Securities Office: Investor Education
Mutual Funds - What You Need To Know
In recent years, more and more Canadians have invested in mutual funds. Because mutual funds are popular and widely available, many people believe they are simple and low-risk investments. While mutual funds are a sound investment option for many people, investors should keep in mind that not everything about mutual funds is simple and not all mutual funds are low-risk investments.
In this brochure, you'll find some basic information about mutual funds that will help you decide whether mutual funds are right for you.
- What is a mutual fund?
- What are the different types of mutual funds?
- Common Types of Mutual Funds
- How can I make (or lose) money from a mutual fund?
- What are the potential advantages of investing in mutual funds?
- What are some of the potential disadvantages?
- Where can I find out about a particular mutual fund?
- How will I know if mutual funds are right for me?
- Who can sell mutual funds?
- What fees and commissions will I pay when I invest?
- How do financial advisers get paid for selling mutual funds?
- What should I expect from a salesperson when I buy mutual funds?
- Can I change my mind after I buy a mutual fund?
- How is the mutual fund industry regulated?
- What do I do if I have concerns about my mutual funds?
- How do mutual funds compare with other types of investments?
A mutual fund is a pool of money that is managed on behalf of investors by a professional money manager. The manager uses the money to buy stocks, bonds or other securities according to specific investment objectives that have been established for the fund. In return for putting money into the fund, you'll receive either units or shares that represent your pro rata share of the pool of fund assets. In return for administering the fund and managing its investment portfolio, the fund manager charges fees based on the value of the fund's assets.
Mutual funds are ‘open-ended' investment funds, meaning that new investors can contribute money to the fund at any time, and existing investors can return their units or shares to the fund for redemption at any time. When you redeem your units or shares of a mutual fund you will receive a cheque for your pro rata share (the Net Asset Value per Share, or NAVPS) of the current market value of the fund's portfolio.
Several parties are involved in the organization and operation of a mutual fund, including:
- Mutual Fund Manager: Establishes one or more mutual funds, markets them and oversees their general administration.
- Portfolio Adviser: The professional money manager appointed by the Mutual Fund Manager to direct the fund's investments. The Mutual Fund Manager also often acts as the Portfolio Adviser.
- Principal Distributor: Coordinates the sale of the fund to investors, either directly or through a network of registered dealers.
- Custodian: The bank or trust company appointed by the Mutual Fund Manager to hold all of the securities owned by the fund.
- Transfer Agent and Registrar: The group responsible for maintaining the register of unit holders of the fund.
- Auditor: The independent accountants retained by the Mutual Fund Manager to audit each year, and report on the financial statements of the fund.
Mutual funds are generally categorized according to their investment objectives. Some mutual funds focus on stocks, others on bonds, money market instruments or other securities. Some mutual funds invest primarily in Canada, others invest internationally, and some specialize in specific countries or specific industries. Some mutual funds will target only low-risk investments, while others may invest in much riskier securities. If you decide to become a mutual fund investor, choosing funds whose investment objectives and risk profile are right for you will be one of your most important decisions.
Money Market Funds:
Invest in short-term (less than one year to maturity) corporate and government debt securities such as treasury bills, bankers' acceptances and corporate notes. Some money market funds specialize in Canadian or US money market instruments or invest only in treasury bills. These are generally very low-risk funds offering moderate returns.
Fixed Income Funds:
Invest in debt securities like bonds, debentures and mortgages that pay regular interest, or in corporate preferred shares that pay regular dividends. The goal, typically, is to provide investors a regular income stream with low risk. Fund values will go up and down to some extent, particularly in response to changes in prevailing interest rates.
Growth or Equity Funds:
Invest primarily in common shares (equities) of Canadian or foreign companies, but may hold other assets as well. The goal is typically long-term growth through capital appreciation of the assets held. Some growth funds focus on large ‘blue-chip' companies. Performance will be affected by the success or failure of specific investments and by the performance of the stock markets generally.
