Chapter 1

Mutual Funds 101

IN THIS CHAPTER

Understanding mutual funds

Looking at how funds can make you money

Identifying the four types of mutual funds

Knowing where to buy funds

There’s a good chance you or someone in your family already owns some mutual funds. They can seem complicated — especially today, given how many options there are on the market, which leads people to buy the first fund their financial planner suggests. All too often, Canadians end up disappointed with their funds’ performance, because they’ve been sold something that’s either unsuitable for them or just too expensive.

But not to worry! Building a portfolio of excellent funds is easy if you follow a few simple rules and use your own common sense. This stuff isn’t complex — a mutual fund is just a money-management tool that operates under clear rules. Yes, it involves a lot of marketing mumbo-jumbo and jargon, but the basic idea could be written on a postage stamp: In return for a fee, the people running the fund promise to invest your money wisely and give it back to you on demand. The fund industry is competitive and sophisticated, which means plenty of good choices are out there.

In this chapter, we show how funds make you money — especially if you leave your investment in place for several years. We also touch on the different types available, and quickly describe the main places you can go to buy funds. We discuss these topics in greater detail throughout the book, but after you read this first chapter, you’ll know the basics.

Getting the Scoop on Mutual Fund

A mutual fund is a pool of money that a company gets from investors like you and me and divides into equally priced units. Each unit is a tiny slice of the fund. When you put money into the fund or take it out again, you either buy or sell units.

For example, say a fund has total assets — that is, money held in trust for investors — of $10 million and investors have been sold a total of 1 million units. Then each unit is worth $10. If you put money into the fund, you’re simply sold units at that day’s value. If you take money out, the fund buys units back from you at the same price. (Handling purchase and sale transactions in units makes it far simpler to do the paperwork.) And the system has another huge advantage: As long as you know how many units you own, you can simply check their current price to find out how much your total investment is worth. So, if you hold 475 units of a fund whose current unit price is $15.20, then you know your holding has a value of 475 times $15.20, or $7,220.

Owning units of a mutual fund makes you — you guessed it — a unitholder. In fact, you and the other unitholders are the legal owners of the fund. But the fund is run by a company that’s legally known as the fund manager — the firm that handles the investing and also deals with the fund’s administration.

The terminology gets confusing here because the person (usually an employee of the fund manager) who chooses which stocks, bonds, or other investments the fund should buy is also usually called the fund manager. To make details clear, we refer to the company that sells and administers the fund as the management company or fund sponsor. We use the term fund manager for the person who picks the stocks and bonds. Their skill is one of the main benefits you get from a mutual fund. Obviously, the fund manager should be experienced and not too reckless — after all, you’re trusting them with your money.

Under professional management, the fund invests in stocks (shares in companies) and bonds (loans from government and businesses) and potentially other assets depending on the fund. That could include physical infrastructure, like toll roads, airports, and highways, or more recently bitcoin, a digital currency that many people use to buy and sell goods (often illicit goods) online increasing the pool of money for the investors and boosting the value of the individual units.

For example, if you bought units at $10 each and the fund manager managed to pick investments that doubled in value, your units would grow to $20. In return, the management company slices off fees and expenses. (In the world of mutual funds, just like almost everywhere else, you don’t get something for nothing.) Fees and expenses usually come to between 0.3 percent and 3 percent of the fund’s assets each year, depending on how a fund invests. Some specialized funds charge much more.

Mutual fund investing is not as confusing as it may seem. A fund company buys and sells the units to the public at what’s called a net asset value. You get this number by dividing the total net asset value of the fund or company by the number of shares outstanding. This number is known as the net asset value per share (NAVPS). This value increases or decreases proportionally as the value of the fund’s investments rises or falls. Say in January you pay $10 each for 100 units in a fund that invests in technology stocks, such as Microsoft, Apple, and NVIDIA. Now, say, by July, the value of the shares the fund holds has dropped by one-fifth. Then your units are worth just $8 each. So your original $1,000 investment is now worth only $800. But that August, several companies in the fund launch a bunch of game-changing artificial intelligence tools. That sends the value of their shares soaring and lifts the fund’s units to $15 each. The value of your investment has now grown to $1,500.

Open-and closed-end funds

Say you’ve made a profit on that technology fund you held. Where can you go from here? Well, that depends on you. You can hang in there and see if the fund can climb higher, or you can cash out. With most funds, you can simply buy or sell units at that day’s net asset value. That flexibility is one of the great beauties of mutual funds. Funds that let you come and go as you please in this way are known as open-end funds, as though they had a giant door that’s never locked. Think of a rowdy Viking banquet where guests are free to come and go at will because the wall at one end of the dining hall has been removed.

That means most mutual funds are marvelously flexible and convenient. The managers allow you to put money into the fund on any business day by buying units, and you take money out again at will by selling your units back to the fund. In other words, an investment in a mutual fund is a liquid asset. A liquid asset is either cash, or it’s an investment that can be sold and turned into good old cash at a moment’s notice. The idea is that cash and close-to-cash investments, just like water, are adaptable and useful in all sorts of situations. The ability to get your cash back at any time is called liquidity in investment jargon, and professionals prize it above all else.

The other type of fund is a closed-end fund. Investors in these funds often are sold their units when the fund is launched, but to get their money back they must find another investor to buy the units on the stock market such as a share, often at a loss. The fund usually won’t buy the units back or may buy only a portion.

You can make money in closed-end funds, but it’s very tricky. As craven brokerage analysts sometimes say when they hate a stock but can’t pluck up the courage to tell investors to sell it: “Avoid.”