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What Are Mutual Funds?

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RANGA CHAND
From Ranga Chand's Getting Started with Mutual Funds

A mutual fund is quite simply a collection of stocks, bonds, or other securities owned by a group of investors and managed by a professional investment company. When you put money into a mutual fund, it is combined with money from similar-minded investors. This large pool of money gives you much greater purchasing power than you could possibly have investing on your own. "Pooling" of money is neither complicated nor exclusive to the mutual fund industry. If, for example, you and your co-workers put your money together to buy lottery tickets, you already know how "pooled" money works. On your own, you might be able to afford one or two tickets, but your money combined with your co-workers' gives you a share in a great many more.

Most experts agree that as an individual investor, you would need anywhere from $50,000 to $100,000 to create a suitably diversified portfolio. For the average Canadian, that's a lot of money. That is why millions of investors now own units in mutual funds. According to the Investment Funds Institute of Canada, assets under management have shot up nearly fifteenfold, climbing from about $10 billion in 1985 to more than $146 billion in 1995. During this period, the number of shareholder accounts also increased sharply, rising from less than one million to more than fifteen million. Approximately one in four households, or seven million Canadians, now own at least one mutual fund.

Mutual funds are popular because they make investing in financial markets easy. Funds invest your and other unitholders' dollars in equity and debt securities. An equity security is a stock or share in a corporation's earnings and assets such as land, buildings, or machinery. Debt securities include bonds and money-market instruments. A bond is an IOU issued by a government or corporation certifying how much you have loaned it and the terms of the loan. Money-market instruments are short-term (less than one year) debt securities such as treasury bills, certificates of deposit, or commercial paper. The investment objectives of the fund determine which of these securities the manager buys. If the objective is "maximum growth" then the manager invests in equity securities, as traditionally the stock market has provided the highest returns. This type of fund, not surprisingly, is known as an equity mutual fund.

Who Sells Mutual Funds?

Unfortunately, when it comes to purchasing mutual funds, there is no such thing as one-stop shopping. Who you buy your mutual funds from will, to a large extent, depend on whether you choose a load or a no-load fund.

Load funds -- mutual funds that charge a sales commission either at the time of purchase or when you sell back units -- are generally not sold directly to the public by the mutual fund companies. Instead, these companies rely on independent sales representatives such as brokers, discount brokers, and some financial planners to promote their products; hence the sales commission. Some insurance and individual mutual fund companies, however, sell their funds through their own salespeople.

No-load mutual funds -- funds that charge no sales commissions -- are generally offered by banks, trust companies, and some individual mutual fund companies. These mutual funds are sold directly to the public Don't jump to the conclusion, however, that you can walk into any one of these institutions and buy any no-load fund. Each financial institution and mutual fund company sells only its own funds. In other words, the Royal Bank will offer investors Royal Bank funds. It does not sell any other mutual fund company's funds. Similarly, Phillips Hager & North, a Vancouver-based mutual fund company, sells only its own funds. The Toronto Dominion Bank, however, recently announced plans to offer third-party funds, starting with the funds of about half a dozen well-known mutual fund companies.

Brokers offer the widest selection of mutual funds to choose from -- in some cases up to 400 or 500 funds. Since brokers are not salaried employees, however, but rely on the sales commissions from the financial products they sell in order to make a living, the majority of these will be load funds. Moreover, many brokers and financial planners promote only a short list of funds, from five or six mutual fund companies.

How Does a Mutual Fund Make Money?

Mutual funds make money by investing unitholders' money in stocks, bonds, and other securities that earn dividends or interest, and by selling these investments at a higher price than originally paid. The money (such as interest income from bonds) earned from a fund's investments is paid to unitholders as income distributions, while any profits from selling these investments at an increased price are paid out as capital gains distributions. Unitholders can also make a capital gain or capital loss when selling back their units to a fund, depending on whether the unit price has increased or decreased since the units were purchased. Funds also pass on to unitholders responsibility for the annual income tax payable on such distributions.

