Each mutual fund has a portfolio manager that determines what securities are bought and sold within the fund on a regular basis. But if it’s up to the mutual fund portfolio manager to buy and sell securities that the fund holds, how do you know that’s aligned with the kind of investments you want? In my previous video I outlined how portfolio managers run mutual funds and the way they invest is broadly determined beforehand and outlined in the fund’s prospectus. In today’s post, I’ll outline the two main ways mutual funds are invested.

The first way that mutual funds can be invested is passively.

These types of mutual funds are called index mutual funds. Before I get into index mutual funds, it’s necessary to outline what an index is in the world of finance. An index is a basket of securities that is used to measure a market. So for example, the S&P/TSX Composite is an index produced by Standard and Poor’s that tracks the Canadian markets (or the Toronto Stock Exchange). The S&P 500 tracks the 500 largest stocks in the US market, while the FTSE US Total Market Index is comprised of over 4,500 stocks on the US exchanges. The broader the index (i.e. the more stocks it includes), the more it tracks the total market. The indexes most often weigh the stocks within them by their size, or market capitalization. Side note: market capitalization is equal to the price of the stock multiplied by the number of shares issued. So a stock with a higher price doesn’t necessarily make it bigger than a company with a smaller share price. So if we go back to the S&P/TSX Composite that is used to estimate the total Canadian market, Royal Bank of Canada is the largest holding in that index, because it is the biggest public company, measured by market capitalization, in Canada. There are multiple index providers (i.e. companies that create these indexes), and each have their own rules for including companies within the indexes. They may vary slightly, but there is little leeway for an index provider to include more of a specific company because they like that specific stock, or exclude a stock they dislike, it’s mainly rules-based. The main providers for Canadian investors include S&P, FTSE, Russell, and MSCI.

Back to index mutual funds. An index mutual fund is one where the Portfolio Manager of the fund looks to track the index the fund has chosen. Using the Canadian example again. The fund prospectus may outline that the fund seeks to track the S&P/TSX Composite. In this case, the portfolio manager will seek to track this index as closely as possible. When the underlying index changes (either adds or deletes stocks, or the proportion changes), the portfolio manager will make changes to the mutual fund holdings so that it is in line with the index. Because the Portfolio Manager isn’t making decisions on which stocks to buy and sell and the weight of each stock within the fund, they don’t need to hire smart research analysts and can keep costs low.

The second way mutual funds are managed is actively.

Active mutual funds seek to beat the market (and their index mutual fund competitors) in two ways:

The first is by selecting individual securities that they believe will do well. Back to our Canadian Equity example, let’s say the portfolio manager thinks that RBC will do well, and CIBC is not. Rather than holding onto both of those stocks in the same proportion as the index does, the Portfolio Manager can choose not to buy (or sell if the fund already owns) CIBC. With the money that would have been allocated to CIBC, they can now buy more RBC shares. If CIBC does better than RBC, the fund will underperform (all else being equal), if RBC does better, the fund will outperform.

The second way managers try to beat the market is through market timing. This is where the portfolio manager will try and predict how markets will move and react to specific events and economic factors. For example, they may choose specific market sectors (financial corporations, materials companies) they believe will do better based on the economic conditions (low interest rates, economic recessions). Another example is moving assets in and out of asset classes (stocks or bonds) or geographies in expectation of market movements based on specific events. For example someone basing their investment decisions by predicting whether Trump would be elected and how the US stock and bond market would react if he was elected. Or predicting a financial recession, so moving out of stocks and holding cash instead.

That’s why you see active funds like the Investors Canadian Equity Fund allowing up to 50% of foreign securities. If the Portfolio Manager thinks that US equities will do better than Canadian equities, he or she can load up on US equities and try and do better than the fund’s Canadian Equity mutual fund competitors.

Since actively managed mutual funds are making specific investment decisions on what to hold all the time, they need to employ analysts and purchase research to inform these decisions constantly. This drives the cost of the fund up significantly compared to index mutual funds. Is this cost increase to have someone actively manage your mutual fund worth it? I’ll talk about that in a future video, but I’d love to hear your thoughts in the comments below. In my next video, I’ll be outlining the various fees associated with mutual funds, active and passive.