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The Different Types of Mutual Funds

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

At first glance, mutual funds seem to present a dizzying array of products geared to just about every possible investment need. It is enough to make anyone but the most committed investor run back to the more familiar territory of GICs and Canada Savings Bonds. But don't get overwhelmed. Although there are over 1,200 mutual funds to choose from and no two are exactly alike, they fall into several broad-based categories.

Money-market and treasury-bill funds are the most conservative mutual funds and invest primarily in government (or equally safe) securities. These funds generally pay two or three percentage points higher rates of return than savings accounts and are extremely safe.

Fixed income funds invest in some combination of treasury bills, debentures, bonds, and mortgages. The aim of fixed income funds is to provide high, regular income payments with the possibility of some capital gains.

Equity funds invest in common and preferred shares of Canadian companies and are recommended for investors seeking long-term growth through capital gains. An investment time frame of at least five years is generally recommended for this type of fund.

Balanced funds provide a combination of income and growth by investing in a mixed portfolio of common stock, preferred shares, bonds, and cash. This type of fund is suitable for investors with limited dollars or who want a more diversified portfolio in one fund.

Special equity funds invest in areas such as real estate, resources, and precious metals. Due to the specialized nature of these funds, returns tend to be dramatic, both positive and negative. The experienced investor will have, at most, only a small percentage of his or her portfolio invested in these funds.

Dividend funds invest in dividend-paying preferred shares of Canadian corporations and in common shares that are expected to yield a high level of dividend income. As with equity funds, there is the potential for long-term capital growth. Dividend funds also receive preferential tax treatment.

Global and international funds invest in money-market securities and in bond and stock markets in various countries and regions of the world. These funds offer investors the opportunity to increase returns through extra diversification. If Canadian markets are doing badly, China, Japan, or Europe may nevertheless be doing well.

This survey of fund categories should give you a good idea of the range of investment possibilities. For a more detailed look at any of these categories, turn to the relevant chapter in Part 2.

Before you invest in any fund, however, there are two important factors to consider: a fund's investment objectives and its level of risk. Both of these should be given equal weight when making an investment decision. Failure to do so could prove hazardous not only to your finances but also to your mental well-being.

A Fund's Investment Objectives

Every mutual fund has a specific investment objective, and it is the job of the fund manager to buy and sell securities to attain that goal. In general, these objectives are safety of capital, income, and growth. A fund that seeks to provide safety of capital as its main objective will look for ways to protect your initial investment from loss. Income funds, on the other hand, will aim to provide investors with stable and regular payments in the form of a monthly or quarterly cheque. Funds that aim for growth will invest in equity securities to increase the value of the fund's assets and provide investors with long-term capital gains. Some funds seek to provide a combination of income and growth, and sometimes all three objectives, in one package.

As an investor, you have to decide which investment objectives match your own and concentrate on those particular funds. Mutual funds never invest at random, and neither should you. The more clearly you define your investment objectives, the easier it will be to identify appropriate mutual funds. More about this in Chapter 15.

A Fund's Level of Risk

To find the funds that are best for you, you have to understand the concept of investment risk. Risk is, simply put, the possibility that an investment may go down in value or not perform as well as expected. No investment, whether domestic or international, is risk free. That's a fact you should not ignore. Even money lying securely in a savings account is at risk from inflation. Some common risk factors are:

Credit risk. The possibility that the company holding your money will not pay the interest or dividend due, or the principal amount when it matures.

Inflation risk. The risk that the dollar you get when you sell will buy less than the dollar you originally invested.

Interest-rate risk. The possibility that a fixed debt instrument, such as a bond, will decline in value due to a rise in interest rates. Chapter 9 tells you why.

Market risk. The risk that the unit price or value of your investment will decrease.

One fundamental rule applies to all investments. The smaller the risk, the smaller your potential return. The higher the risk, the higher the potential reward. How much risk you should take depends to a large extent on your investment objectives. The further away from your financial goals or the younger you are, the more risk you can afford to take. This is because the ups and downs of financial markets tend to even out over time. Remember, historically the stock market has risen steadily regardless of its temporary declines. The closer to your financial goals or the older you are, the less time you will have to make up any losses.

You should also examine your own feelings with regard to risk. Are you the type to rush off and buy units in an overseas equity fund with the expectation of receiving high returns year after year? If you are, stop for a moment to consider how you would feel if the fund posted a -20% return. Would you panic and sell? If you had fully understood the level of risk associated with buying. the fund, you might well have been prepared to ride out its volatile yearly returns.

Taking an ultra-conservative approach to investments, however, is also subject to risk. By investing in only the "safe and familiar" such as GICs and Canada Savings Bonds, you run the risk of shortchanging yourself over the long term. While a 7% guaranteed rate of return may look attractive today, inflation or increased taxes could reduce it to a real rate of return of only 2% or 3% further down the road. All investors would like the high returns without the risk. To achieve higher returns, however, you must be willing to live with some risk and be prepared to stay put.

Most financial experts stress that in order to minimize risk, you should hold a well-balanced investment portfolio. If you put $4,000 into a single investment, such as one company's stock, you give yourself very little cushion should. it falter. Let's say that the stock market declines by 10%. You will suffer a capital loss of $400. If you had put $2,000 into a bond fund and $2,000 into an equity fund, your capital loss would be reduced to $200. On top of that, bond markets may have performed well, decreasing your loss further.

To a large extent, by investing through mutual funds, we relieve ourselves of the time-consuming and almost impossible task of researching each investment opportunity and its possible risk. Instead, we rely on the knowledge and expertise of a fund manager, or a team of professionals, to buy and sell the best investments at the right time. Some mutual funds have excellent track records. Some do not. Doing your homework before you invest will reduce the risk of investing in the latter. Chapter 18 shows you how.

