value, and the investments often fail to perform better than lower-fee, exchange-traded funds.
A hot tip: every bank sells lower-cost versions of their expensive mutual funds. These low-cost mutual funds are called index funds, and their fees are half (or less) of what most mutual funds charge. Insist that your bank advisor uses index funds to build your portfolio. If you get any flack (because index funds don’t pay as high of a commission to your advisor), then you may need to open a discount brokerage account and invest in the index funds on your own.
Some index funds and actively managed funds have fees low enough—and performance good enough—to make them worthwhile. If you choose to invest in them, save even more by using a reputable discount brokerage that offers rebates on trailer fee charges embedded in the MERs.
Fee-conscious investors who want added value can often do better with a robo-advisor, which will build a diversified portfolio of low-fee ETFs for you, matching your risk tolerance and even rebalancing your funds regularly to maintain your preferred asset allocation. All this for a total fee (including both MER and management fees) of around 0.5%. And that’s a heck of a lot better than paying 2-3% for mutual funds.
READ MORE: ETF Investing 101