Invest in a ‘balanced' portfolio of equities, debt securities and money market instruments with the objective of providing reasonable returns with low to moderate risk.
Global and Foreign Funds:
May be fixed income, growth or balanced funds that invest in foreign securities. These funds can offer investors international diversification and exposure to foreign companies, but are subject to risks associated with investing in foreign countries and foreign currencies.
May invest primarily in a specific geographical area (e.g., Asia) or a specific industry (e.g., high technology companies).
Invest in a portfolio of securities selected to represent a specified target index or benchmark, such as the Toronto Stock Exchange 300 Composite Index.
As a mutual fund investor, you may earn a return on your investment from:
- any distributions to you of the interest, dividends or capital gains earned by the fund, and
- any net increase in the NAVPS of your fund shares or units.
Conversely, the NAVPS of your fund shares or units could decrease depending on the current market value of the fund's portfolio.
For example, in a fixed-income fund you would expect a good portion of your return to come in the form of interest and dividends that are either paid out to you or, if you like, reinvested on your behalf in additional units of the fund. You might also expect some fluctuation, up or down, in the value of your shares or units as conditions in the bond markets change. the value of fixed income securities will be affected, for example, by changes in interest rates. If prevailing interest rates drop, you would expect to see the value of your fund's portfolio, and your NAVPS, increase.
In an equity fund, your returns will be more closely tied to the performance of the stock markets. You might expect some return from distributions of dividends or capital gains that the fund has earned, but you would also expect much of your profit or loss to come from changes in the value of the fund's portfolio. If the value of the stocks held by the fund increases, so will the value of your shares or units. If stock prices drop, your share or unit values will decline.
You should understand how you will be taxed on your mutual fund investment. Generally, a mutual fund will distribute enough income and capital gains each year so that the mutual fund itself will not have to pay any income tax. This means that you will have to pay income tax on the distributions you receive, unless you hold your investment in a Registered Retirement Savings Plan (RRSP) or other registered plan for which the fund is a qualifying investment. If you hold your investment in a registered plan, you will generally not be taxed on distributions of income or capital gains, as long as the distribution stays in the plan. However, when you withdraw money or securities from the registered plan, you may be taxed. When you redeem your mutual fund holdings you must report any capital gains. You may wish to ask your tax adviser about the tax implications of holding a mutual fund investment and you should read carefully any tax information provided by the mutual fund.
There are many reasons why people invest in mutual funds:
- Diversification: Investing in a number of different securities helps reduce the risk of investing. When you buy a mutual fund, you are buying an interest in a portfolio of dozens of different securities, giving you instant diversification, at least within the type of securities held by the fund.
- Affordability: With many mutual funds, you can begin buying units with a relatively small amount of money (e.g., $500 for the initial purchase). Some mutual funds also let you buy more units on a regular basis with even smaller installments (e.g., $50 per month).
- Professional Management: Mutual funds are managed by professionals who are experienced in investing money and who have the skills and resources to research many different investment opportunities.
- Liquidity: Units or shares of mutual funds can be redeemed at any time at the NAVPS of the fund.
- Flexibility: Many mutual fund companies administer several different mutual funds (e.g., money market, fixed-income, growth, balanced and international funds) and allow you to switch between funds within their fund family at little or no charge. This can enable you to change the balance of your portfolio as your personal needs or market conditions change.
- Performance Monitoring: The NAVPS of most mutual funds is reported daily in the financial press and on many internet sites, allowing you to continually monitor the performance of your investment.
When you invest in a mutual fund you place your money in the hands of a professional manager. The return on your investment will depend heavily on that manager's skill and judgment. Even the best portfolio advisers are wrong sometimes, and studies have shown that few, if any, portfolio advisers are able to consistently out-perform the market.
