A mutual fund is an investment vehicle that pools contributions from investors and invests that money into a variety of securities. So what does that mean to you and why might you want to use, or stay away from mutual funds when you’re investing your money? I’ll get into that in today’s post all about mutual funds.

So let’s break down our initial definition of a mutual fund. It’s an investment vehicle that pools contributions from investors. This allows investors to contribute small amounts of money to invest in a diversified portfolio. If you had $100 to invest, you might be able to buy 2 shares of Suncor, 1 share of RBC, or you’d have to save another $50 to even get 1 share of Shopify. As I talked about in a recent video, diversification is extremely important in investing, and clearly in this instance your $100 won’t get you a diversified portfolio. With a mutual fund, you pool your $100 with lots of other investors’ money so you can invest in a small portion of 100’s or 1000’s of stocks. For example, if you purchase a plain vanilla Canadian index fund (and I’ll explain what that means in the future), you’ll be buying a small portion of over 250 stocks.

How are mutual funds structured?

Mutual funds are structured so that you can purchase partial units. If you want to invest $100 and the price of 1 unit was $52, you could buy 1.923 shares and invest your full $100. With an individual stock for example, you could only purchase 1 share, and would have $48 in cash remaining because you didn’t quite have enough money to buy 2 shares. Investors are able to easily save on a regular basis by setting up a Pre-Authorized Contribution, or PAC. This allows investors to say, I’ll contribute $100 every two weeks and the full $100 will be automatically invested every two weeks at the fund’s current price. Since you can buy partial units, the full $100 will be invested each time. For regular savers without a lot of money to start, mutual funds can be a fantastic tool to get started. And before robo-advisors came onto the scene, this was really one of the only feasible ways for people just starting to invest. You may have heard from friends, family members and/or the media that mutual funds are terrible, but based on my description above, they don’t seem that bad! Why do mutual funds have such a bad rap? I’ll explain that in more detail in a future video.

The next part of the earlier definition is that it invests investors’ contributions into a variety of securities. So how do mutual funds pick what securities they invest in? Each mutual has a portfolio manager that sits in an office somewhere in Toronto (most likely) that manages the fund. This portfolio manager gets to make the final decision on what should be bought and sold within the fund. Now he or she can’t necessarily just go off and load your money into some obscure security in a developing country. There are specific rules for each mutual fund that are outlined in what’s called a fund’s prospectus. The prospectus for a balanced fund will say for example that 40% of the fund will be invested in Fixed Income, 25% invested in Canadian equity, 20% in US Equity and 15% in International Equity. So the portfolio manager wouldn’t be allowed to invest all of your money in US equities because they thought that the market was going to take off. There are limits. Unfortunately however, many mutual funds have a significant latitude in what they can actually invest in, so it’s important to read the prospectus and understand what the fund is allowed to invest in. For example, if you chose to invest in a Canadian equity fund, a US equity fund, and an International equity fund, and you (or your advisor) selected a specific target for the weighting of those funds. If you purchased the Investor’s Canadian Equity Fund, for your Canadian equity portion, your overall portfolio weighting might not be what you thought it was. Since within this fund’s prospectus, it outlines that the fund is allowed to invest in up to 50% percent of the fund in foreign securities. If they did that, rather than having say a 30% allocation of your portfolio to Canadian equities, your portfolio might only actually hold 15%. This is the risk when you invest in active mutual funds.

What’s an active mutual fund you ask?

Do you hold mutual funds? Why or why not? If you do, do you know what they are really invested in? I’d love to hear from you in the comments below!