The mutual fund company makes its money through the management fees charged to unitholders. Although all the glossy brochures telling you which fund to buy and why are free, investing in a mutual fund is not. This is discussed in more detail in Chapter 3, "How Much Will It Cost?"

How a Fund Works

Managing a fund obviously requires some degree of skill, combined with long hours, the necessary support staff, and the crucially important computers and software. On a day-to-day basis, a fund manager or team of professionals must review the previous day's market performance, compare their fund's return with others, and analyse the economic news and indicators that are affecting the value of the fund. They must also buy and sell securities, such as stocks or bonds, that meet the objectives of their specific fund, and research possible new markets.

On the administrative side, there are, among many other activities, new accounts to be opened, cheques to be mailed, questions to be answered from new and existing clients, and detailed accounts to be kept of each and every buy and sell transaction. All this bookkeeping is usually completed by the end of each business day, when the new net asset value (NAV) of the fund must be reported. Most funds report their NAV daily, although some may report weekly or monthly. This figure is quoted the next day in the business section of many newspapers, under mutual funds. Look under the column headed NAV per share.

What Is the Net Asset Value?

The net asset value of a mutual fund is the dollar value of one unit of the fund and is calculated by dividing the current market value of the fund's assets, less liabilities, by the number of units already sold. For example, if the fund you are interested in has assets worth $200 million, after deducting liabilities, and there are 10 million units already sold, each unit is worth $20 ($200 million divided by 10 million). This means you would pay $20 for one unit of the fund. If you bought 100 units, you would pay $2,000. In this example, no matter how many people buy or sell units in the fund, the NAV wi' remain unchanged at $20.

The only way the NAV will change is due to the rise or fall in the market value of the assets held by the fund.

Let's say that the same fund's assets increased to $300 million due to some great investment decisions of the fund manager and the number of units outstanding (sold) remained unchanged at 10 million. The net asset value of each unit you held would now be worth $30 ($300 million divided by 10 million). Anyone now buying into the fund would have to pay the new NAV of $30 per unit. If you decided to sell, you would have made a capital gain of $1,000, the positive difference between the price you originally paid ($2,000) and the price you received when you sold ($3,000). On the other hand, if you decided to stay with the fund, this capital gain would be paid out in the form of a distribution, usually by being reinvested in additional units. The NAV would then fall by the amount of the per-share distribution.

Of course, if the markets took a tumble or the manager made some poor investment decisions, the reverse would be true. The NAV would drop, and if you decided to sell at that point, you would suffer a capital loss.

The NAVs of most mutual funds will fluctuate, some more than others; you should be aware of this before purchasing. The NAV for some equity funds, for example, may be up one month and down considerably the next. You won't panic and make a bad investment decision if you know what to expect.

Safety

Mutual funds are not the same as savings deposits, Guaranteed Investment Certificates, or Canada Savings Bonds. There is no guarantee that the money you invest in a mutual fund will remain intact, or even grow. As mutual funds are "securities," not "deposits," they are not insured by the Canada Deposit Insurance Corporation (CDIC). Whether you purchase mutual fund units at your local bank, trust company, or broker, they are still not insured. All assets in a mutual fired, however, are kept separate from the mutual fund company and are held in trust by a Canadian chartered bank or trust company, and as such are protected under banking and trust laws. This segregation is important. It means that even if the company itself collapses, the assets of the mutual fund are protected. These safeguards do not mean that the value of your investment will not increase and decrease in value. Mutual funds are not a magic carpet ride to continuous high returns. Many funds have decidedly bumpy rides, some even nosedive. The extent to which your investment fluctuates will, of course, depend on the type of fund you hold and the expertise of the manager.

The bottom line here is that although mutual funds are not insured, there are many safeguards in place to ensure that no one runs off with your money. There is no guarantee, though, that the $1,000 or $10,000 you invest in a mutual fund will remain intact, or even grow.

Key Points to Remember

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