As a mutual fund investor, you will also be paying, through management expenses and commissions, for management services and for various administrative and sales costs. Those fees and commissions reduce the return on your investment and are charged, in almost all cases, whether the fund performs well or not. Sales commissions and redemption fees can have a very significant impact on your return if you decide to redeem your mutual fund investment in the short-term.
The best source of information about any mutual fund is its prospectus -- a disclosure document that contains all of the important facts about the fund, its management, the securities it holds, its investment objectives, risk profile and fees. Before any mutual fund can be sold to the public, a prospectus must be prepared and filed with the securities regulators in each jurisdiction where the fund will be sold. You will receive a summary disclosure document (a simplified prospectus) and financial information for each mutual fund in which you invest. You can also obtain additional information about the fund by asking for the fund's annual information form.
For most investors, choosing a qualified financial adviser is an important first step in any investment program. (See our section "Choosing Your Financial Advisers.") With the help of your financial adviser(s), you'll want to establish your investment goals, assess your risk tolerance, and develop a personal investment strategy. (See our section "Getting Started.") Ask your financial adviser if mutual funds are an appropriate investment for you. Discuss what type of fund best matches your personal investment strategy, then ask for some specific suggestions.
Once you have identified some funds that seem to meet your investment needs, read the prospectus and financial statements for each one. Consider:
- Investment Objectives: Are the fund's investment objectives consistent with your own? Can the fund provide the level of regular income you need? Does it provide the type of diversification you're looking for? If you have other investments, how will this fund affect the overall balance of your portfolio?
- Risk: Are you comfortable with the level of risk associated with the fund? If you have other investments, would this fund tend to increase or decrease your overall risk exposure? Unlike GICs or savings accounts, mutual funds are not covered by deposit insurance. Values of most mutual funds will fluctuate and you can lose money depending on changes in the marketplace.
- Time Horizons: Does the investment fit with your expected investment time horizon? For example, if you're investing for a relatively short time, will sales charges and redemption fees offset any potential gains? Might the value of the fund be down just when you need to redeem your investment?
- Expected Return: Does the fund have the potential to provide the returns you need to meet your goals? Remember, predicting the return of any mutual fund requires that you predict the future -- something that can never be done with certainty. Past performance will tell you about the fund's historical volatility and its performance relative to competing funds, but it is not a reliable indicator of future performance. The return you can expect from a mutual fund is closely related to its risk. The lower the risk of the fund, the lower the return you should expect. Be realistic in your expectations.
- Costs: Fees and commissions associated with mutual funds will affect your overall return and can vary widely from one fund to the next. Higher fees and commissions do not necessarily mean better performance. Check and compare fees and commissions before you invest.
- Service Provider: Do you know something about the mutual funds for sale? Consider who operates the mutual fund and who provides the services necessary for its operations.
- Flexibility: Will you be entitled to switch your investment to other funds in the same ‘fund family'? Can you afford the minimum initial investment? Does the fund offer other features, such as regular monthly purchase plans or redemption plans that are attractive to you?
- Tax Considerations: Is the mutual fund a qualifying investment for your RRSP, Registered Retired Income Fund (RRIF) or other registered plan? If you are investing in the fund outside a registered plan, do you understand the tax implications of the distributions of income or capital gains that the fund may make to you?
Like other securities, mutual funds must be sold through dealers who are registered with the securities regulator in your province or territory. The names of registered dealers in your area can be found in the telephone book. Most financial institutions -- such as banks, credit unions and trust companies -- also have subsidiaries that are registered to sell mutual funds.
The fees and commissions you may be charged can vary widely from one fund, and one dealer, to the next. Some of the charges may be negotiable, but you should make sure that you understand all of the costs before you invest. There are two main costs to consider -- the management and operating expenses that are charged to the fund each year, and the sales charges (or loads) that you pay when you buy or sell the fund.