What Is Volatility?

There is a lot of talk about a fund's volatility. But what exactly is it, and, more importantly, should you be worried about it? Volatility is a measure of the historical variability in a fund's rate of return compared with similar funds. In other words, when you take into account the returns on all mutual funds, some funds will have wider swings in returns than others. Factors that can contribute to a fund's volatility include the type of assets held, degree of diversification, sector, country or region of investment, use of derivatives, turnover and quality of portfolio holdings, and management investment style. For example, a fund that invests in Government of Canada treasury bills, which are perceived to have no credit risk, is less volatile than one that invests in shares of small new companies. Similarly, a fund that invests in many countries, because of its diversification, is going to be less volatile than a fund that invests in only one country.

One widely accepted measure of risk is standard deviation. Standard deviation is a statistical measure of the (say) month-to-month ups and downs of a fund's return relative to the average, or mean, monthly return for the fund over the period. In this way, standard deviation allows us to compare funds with similar investment objectives over a particular time frame. It can also be used as an indication of how much more risk a fund in one category has than a fund in another category. To arrive at a volatility rating, we compare a fund's standard deviation with all other funds' standard deviations and classify it into one of ten deciles. A low volatility rating of 1 indicates a fund with a stable monthly rate of return. The higher the volatility rating, the wider the swings in rate of return.

Beta value is another statistical measure of volatility, which tells you how much a fund or security moves in relation to the market. For example, the TSE Total Return Index (TRI) has a beta value of 1. A fund with a beta value of 1.05 would move up or down about 5% more than the TRI. The higher the beta, the greater the volatility.

The following chart shows the average volatility rating, and the volatility range from the lowest to the highest, for each mutual fund category. Since a minimum of thirty-six months of data is needed to compute standard deviation reliably, funds that have been in existence for less than three years do not have a volatility rating.

TYPE OF FUND VOLATILITY RATING
Average Range
Canadian
Money-Market 1.0 none
Short-Term Bond & Mortgage 1.6 1-2
Bond 2.5 2-3
Dividend 2.5 2-4
Balanced 2.6 2-4
Equity 3.5 2-8
Small-to-Mid-Cap Equity 4.6 3-10
Special Equity 5.0 1-9
International
Money-Market 1.2 1-2
Bond 2.3 2-3
Balanced 2.8 2-4
U.S. Equity 3.5 2-5
International Equity 3.7 3-5
European Equity 4.3 4-5
Emerging Markets 5.5 5-6
Asian Equity 6.2 4-8

Source: Ranga Chand's World of Mutual Funds

As you can see, all Canadian money-market funds have a volatility rating of 1. This means the volatility of these funds will not be a factor in deciding which moneymarket fund to invest in. When you look at Canadian equity funds, however, although the average volatility rating for this group is 3.5, the range goes all the way from a low volatility rating of 2 to a high of 8. If you invest in this type of fund, its volatility rating should most certainly influence your choice.

The following chart shows the returns over the past ten calendar years of various mutual funds with different volatility ratings. Of course, every fund is different, but the chart will give you some idea of what to expect.

Type of Fund 85 86 87 88 89 90 91 92 93 94 Volatility
Rating
Cdn. Money-Market 9.7 8.8 8.0 8.9 11.6 12.5 9.0 6.0 4.4 4.2 1
Canadian Equity 20.6 1.3 -6.6 12.5 24.1 -6.5 16.5 10.2 30.9 3.3 4
Asian Equity 35.2 61.5 26.8 4.1 6.3 -27.1 7.1 -5.9 35.3 21.1 7
Special Equity 16.3 14.2 1.2 14.0 -3.8 -27.8 -10.0 31.9 85.3 -13.4 9

As you can see, the spread between the highest return and the lowest return (both italicized) is much less for a fund with a low volatility rating of 1, compared with a fund with a volatility rating of 7 or 9. Although over time these wide fluctuations in returns get smoothed out, the roller-coaster ride may be too much for some investors to take. For example, the value of your investments will not always move in an upward direction. Returns will vary from one period to another, sometimes showing a significant decline. This could mean the value of your investment drops from $10,000 to $8,000. If you are unaware of or uncomfortable with this volatility, it could lead to selling at the wrong time at considerable loss.

Your goal, therefore, should not necessarily be to invest in the fund with the highest returns regardless of its volatility. Your goal should be to invest in a fund with a good track record that meets your investment objectives and has a level of volatility that you can comfortably live with. Keep in mind that two funds can average the same return but perform very differently. One fund may earn 11% one year and 13% the second. The other fund may earn 25.4% the first year but have a return of 0% the second. Through the law of compounding, both funds average 12% a year. Everything else being equal, most investors would prefer the steady performer.

If, on the other hand, you are comfortable investing in a fund with a high volatility rating, you should expect to earn more than the market in good years and lose more in bad years. The key is to stay with a fund long enough so that your gains will substantially outweigh your losses, in order to justify the risk. Regardless of your comfort level, however, you should ask the sales representative to provide you with a fund's annual returns over, if possible, the last five or ten years. This will give you a very good idea of its volatility. That way, if you decide to invest, you do so with your eyes wide open.

You can easily compare the volatility ratings of all mutual funds in their specific categories by looking at the monthly mutual fund surveys in the Globe and Mail and Financial Post. Look under the "Volatility" or "Standard Deviation" heading. The average for the group is given at either the beginning or the end of each fund category.

As a final word, keep in mind that there are many investment options that are less secure than mutual funds. The single-issue aspect of investing in a bond, stock, real estate, or antiques may make these investments more vulnerable than even some of the riskier equity mutual funds.

Key Points to Remember

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