Mutual Funds 101

mutual funds

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A primer to understanding mutual funds. Keep reading to learn about the types of mutual funds, fees, and the pros and cons.

Mutual funds soared in popularity in the 1990s, as interest rates fell and “GIC refugees” looked for higher returns. Today, they’re the primary investment vehicle for Canadians, who have invested more than $1.88 trillion in mutual funds as of April 2021 (compared to just $288 billion invested in ETFs).

This article explains everything you need to know about mutual funds so you can make an informed investing decision.

What is a mutual fund?

A mutual fund is a professionally managed pool of investments that typically hold stocks, bonds, or money market securities. It uses the collective buying power of many investors to build a diversified portfolio that would otherwise be too expensive or unwieldy for an individual to manage on their own.

When you invest in a mutual fund, your contributions go into the professionally managed investment pool. When those collective assets rise or fall in value, your share of the fund will also increase or decrease in value.

Unlike stocks or exchange-traded funds, which can be bought and sold at any time during trading hours, mutual funds are only priced once at the net asset value of all the shares at market close (the end of the trading day).

Mutual funds can be classified by categories such as equities, bonds, or balanced funds (which invest in a mix of stocks and bonds). Each fund is run by a professional manager who is responsible for setting a fund’s objectives and making investment decisions. Some mutual funds passively track a specific market index and therefore don’t require active decision-making from a professional manager.

READ MORE: Active vs. Passive Investing

Types of mutual funds

Mutual funds come in a wide variety of flavours and indeed there are more than 5,000 mutual funds to choose from in Canada.

  • Equity mutual funds hold shares of publicly traded companies. They are a core holding for long-term investors. You can find equity mutual funds that focus specifically on Canadian stocks, U.S. stocks, international stocks, and emerging markets. Equity mutual funds can also specifically target shares in large companies, mid-sized companies, or small companies.

  • Bond mutual funds can also be known as fixed income mutual funds, and they are a core holding for long-term investors. This category includes short- and long-term government bond funds, aggregate bond funds, corporate bonds funds, and more. Holding a bond mutual fund will help reduce the volatility of a portfolio and provide income for investors.

  • Balanced mutual funds combine equity and bond funds into one easy-to-manage product. They’re an ideal solution for medium-risk investors. The most common is a global balanced fund, which offers investors a one-stop investing solution that includes roughly 50% stocks and 50% bonds from all over the world.

  • Specialty mutual funds invest in certain sectors or themes such as science and technology, oil & gas, biotech, cannabis, and more.

  • Money market mutual funds invest in highly liquid cash and cash equivalents. This could include short-term government bonds or treasuries.

  • Index funds are mutual funds that passively track a particular market index with the goal of closely matching its return. Index funds could fit into any of the above categories, with the difference being the passive, rules-based approach to investing rather than a fund manager actively making investing decisions.

READ MORE: Index Funds vs. Mutual Funds

Mutual fund fees

Mutual funds charge fees called a management expense ratio (or MER). Funds are required to publish their MER and investors can find the costs listed in the fund fact sheet.

The MER is the total of the fund’s management fee, which also includes the trailing commission paid to the mutual fund dealer representative or advisor, plus administration fees and any other expenses.

Then, there’s the trading expense ratio or TER. These are the fund’s trading costs and are added to the MER to determine the total fund expenses.

Let’s look at the fee breakdown of a typical Canadian equity mutual fund (A series):

Fees for Typical Canadian Mutual Fund
Administration fees0.25%
Fund manager fees1.00%
Trailing commission (split between advisor and firm)1.00%
Total MER2.25%

Fees might not end there, though. Costs may include a sales charge, which could be a front-end load where investors pay a commission upfront (these are rare), or a deferred sales charge (DSC) paid by investors if they sell before a certain date.

It’s important to note that a mutual fund’s returns are published after fees and expenses have been deducted. This is the net return.

In Morningstar’s sixth Global Investor Experience Study on fees and expenses, Canadian investors received a “Below Average” fee experience. The median expense ratio for an equity fund sold in Canada was a whopping 2.28%.