- Management and Operating Expenses: Are expenses paid each year by the fund and include such things as the manager's fees, legal and accounting fee, custodial fees and bookkeeping costs. The Management Expense Ratio (MER) is the percentage that these expenses represent of the fund's average net assets. For example, if a $100 million fund has $2 million in costs for the year its MER will be 2%. MERs can range from under 1% per year for some money market funds to almost 3% for some equity funds. The higher the MER, the greater the impact on the fund's performance and the return to its investors.
- Sales Charges (Loads): Are the commissions that you may have to pay when you buy or redeem units of a fund. Sales charges may be applied when you buy units of the fund (a front-end load), when you redeem your units (a back-end load), or there may be no sales charges at all (no-load). Where front-end loads are charged, the rate can vary from dealer to dealer and may be negotiable. Shop around, and remember that every dollar you pay up-front in commission is a dollar that does not go to work for you in the fund.
Many funds are sold on a back-end load basis, meaning that the sales charges will be applied only when you redeem the fund. Many back-end load (also called deferred sales charges or DSCs) are charged on a sliding scale that declines for each year that you hold the fund. For example, you might be charged a 6% commission if you redeem the fund after one year, 4% if you redeem after three years, and no commission if you redeem after seven years.
An increasing number of funds are being sold on a no-load basis, in which investors pay no sales charges on either purchase or sale. There are obvious advantages in paying no sales charges, but before you decide that a no-load fund is right for you, consider the fund's performance, its management expense ratio and the level of service and advice you will receive.
- Other Fees: May also be charged by the fund when you switch funds, register an RRSP or open or close an account. Details will be provided in the fund's prospectus.
Some mutual fund managers employ their own sales force to sell their mutual funds. Most, however, rely on independently operated dealers to sell their funds and pay sales incentives to these dealers to encourage them to do so. These incentives generally take the form of sales commissions, but fund manager can also pay for some of the marketing and educational costs incurred by a dealer. You do not pay these sales incentives directly. The mutual fund managers pays them to dealers out of the management fees it receives from its mutual funds.
The compensation paid to the dealer can vary depending on how the mutual fund is acquired. For example, if you buy a mutual fund with a front-end load, the mutual fund firm may allow your dealer to keep the front-end load fees you pay. If you buy a mutual fund on a deferred sales charge basis, the mutual fund manager will still pay your dealer a sales commission at the time of sale (generally 5% of the amount you invest). When you redeem a deferred sales charge fund, you pay any applicable redemption fees directly to the mutual fund manager.
Mutual fund managers also pay trailing commissions to dealers. Trailing commissions are generally paid quarterly and typically range from 0.25% to 1.0% of the value of the funds held by the dealer's clients. The amount of trailing commission paid to your dealer can depend on the type of mutual fund you buy and on the load that you pay. Generally, mutual fund firms pay lower trailing commissions on fixed income and money market funds than for equity funds.
The sales incentives paid by the fund manager are described in the fund's prospectus. You can also ask your financial adviser for details. Securities regulations govern the types of incentives that can be paid and the sales practices that must be followed by both mutual fund firms and dealers.
You should expect your salesperson:
- to deal with you fairly, honestly and in good faith;
- to discuss with you your general investment objectives and your tolerance for risk;
- to make recommendations that are consistent with your objectives and risk tolerance;
- to disclose to you any significant conflicts of interest (the form of disclosure may vary depending on the nature of the conflict);
- to promptly deliver a disclosure document (simplified prospectus) and current financial information for any mutual fund you buy;
- to relay your purchase order to the fund on the day you place it, or on the next business day if the order was given after normal business hours;
- to promptly deliver a written confirmation of each purchase and redemption made on your behalf, with details of the value of the transaction and the commissions charged;
- to provide statements of account at least annually detailing the transactions in your account and any securities held on your behalf;
- to obtain your express authorization in advance of every purchase and redemption made on your behalf;
- to make no promises about a fund's performance and to make no suggestions that future performance can be inferred from past performance; and
- to offer no guarantees of your investment.
