Week 5 - Mutual Funds

So we have covered both sides of the ledger, between debt and equity (bonds and stocks). That said, as you may have guessed, buying individual stocks and bonds can take a lot of research, not to mention following your picks once you make them. It's not as big a deal on the bond side of things (they are more 'set it and forget it' if you buy good quality bonds) but stocks do require some degree of maintenance. We are often busy or just choose to do other things with our spare time than research our stock picks. Many investment advisors don't 'do' stocks for this reason; they would rather spend their time building their businesses or monitoring other aspects of their clients' financial situations, so they leave the stock and bond selection up to others; quite often, mutual funds.

Most of you probably own mutual funds but many may not know what they actually are. A mutual fund is like a pool of different investors' money that is then used to buy many different stocks or bonds, or sometimes other asset classes, like real estate holdings. It's easiest to follow a dollar invested to find out how they work.

1) You decide it's time to do some investing but don't have all that much money to buy a diversified portfolio of stocks and bonds. Let's say you're starting with $10,000. You take your money to a bank, and ask to open an investment account.

2) After meeting with an advisor, you decide that the best idea would be to buy units (they're called units, as opposed to stocks which are called shares) in a mutual fund. For the sake of the example, we will use one of Canada's oldest funds, the Mackenzie Ivy Canadian Equity fund.

3) Let's take a look at the name. Mackenzie is the company itself. It has employees that are in charge of buying and selling the investments for a wide array of mutual funds, one of which is your Ivy Canadian Equity fund. These employees are called fund managers. When you give your money to Mackenzie, you now own units in the fund and benefit (or suffer) from the manager's ability to pick stocks that go up (or down). In this case, as the name 'Canadian Equity' tells us, this fund invests only in equity (stocks) of Canadian companies. No bonds. The 'Ivy' part is just some word they decided to use for the name.

Here's a link to globefund.com which is a good enough site for checking out different mutual funds.

http://www.globefund.com/servlet/Page/document/v5/data/fund?style=na_eq&id=17974&gf_uid=globeandmail.gf.04382357814

What's most important with mutual funds if their ability to grow your money over time. The different funds and fund companies (e.g. Mackenzie, Fidelity, Templeton, Trimark to name a few of the bigger ones in Canada) are constantly being measured against one another for their performance. There are awards each year for which managers or companies returned the highest amount of money (or lost the least amount, as was certainly the case in 2008) for their unit-holders. The ironic thing about having annual awards is that any advisor will tell you that you should hold a fund for at least three years before you make any judgement on whether or not the money is being well-managed, but I digress.

Here are some key terms that you will come across when checking out different funds:

NAV - Stands for Net Asset Value, which is a technical term for the current price of your fund units. It is better defined as the total value of all the shares of all the companies in the fund, divided by the total number of units sold. The 'Net' means that the units are valued net of any fees that the company has taken for their services, which leads us to...

MER - Stands for Management Expense Ratio, which is another name for the fees you pay to own a fund. I will speak more on fees in another column. That said, a typical Canadian equity fund usually charges fees of around 2-2.5% per year. With the fees, the company pays its employees, including the manager who is making their picks. There are also trading costs for buying and selling the stocks, which this fee pays for. Lastly, often the advisor that recommended the fund to you will be compensated a portion of the annual fee, normally 0.5-1%.

FE, ISC, DSC - Some advisors will also charge an up-front (Front End or Initial Sales Charge) commission if you want to buy a fund, while others will sell funds with bank-end (Deferred Sales Charge) penalties (you pay if you sell the fund before a set time period lapses; generally 3 years or more). Advisors are compensated additional money by the fund company, depending on how long your funds are committed before you can sell them without penalty. It can be as much as 5%, which would be the penalty you would pay if you sold the fund in the first year. There are virtually limitless fee options for buying funds - be sure to have all the information on the fee structure before you buy.

Star Rating - some websites will use a star rating to measure funds for their performance over different time periods. The rating is based on how well the fund performed, relative to the other funds in the same asset class (i.e. Canadian Equity funds). If a fund has returned the highest percentage gain over a three year period compared to all other funds that invest the same way, then it is often garnered a 5-star rating. Buyer beware: sometimes ratings do not tell the whole story. Maybe the fund had a very high percentage of its holdings in oil stocks during a time period when the price of oil rose dramatically, which led to a 5-star rating. This could lead to a few bad years, if oil prices fall and the fund still has a big position in the sector. Try to buy funds that have good long-term track records with no change in management. A fund is only as good as the individual making the investment decisions. Otherwise it is just a name.

Here are some different types of funds that are commonly available for purchase:

Canadian Equity - invests in stocks of Canadian companies

Canadian Bond - invests in bonds of either Canadian companies or governments

Global - invests in stocks or bonds anywhere in the world

International - buys and sells stocks or bonds anywhere OUTSIDE North America

Emerging Markets - invests in countries that are developing. The four most common are the BRIC nations; Brazil, Russia, India and China

There really are no limits as to what kind of mutual funds could be launched. If some manager thinks that the prospects for investment in Germany are going to be massively successful over the next few years, he or she may launch a German Equity fund to take advantage. More likely however, he/she will launch a European Equity fund and concentrate the buying to German companies while the prospects are good. Then, if things work out in Germany, they can still look elsewhere in Europe for other good investments. Funds will also focus on different sectors. Back in the late 1990s, technology funds were started to invest only in 'high-tech' companies that were sure to change the world. Some of them did but most went bankrupt. When you buy a fund, you will get a document called a prospectus, which will outline the investment parameters for the fund; locations, company size limits, etc.

In my opinion, the best way to buy mutual funds is to buy a few in different areas. Maybe buy one Canadian Equity, one International or Global equity and one bond fund. Then, each year, add to the one that did the worst (buy low) and trim from the one that did the best (sell high).

Mutual Funds in a Nutshell

Upside: Good way to own many stocks and access professional management, as well as gain access to other areas that are more difficult to research from home.

Downside: Fees can be high, managers can leave, performance not guaranteed.

As always, there is much more. But these things start looking like mini-novellas by the time I'm done writing them and I don't want to bore you. But on the other hand, it's your money! By taking the time to digest a bit of knowledge here and there, you will be much better off in the long run.

Please feel free to ask questions. Thanks, as always, for reading.

GW