A mutual fund is simply a financial product that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund.
Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in (you don't have to figure out which stocks or bonds to buy).
By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification.
Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously.
The most basic level of diversification is to buy multiple stocks rather than just one stock. Mutual funds are set up to buy many stocks (even hundreds or thousands). Beyond that, you can diversify even more by purchasing different kinds of stocks, then adding bonds, then international, and so on. It could take you weeks to buy all these investments, but if you purchased a few mutual funds you could be done in a few hours because mutual funds automatically diversify in a predetermined category of investments (i.e. - growth companies, low-grade corporate bonds, international small companies).
Money Market Funds
These funds are a great place to park your money. Whether you're storing money for emergencies, saving for the short-term, or looking for a place to store cash from the sale of an investment, money market funds are a safe place to invest. These funds invest in short-term debt instruments and typically produce interest rates that double what a bank can offer in a checking account or savings account and rival the returns of a GIC’s in some cases. The beauty of money market funds is that you can often write checks out of your account and they provide a high amount of liquidity (ability to cash out quickly) not found in GIC’s. These funds are not CDIC insured, but in the history of money market funds no money market fund has ever folded, yet many banks have failed and many investors with over $100,000 lost out.
Bond funds carry more risk than money market funds are often used to produce income (useful in retirement) or to help stabilize a portfolio (diversification). The primary types of bond funds are:
- Municipal Bond Funds -uses tax-exempt bonds issued by state and local governments (these funds are non-taxable).
- Corporate Bond Funds -uses the debt obligations of U.S. corporations.
- Government Bond Funds -uses Canadian treasury, federal government securities.
Another way bond funds are often classified is by maturity, or the date the borrower (whether it be the bank, the government, a corporation or an individual) must pay back the money borrowed. Using this classification bonds are often called short-term bonds, intermediate-term bonds, or long-term bonds.
Stocks funds are considered riskier than bond funds (although certain bond funds can be very risky) and are used for growing your money. Money market funds and bond funds typically provide returns just a percentage or two above inflation, but stock funds should do much better over long periods of time.
- Growth Funds - These funds invest in stocks believed to be the fastest growing companies in the market. Growth funds rarely provide dividend income and are considered riskier investments.
- Value Funds - These funds invest in large and mid-sized companies that appear to be overlooked or out of favor. These undervalued stocks tend to pay dividends.
- Blend Funds - These funds are a "blend" of both growth and value stocks.
- Large-Cap Funds - These funds invest in companies whose market value (# shares outstanding X current market price) is large. Usually greater than $9 billion. These "blue-chip" funds tend to be well-established corporations and tend to pay dividends.
- Mid-Cap Funds - These funds invest in mid-sized companies whose market value is more in the range of $1 billion to $9 billion.
- Small-Cap Funds - These funds invest in emerging companies whose market value, is less than $1 billion. These companies tend to use profits to grow rather than pay dividends.
These funds try to mimic a chosen index. Examples of indices include the S&P 500, NASDAQ, and the Russell 2000 and the TSX. An index is simply a group of stocks chosen to represent a particular segment of the market. Usually this is accomplished by purchasing small amounts of each stock in a market.
Index funds are a hands-off approach to investing. The manager is not trying to find the hot stocks or great deals. Instead, the manager is simply trying to match a chosen index. The results are funds that are very cost efficient, meaning the operating costs are very lower.
- Global Funds - These funds invest in both U.S. and International stocks.
- Foreign Funds - These funds invest primarily outside of Canada.
- Country Specific Funds - These funds focus on one country or region of the world.
- Emerging Markets Funds - These funds focus on small developing country and are considered very risky.
Sector funds choose to invest in a particular industry or segment of the market. Examples of sectors include automotive, technology, baking, air transportation, biotechnology, health care and utilities, oil and gas and mining and precious metals.
Sector funds are considered less diversified than most mutual funds, but they do offer diversification within a particular industry.