In most provinces and territories you can cancel an agreement to buy a mutual fund by giving written notice to your dealer within two business days after receiving the fund's prospectus. This is known as the right of withdrawal. If you exercise this right, you are entitled to receive the full purchase price paid, plus any sales commission or fees that were charged to you.
In most provinces and territories you will also have the right to cancel your mutual fund purchase by giving written notice to your dealer within 48 hours of receiving your written confirmation of purchase. This is known as the right of rescission. If you exercise this right, you will receive the full purchase price you paid for the shares or units or their net asset value at the time of your rescission, whichever is lower. Sales charges and fees will also be returned to you. Of course, if you change your mind about a mutual fund purchase, you can always redeem your shares or units at the current NAVPS, but you may incur significant sales charges if you do.
In Canada, all securities are subject to provincial and territorial securities laws that are administered and enforced by the securities regulator in each jurisdiction. Together, the regulators are known as the Canadian Securities Administrators. Canadian securities laws regulate the mutual fund industry in three basic ways:
- Through registration requirements: Every person or dealer who sells mutual funds or manages the investment portfolio of a mutual fund must be registered (licensed) in each jurisdiction where they do business. Those who sell funds are registered as dealers and salespersons. Those who make investment decisions for mutual funds are registered as advisers. The registration requirements enable securities regulators to ensure that each dealer, salesperson or adviser has the basic qualifications required to act on behalf of the public investors.
- Through prospectus requirements: Every mutual fund that intends to sell securities to the public must first file a prospectus with the regulators and must give a summary disclosure document to each purchaser. The information contained in these documents is intended to allow investors and their financial advisers to make prudent and informed investment decisions. The mutual fund, the mutual fund firm and the mutual fund's principal distributor are accountable at law for the statements made in the prospectus documents. Once a fund has filed a prospectus it is also obliged to provide investors with financial statements and other important information on a regular basis.
- Through rules and policies on fund operations and sales conduct: Securities regulators have also established a number of policies and rules that govern investment and marketing practices, the way in which mutual fund assets must be held and the types of incentives that can be paid to those who sell the funds.
Many dealers who sell mutual funds are also members of industry self-regulatory organizations (SROs) and both they and their employees are subject to the rules, bylaws and policies that are established by those SROs.
If you are concerned about the conduct of your salesperson, see the suggestions provided in our section "Choosing Your Financial Advisers." If you have concerns about the conduct of the fund, you should start by contacting the customer service representatives at the fund company. If your concerns persist, contact the securities regulator in your province or territory.
You have other investment options if you wish to put your money in a professionally managed investment fund. Two of the most common types of investment funds, other than mutual funds, are closed-end investment funds and segregated funds.
Closed-end Investment Funds
Like mutual funds, closed-end investment funds are pools of money managed on behalf of investors by a professional money manager. Unlike mutual funds, closed-end funds issue a fixed number of shares or units and then list them on a stock exchange so they can be traded among investors. In a closed-end fund, new shares or units are not issued continually by the fund, and existing shares or units are sold by investors through the stock exchange rather than being redeemed by the fund.
Segregated funds are investments offered by insurance companies that are similar, in many ways, to mutual funds. When you invest in a segregated fund you are buying an insurance contract, the benefits of which are based on a professionally managed pool of assets owned by the insurance company but segregated from the other assets it holds. Unlike mutual funds, segregated funds offer a limited guarantee protecting at least part of your investment. The insurance company guarantees that the money originally invested (the principal) will be returned upon a specific maturity date (e.g., ten years) or on your death. Typically between 75-100% of the principal is guaranteed, with the level of guarantee sometimes declining as you age.
Segregated funds may also offer some creditor protection and the ability to avoid probate fees that might otherwise be charged to the fund holder's estate. However, management fees for segregated funds may be higher than for mutual funds.
There are many different segregated funds with different investment objectives, risk profiles, potential returns and fees. Segregated funds are regulated by insurance regulators with some differences in regulation from mutual funds. They are generally sold through different channels (insurance agents).