Pros and Cons

Mutual funds get a fair share of criticism in Canada thanks to their generally high overall fees compared to index funds and ETFs. But not all mutual funds are bad, and if used properly they can be an incredibly effective tool for investors to build a portfolio.

  • No commission to buy and sell – Unlike stocks and ETFs, which typically come with trading fees of $9.95, investors don’t pay trading commissions when they buy and sell mutual funds. This can be a tremendous advantage for new investors who are adding small, frequent amounts to their RRSP or TFSA.

  • Instant diversification – Mutual funds are a pool of investments that give investors access to broad diversification even with a small amount of money.

  • Access to professional fund managers – While most actively managed mutual funds don’t beat the market over long periods of time, there are some fund managers who do have a strong track record of beating their benchmark. Besides, having a professional manage your portfolio means you don’t have to play an active role in buying, selling, or building your portfolio.

  • High management fees – Canadian mutual funds charge some of the highest fees in the world at between 2% and 3% for an equity mutual fund. That compares to index-tracking ETFs, which can charge 1/10th of the cost for a similar, diversified portfolio.

  • Underperformance – High fees are a drag on performance so it’s no surprise that the vast majority of actively managed mutual funds fail to keep up with their benchmark index. An incredible 98.63% of Canadian mutual funds underperformed the S&P / TSX Composite index over a five-year period.

  • Difficult to purchase on your own – Canada’s big banks want you to buy mutual funds through their network of bank branches. Investors typically get placed into mutual funds that pay the advisor and bank the highest commission. Investors looking to buy index funds need to insist on these low-cost products or open a discount brokerage account and purchase index funds on their own.

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    READ MORE: How to invest in mutual funds

    Evaluating mutual funds

    There are thousands of mutual funds available in Canada. How do you decide which one(s) are suitable for your own portfolio? Here are some guidelines:

    Determine your asset allocation

    First, you must determine your asset allocation —or the mix between stocks and bonds in your portfolio. Young investors with a long time horizon should be able to withstand more volatility and tend to hold a higher percentage of equities. More risk-averse investors, or those nearing retirement, may want a less aggressive portfolio and therefore should have a higher allocation to bonds.

    Diversify your portfolio

    Next, determine how to allocate your investments across various geographical regions to diversify your portfolio.

    For example, let’s say you’re a young investor who wants to invest in a growth portfolio consisting of 80% equities and 20% bonds. On the equity side, you’ll want representation from Canadian stocks, U.S. stocks, and international stocks. On the fixed-income side, you may want to hold a Canadian aggregate bond mutual fund comprised of government and corporate bonds.

    • Canadian equities – 20%
    • US equities – 40%
    • International equities – 20%
    • Canadian bonds – 20%

    Find out about the fees

    Fees are a key predictor of future returns. That means when you’re comparing similar mutual funds, you’ll want to choose the one with the lowest fee or MER.

    Look at past performance

    Past performance, particularly over a five- or 10-year period, can reveal whether a mutual fund manager consistently outperforms his or her benchmark. It can also show how well the fund has performed compared to similar funds in its category. However, past performance is not indicative of future returns.

    Do your homework

    The mutual fund research firm Morningstar is an excellent source for comparing and evaluating mutual funds. Prospective investors can screen for low fees, short-term performance, long-term performance, and by Morningstar’s own 5-star rating system.

    At the individual fund level, investors can dig into a fund’s profile to see how it stacks up against its benchmark index and its category peers. You can also find the fund’s fees (MER) if there’s a minimum initial investment, and how well it has performed over a 10-year period.

    READ MORE: How to Buy Stocks in Canada


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    Are mutual funds safe?

    Any investment that is not held in cash or guaranteed investment certificates will carry some risk. Mutual funds are no different.

    One way to measure the risk of a mutual fund is to look at how much its returns change over time. Typically, a fund with higher volatility will have returns that change more over time. This could mean a greater chance of losing money, but also could mean the potential of higher returns.

    Meanwhile, a fund with lower volatility will have returns that change less over time. These funds will have lower returns and may have a lower chance of losing money.

