A Mutual Fund is an investment product that pools investors’ funds for the purpose of investing in stocks, bonds or money market instruments. A Mutual Fund will have a designated sector or style, such as Canadian Growth Stocks, Canadian Government Bonds or Asian Stocks. There is an endless amount of categories of assets that Mutual Funds attempt to track.
An actively managed Mutual Fund is an investment vehicle where the fund manager actively makes investment allocation decisions with the goal of outperforming the benchmark index the fund is compared to. For example, if the mutual fund were a Canadian Energy Stock Mutual Fund, the manager would try to select stocks of Canadian Energy Corporations that together provide a better return than the index of all Canadian Energy Stocks. The allocation of funds and universe of investments is restricted by the Investment Policy Statement, a document that can be accessed with the prospectus of the fund.
Multiple research studies have shown that few managers outperform their benchmark for an extended period of time. Many can do so over a year or two, but ultimately performance tends to revert to the mean.
A passively managed Mutual Fund is an investment vehicle where the fund manager attempts to replicate a benchmark by tracking the returns on an index. For example, if the benchmark were Canadian Government Bonds, the manager would hold assets in the universe of Canadian Government Bonds that replicated the bond index before fees. The manager would only change the allocation of assets after the benchmark index has been changed.
Investors purchase mutual funds primarily for two reasons:
A Mutual Fund will have a minimum investment allocation, but one set small enough for individual investors to be able to participate. The fund then uses the aggregation of the individual investors’ funds to purchase a diversified portfolio. This allows an investor to obtain a diversified allocation with a small initial contribution. When an investor then diversifies the types of mutual funds owned a geographically, asset class and across sector diversified portfolio can be obtained for a lower cost than the outright purchase of each asset.
In Canada and the United States, a minimum level of education as well as ongoing professional development is required to be qualified to manage a mutual fund portfolio. Often the manager of a Mutual Fund has become an expert in the area he or she invests, such as Energy Stocks or Technology Stocks. The manager’s expertise is in selecting the outperforming stocks in these sectors.
In the United States and Canada, to be a Mutual Fund portfolio manager one has to pass the Chartered Financial Analyst Exam, a three level financial accounting and investment technique program.
In Canada, to be a mutual fund sales representative one has to be registered with the Mutual Funds Dealers Association (MFDA) that registers and self-regulates sales representatives by ensuring competency of investment knowledge and ethical standards.
In the USA, the SEC performs the same role that the MFDA does in Canada.
Mutual Funds are a relatively high cost investment product. Mutual Funds charge a variety of fees, MER (management expense ratio), which is the day-to-day cost of managing the fund and can be as high as 3%, as well as sales fees (either up front or deferred upon sale) that range as high as 5-7%. Due to the high fees on Mutual Funds, investors tend to underperform the market or their benchmark.
A second drawback is the lack of liquidity. A Mutual Fund can be only bought and sold after the close of the market when the NAV (Net Asset Value) is calculated. This means that a Mutual Fund cannot be bought/sold during the trading day if a price discrepancy happens, and is often acquired or sold after that discrepancy is priced into the NAV.
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