A mutual fund is a collection of assets (namely, stocks and bonds) that allow investors to pool their money with others in order to invest together. A mutual fund manager (or group of managers) is in charge of managing the fund’s assets. Investing in a mutual fund is one way to diversify your portfolio, since it gives you a stake in many different stocks at once. Where mutual funds were once the primary way to do this, newer security types like exchange traded funds (ETFs) offer the same service, but without some of the same drawbacks. And yet, some banks still try and sell their customers on mutual funds. A savvy investor should know how they work, and how they stack up against other investment options.
A brief history
Mutual funds used to be the primary way to diversify your investment portfolio. Stock commissions used to be far higher than they were today, which made it prohibitively expensive to go out and pick and choose a number of different companies to invest in. Your choices were to either put all of your money in a couple of stocks, or invest in a mutual fund, which would divide it between far more at once, a much more viable option. This also meant that fund managers were free to charge a variety of fees for the trouble of managing their clients' investments.
Another thing holding funds back was the effort it took to calculate their value on a day-by-day basis. Before modern computers, it took a lot of work to go through all of the fund's component stocks, record their value, and then figure out the net value of the mutual fund as a whole. As a result, a mutual fund’s value was only calculated at the end of every day, a feature that persists to this day.
All this changed in the 1990s, when when modern computers became powerful enough to calculate a fund's value in an instant. Stock commissions have also plunged since then, meaning mutual funds are a relic of the past. They persist because they’re profitable for the banks that collect all those juicy fees – and get to recommend them to their customers. And while it’s true that they offer the expertise of a professional portfolio manager, actively managed mutual funds have historically underperformed compared to the stock market at large.
Where to invest in mutual funds
Mutual funds are typically invested through a bank that manages your money for you. The bank will have you fill out a risk questionnaire to determine which one best suits your needs, and then invest your money accordingly. In most cases, the bank will invest your money in mutual funds that are run by the bank itself.
It’s also possible to invest in mutual funds outside of a bank, since many of them are accessible through brokerages. To find them, though, you’d need to know the mutual fund code of the fund you’re looking for. These can be found in the mutual fund’s ‘fund facts’ document (who says bankers don’t have a sense of humour?) which will be available online. That same document will also have information about the fund’s specific holdings and fees.
Mutual fund fees
Mutual funds are often criticized for the fees they charge their investors, which can be quite high. Each one has a management expense ratio (MER) which is charged against your investment total, and can be as much as 2% each year. That charge is intended to cover the cost of managing the fund itself, as it is overseen by professional investors.
MERs aren’t the only fees that mutual funds charge. In addition, they may also contain…
- Front-End Fees: An initial percentage paid simply to invest with that mutual fund in the first place.
- Back-End Fees: Some mutual funds make you wait a certain amount of time before you can sell. This is called a redemption period, and if you choose to sell before it’s up, they’ll charge you this fee.
- Trailer Fees: This is paid to the financial institution that invests on your behalf. If you have an account with a bank and they invest your money in a mutual fund, you pay them a trailer fee on top of the fund’s own MER.
- Transaction Fees: These cover any administrative costs associated with facilitating the trades within a mutual fund, and are sometimes included in the MER.
Mutual funds vs ETFs
ETFs came along in the 1990s, when computers made it possible to calculate a fund's value on a second-by-second basis. While ETFs also charge a management fee, they tend to be far lower than mutual funds’, sometimes in the range of 0.2% – ten times cheaper – and often while covering the exact same investments.
ETFs often offer the same benefits as mutual funds: they give you a way to diversify your holdings, and through a fund managed by a professional, just for far cheaper. However, ETFs are traded like stocks throughout the day, second-by-second, while mutual funds are only traded once per day. Some investors appreciate this limitation, as it can deter them from making quick, emotional decisions.
Different types of mutual funds
To accommodate various different investors – and address criticisms of their fees – a given mutual fund will be offered in several different versions, called series. The most common classes are Series A, Series D, and Series F.
- Series A are what you’ll often see when investing through your bank. They often come with a front end fee. In the past, these were more accessible than the other types, but changes to the fee structure have since removed that advantage.
- Series D was designed for investors who use brokerages outside the bank. They tend to have lower fees, since they don’t have to pay for the bank’s assistance, but they’re relatively uncommon.
- Series F is the preferred mutual fund for do-it-yourself investors, since they come with the lowest management fees. However, some mutual funds only offer these to customers who are using their own brokerage services.
Summary
Mutual funds are useful for investors who want to diversify their portfolio while still having their money managed by a professional. They often come with fees like a MER, which are laid out in their fund facts document online. This document also lists the assets the mutual fund invests in. Since ETFs are a compelling alternative, mutual funds are most commonly used by investors who have their bank invest on their behalf.