    But just remember: past performance is no guarantee of future results.

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    What is a mutual fund trust?

    A mutual fund trust is a type of structure that allows the Trust to avoid paying income tax on earned income as long as it distributes all of the realized capital gains, dividends, and interest to its unitholders.

    This results in a tax advantage for both the mutual fund trust and the investor. That’s because the Trust would be taxed at the equivalent of the highest personal tax rate if it did not distribute all of the investment income. Furthermore, the after-tax income would be then be taxed a second time in the investor’s hands when they sell their units inside a non-registered account or withdraw the funds from an RRSP or RRIF.

    Distributing all of the investment income to investors means that it is only taxed once at the investor’s marginal tax rate. Fewer taxes paid by the mutual fund trust, and more income for the fund’s investors. Win-win.

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    What is a mutual fund RRSP?

    Mutual funds are an RRSP-eligible investment. Every Canadian bank offers a wide range of mutual funds for investors to choose from. Mutual funds can be ideal for investors who contribute to their RRSP in small, frequent amounts over many years. That’s because there are no fees or commissions to buy mutual funds.

    Investors can reduce their fees even more by purchasing index mutual funds rather than actively managed mutual funds. Index funds charge half the cost or less of their active fund counterparts, and investors can build a low-cost and globally diversified portfolio in their RRSP with just 3-4 index funds.

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    What is a fixed-income mutual fund?

    A fixed-income mutual fund is a fund that holds bonds and other income-producing securities. Most investment portfolios should contain fixed income in the form of government bonds. Investors can target long-term government bonds, which pay a higher yield, but their price is more sensitive to interest rate fluctuations, or they can target short-term government bonds, which pay lower yields but are less sensitive to changes in interest rates.

    Investors can also target fixed-income mutual funds that focus on provincial government bonds. These bonds are riskier but tend to pay a higher yield than federal bonds.

    Finally, yield-hungry investors can target corporate bonds, both from safe blue-chip companies and from riskier companies looking to raise money by issuing debt.

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    What is a good management fee for a mutual fund?

    It depends. There are more than 5,000 mutual funds to choose from in Canada. Some of these funds are index funds, which cost about half as much as their active fund counterparts. The TD e-Series funds, for example, charge extremely reasonable fees in the 0.40% MER range. Every big bank has its own suite of index funds, and the average cost is in the 1% MER range. This is a good deal for investors who are adding to their portfolio regularly since mutual funds can be purchased commission-free.

    And, while it’s difficult for an active fund manager to beat the market over time, there are several solid mutual funds available in Canada that have a long track record of strong performance. Funds like Mawer, Steadyhand, and Leith Wheeler lead the way for active funds in part because of their solid management, in part because their holdings are very different than the index they’re tracking, and in part, because their fees are reasonable – again in the 1% MER range.

    While past performance may show a fund manager’s persistence and skill, it’s no guarantee of future results. Fees matter, and the lower the fee the better the odds of future success.

    Final word

    Mutual funds get a bad rap from investor advocates in Canada due to their high fees relative to the rest of the world. But mutual funds are the investment vehicle of choice for Canadians largely due to their extensive sales channels.

    Any Canadian who wants to start investing can walk into a bank branch or investment firm, open an account, and purchase mutual funds. In most cases, you can start investing with as little as $25 per month. They’re also extremely cost-effective to purchase since mutual funds don’t come with transaction costs like stocks and ETFs do.

    However, before you visit your bank branch or friendly advisor, understand that high mutual fund fees will hurt the overall performance of your investments and over the very long term can syphon as much as 50% of your wealth.

    Our advice? Stick to low-cost index funds or one of the few active managers with strong track records and low fees. You’ll also save big bucks by using an online brokerage or robo advisor.

    READ MORE: How to start investing in Canada

    Robb Engen

    Robb Engen

    Robb Engen is a leading personal finance expert in Canada and the co-founder of Boomer & Echo, an award-winning personal finance blog. He writes a monthly column in the Toronto Star’s Smart Money section and is a fee-only advisor who helps Canadians at different ages and stages get their finances on track and prepare for retirement.

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