Understanding mutual funds

For many people, mutual funds are the most convenient way to invest in the market. To help you decide whether mutual funds are right for you, the following are answers to some frequently asked questions:

What are mutual funds?

Mutual funds are a collection of stocks, bonds and other securities that are owned by a group of investors and overseen by experienced fund managers. You can own a part of these funds by buying units and becoming a unitholder. The fund managers invest the money in a variety of opportunities with the expectation of increasing the fund’s value.

Why should I invest in mutual funds?

Mutual funds offers you several advantages, namely:

  • Built-in diversification
    One of the key benefits of investing in mutual funds is convenient diversification. Diversity in your portfolio can help to increase your potential returns and decrease your overall risk. The more varied (and balanced) your portfolio, the lesser the impact when fluctuations occur in the marketplace.
  • Professional management
    Many investors purchase mutual funds because they lack the time or the expertise to manage their own investments. Access to an experienced, professional fund manager can help save you time, lower your risks and get you where you want to be financially.
  • Liquidity
    With a mutual fund, you will always enjoy convenient, easy access to your money. You can request that your units be converted into cash at any time.

What are the different types of mutual funds?

Mutual funds come in a variety of types, each with its own objectives, risks and rewards. The money raised from issuing new units is invested according to the fund’s policies and objectives. For example, a fund whose objective is to earn current income might hold bonds or mortgages.

  • Bond funds
    Bond mutual funds offer investors competitive returns and a relatively low market risk. While liquidity is the main objective, bond mutual funds are subject to capital gains and losses, depending on interest rate movements.
  • Mortgage funds
    Mortgage funds can offer investors a regular income. And because mortgage fund terms are relatively short (five years or less), they are less risky than bond mutual funds.
  • Dividend funds
    Dividend funds have the goal of tax-advantaged income with some possibility of capital appreciation. These funds invest in preferred shares and high quality common shares that consistently pay dividends. Income from these funds qualifies for the dividend tax credit, making it an advantage to investors.
  • Balanced funds
    Balanced mutual funds offer investors a mixture of safety, income and capital appreciation. These funds hold a combination of fixed-income securities as well as a wide variety of common stocks for diversification, dividend income and growth potential. Balanced funds enable investors to "get their feet wet" in the world of stocks while providing income through bond holdings.
  • Equity funds
    The primary objective of equity mutual funds is capital growth, although dividends may contribute to the total return. In general, the basic distinction among equity funds is their level of aggressiveness—the more aggressive the investment approach, the higher the risk and the greater potential for capital growth.
  • Specialty equity funds
    Some investors like to diversify into specialty areas that they feel have the potential to outperform the overall markets. These types of funds invest in specialized markets or industries such as natural resources, real estate, science and technology, which, although subject to volatility, may provide increased opportunities for growth over the long term.
  • International funds
    As more and more investors realize that some of the best investment opportunities lie outside of Canada, international funds continue to gain in popularity. International funds offer investors greater portfolio diversification and exposure to stocks on a worldwide, regional and even country basis.

What is the difference between open-end and closed-end funds?

The term open-end and closed-end refers to whether or not a mutual fund issues an unlimited or limited number of units.

  • Open-end funds
    The vast majority of mutual funds in the marketplace are open-end. Like closed-end funds, open-end funds allow an investor to own a share of a diversified portfolio of securities managed by professional investment managers. Open-end funds sell units upon demand. When an investor invests money in an open-end fund, new units are issued directly by the fund. There is no limit to the number of units available. Units of an open-end fund can always be redeemed for the Net Asset Value Per Share (NAVPS).
  • Closed-end funds
    Unlike open-end funds, closed-end funds have a fixed number of units that are generally traded like shares on a stock exchange. Closed-end funds also have a NAVPS but they do not necessarily trade at the NAVPS. In fact, their trading value is frequently less than their NAVPS. In this instance, when a closed-end fund is trading at a "discount," an investor may be able to buy a fund for less than the sum of its parts.

How do I determine the value of a mutual fund share?

Buying units or shares of a mutual fund is similar to buying shares of a company. Essentially, each unit you own is a portion of the combined investments owned by the fund. Each unit has a specific value that varies from day to day depending on the value of the investments in the fund. The term used to define this value is Net Asset Value Per Share (NAVPS) and the formula used to calculate the NAVPS of the mutual fund is:

NAVPS = total market value of assets lessliabilities
                   total number of shares (units)

Are there risks involved with mutual funds?

Yes. There are varying degrees of risks depending on the funds you select. Unlike savings accounts and Guaranteed Investment Certificates (GICs), mutual funds are not insured or guaranteed. Although there are several safeguards in place to protect the mutual fund investor, investors must keep in mind that mutual funds differ from other types of investments and should be considered long-term investments.

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