The Bare Necessities: Chapter Four

Chapter Four: The Basket The third and final major investment vehicle available to retail investors are mutual funds. In Canada and the United States, a mutual fund is a basket of investment vehicles managed by a fund manager. They may contain equities, bonds, notes, or money markets, but are restricted from owning or writing options. As a disclaimer, I very rarely promote mutual funds, as I will explain later, however they are very beneficial under many circumstances. I will provide an unbiased argument for both the benefits and downfalls of mutual funds in this chapter after I go through the basics of mutual funds with you. The Basic Concept Mutual funds operate by pooling money from investors with a professional managing it. The fund manager will purchase investments and trade within the fund, similar to a regular investment account. The fund manager earns a management expense ratio (MER) which typically ranges between 1 to 2.5 per cent. The MER only includes the fund manager's fees and do not include potential brokerage fees, trading fees, and custodian fees. These fees are incorporated into the value of the fund, also known as the Net Asset Value (NAV). The NAV is the total value of the fund's assets minus liabilities, and is presented as a price per unit. It is common for investors to ask for the unit price or unit value, and not the NAV of the fund. The unit value's are determined at the end of the trading day, as a result, purchases and sales are not known until the next business day. Unlike equities, mutual funds allow you to buy using a fixed dollar amount, where as stocks require a price per share the amount of shares. That is, you can call in and ask to buy $1000 of a mutual fund, and you may receive 26.358 units. This can not be done with stocks. Reports of mutual funds are also available on the Internet. Morning Star is the world's number one site for reports. These reports will include MER, historical earnings or losses, major holdings, and the fund manager's information. Other Fees All fees associated with a mutual fund is made very clear in the prospectus. Rarely do mutual funds charge you for an original investment, however if they do, this is called a front-load fee. Many funds may charge a redemption fee upon the sale of any units. This can be a flat fee or a percentage of your original investment. No mutual fund will charge you on both, and many mutual funds now do not charge for buying and selling. That is one benefit of mutual funds. It is standard for all funds to contain an "early redemption fee." This is common and is usually just 30 or 90 days. This is to prevent people from buying and selling mutual funds daily, as the cost of buying and selling is expensive and decreases profits for all investors. Exclusive Benefits of Mutual Funds There is very little to know about mutual funds as they are quite straight forward. Give your money to the manager and hope he does a good job. This is one major benefit because many new investors do not know what stocks to pick. Fund managers will have been exposed in the market for years and decades and possess more experience than most individuals. Funds may also have a team of intelligent people making decisions for you. Another benefit are the low costs. As I stated earlier, most funds do not charge you for purchasing their fund. Those that do not plan to sell for years will never have to pay fees (except internal fees like MER). A third pro is that mutual funds require very little capital. You can start investing in a diverse portfolio with $100 only, and many mutual funds allow for systematic investment plans. That is, you can put in $100 every week, or month, or anything and it will slowly build over time. This can be done with stocks, but commissions would eat away at your savings, and stocks require whole units. Cons of Mutual Funds The major downfall of a mutual fund is control. You have absolutely no control as to what is being invested and you do not get to see the daily transactions. The idea that you have given somebody thousands of dollars to trade for you can be scary for many and the choices made by the manager may go against your investment objective and values. What if you were against tobacco companies? It is possible that your fund manager has invested in one of them, and you may not know it. Another problem is the MER. Although for some, paying a manager is a fair trade off, those who have accounts above $10 or $15,000 should consider building their own stock portfolio that replicates a mutual fund. Remember, a mutual fund is basically a regular account, but with millions of dollars more in it. Thirdly, mutual funds do not pay dividends in the same fashion as if you owned a stock. With a stock, you know when you will be paid and how much. Because of the fund's holdings always changing, the dividend is unknown. Some don't even pay a dividend until the end of the year. Those participating in DRIPs also can control which stocks pay dividends in cash and which stocks pay in stock. The final problem with mutual funds is the inability to hedge and protect the investment. I am referring to writing calls and buying puts. Sophisticated traders who expect a drop in the market can protect their account with options, limiting losses, and even gaining on the down side. Covered calls can provide risk-free income as well. But because of regulation, mutual funds can never touch options. Conclusion Well, that's all to mutual funds. Like I said, they are very simple products, but possess a lot of characteristics that you should be aware of. In the last chapter, I will discuss the benefits and risks of options.