Mutual Fund Essentials

What is a Mutual Fund?

Mutual Funds are a pool of professionally managed assets invested collectively, for investors with similar objectives. A fixed income Mutual Fund has a higher percentage of less risky assets, such as bonds and cash, where as equity Mutual Funds have a higher percentage of riskier assets, such as stocks. Keeping in mind, over the long term in the past decade, equity Mutual Funds have outperformed fixed income funds.

Equity vs. Fixed Income

Equity Mutual Funds are for long term investing; these funds may underperform fixed income Mutual Funds in the short term, however, these Mutual Funds outperform in the long term. For short term investing, I would recommend a fixed income Mutual Fund. Keep in mind; there are Mutual Funds that offer a combination of both assets – typically known as a balanced Mutual Fund. This would be a good option for medium term investing.

Below is a comparison of two relatively new Vanguard Mutual Funds – US Aggregate Bond & S&P 500 ETF. This past year, Equities have outperformed bonds – however, keep in mind, when the stock market crashes, typically the Return on Investment from bonds increases, thus it would be beneficial to have a combination of the two.

Vanguard

For the past 5 years, the average annual return of a U.S. Equity, Large Value Mutual Fund is 13.94% where as the average return of a Fixed Income Mutual Fund (Taxable High Yield Bond Fund) is 7.41% (Morningstar).

What to look for in a Mutual Fund?

In every Mutual Fund, you should always review the following

  • Past performance
  • Asset allocation & investment objectives
  • Management Expense Ratio (MER)

Past Performance

It’s true when they say the future is unpredictable. That applies for equity investments – nobody simply can come up with an exact prediction of how much an equity investment will be worth in x years. Fixed Income is the only investment where you know your future Return on Investment. But speaking of Fixed Income (such as GICs), interests rates are at an all time low right now – so the Return on Investment is low.

Yes we cannot come up with an exact prediction of the future, but we can make educated guesses through studying the past performance. Before purchasing into a Mutual Fund, have a good look at the past performance. How did it perform during the 2008 recession? How quickly did it rebound? These are the type of questions you should ask yourself.

Asset Allocation & Investment Objectives

Now we’ve reviewed the past performance – let’s look into the asset allocation & investment objectives. To simplify, there are three different investment objectives:

  • Short term (<1 year)
  • Medium term (1 – 3 years)
  • Long term (> 3 years)

Before knowing whether the fund is a right fit for you – knowing your investment objectives will help you make the right decision. The recommended risk greatly depends on the horizon of your investment objectives.

  • Short term – Fixed Income Mutual Funds (higher asset allocation of bonds)
  • Medium term – Balanced Mutual Funds (combination of bonds & stocks)
  • Long term – Equity Mutual Funds (higher asset allocation of bonds).

Preet Banerjee has mentioned in his book, ‘Stop Over-Thinking Your Money!’ “A useful rule of thumb is that your age should be your percentage allocation to fixed income.” In other words, if you’re 19 years old, you should have 19% of your portfolio in fixed income, if you’re 45 years old, you should have 45% of your portfolio in fixed income, and so on. Have a look into the Mutual Fund’s asset allocation mix, and investment objectives. Make sure it’s the right fit for your situation, i.e., make sure it is in line with your investment objectives.

Management Expense Ratios (MER)

After finding your ‘perfect match’ with a few Mutual Funds, compare the MER. The MER is basically how Mutual Fund/Asset Management companies make money from their Mutual Funds. Investopedia defines the MER as “a measure of what it costs an investment company to operate a mutual fund.” The ratio is calculated by dividing the operating expenses by the value of the assets under management.

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Morningstar

As seen above, average MERs over the years have decreased, as the assets in the funds have grown to a larger amount.

The reduction in MERs has also been partially due to the increase in Exchange Traded Funds on the Market – which typically have MERs of less than 1%. As Investopedia has defined it – “an ETF, or Exchanged Traded Fund, is a marketable security that tracks an index, a commodity, bonds, or basket of assets like an index fund.” Unlike Mutual Funds, ETFs can be traded throughout the day, thus experiences price changes. Mutual Funds can only be purchased or sold once a day, thus having less liquidity. However, Mutual Funds tend to be more actively managed, hence the higher MERs.

Conclusion

Mutual Funds are definitely beneficial to have in your portfolio. It provides diversity, and saves time on Do it Yourself (DIY) investing. Remember to look into the past performance, asset allocation & investment objectives, and MERs. Make sure to have a good understanding of the Mutual Fund before buying into it.


Writer: Jelani Smith

Disclaimer: All investing can potentially be risky. Investing or borrowing can lead into financial losses. All content on Bay Street Blog are solely for educational purposes. All other information are obtained from credible and authoritative references. Bay Street Blog is not responsible for any financial losses from the information provided. When investing or borrowing, always consult with an industry professional.