How to Invest in Mutual Funds in Canada?
What You Should Know
- Mutual funds are pooled investments.
- Mutual funds provide access to professional investment expertise for retail investors.
- Mutual funds give retail investors cost-effective access to diversification.
- Sizable fees are a serious concern when investing in mutual funds.
Canadian Mutual Fund Assets
What are Mutual Funds?
A mutual fund is a pooled investment. What is called a mutual fund in North America has more informative names in Europe and the UK. In Europe, it is called Investment Company with Variable Capital (SICAV); in the UK, it is called Open-Ended Investment Company (OEIC).
Mutual funds are often categorized by the type of investment they make. In other words, they are classified by the type of asset they hold. Thus we have money market funds, bond (fixed income) funds, equity (stock) funds and hybrid funds. Each of these is further divided based on its income strategy, as a fund might seek income in the form of interest, dividend, capital gain or any combination.
Annual Expense of a Canadian Mutual Funds
Mutual fund expense ratios can be as low as 0.05% or as high as 3.4%.
Many financial institutions provide mutual funds. Fidelity, Vanguard and BlackRock are the most famous mutual fund issuers.If you look at Canadian mutual funds, RBC and TD are the most famous Canadian mutual fund issuers. Around 140 issuers have provided approximately 4000 funds in Canada. The Investment Fund Institute of Canada (IFIC) represents these issuers.
Mutual Fund Classification by Asset Class
Money market funds
Money market funds buy investment grade short maturity (typically less than 90 days) debt securities. Thus they entail minimal risk, and their returns are expected to be slightly higher than the Bank of Canada rate. As a result, money market funds can play a role similar to savings accounts.
Bond funds
Bond funds buy bonds with maturities typically longer than 90 days. Bond funds are as diverse as the bond market itself. A bond funds prospectus might limit the fund manager to government bonds, investment grade corporate bonds, to below investment grade (junk) bonds, or it might give the fund manager a free hand to choose bonds offering the best risk-reward ratio.
Equity funds
As the name suggests, equity funds become partial owners of corporations. Equity funds take on a much more significant risk than money market funds and bond funds and are expected to provide higher returns. Bond funds investing in short term government securities can be considered as a substitute for short term GICs, despite certain differences between mutual funds vs. GICs.
Hybrid (balanced) mutual funds
Hybrid mutual funds often have investment strategies more complex than the preceding three types of mutual funds. For example, they might combine stocks and bonds to achieve the highest return for a particular level of risk. Or they might change the combination of their assets over time to start with a high-return portfolio and gain a low-risk portfolio by a target date. It is common for a hybrid mutual fund to be structured as a fund of funds. A fund of funds is a fund which invests in other funds. These other funds are often funds from the same family of funds. Hybrid mutual funds also include specialty mutual funds like those investing in real estate.
Investment In/Withdrawal from Mutual Funds over April and May 2022
Major Banks and Mutual Funds
Most banks have a wealth-management or an asset-management subsidiary which sponsors mutual funds, among other activities. Thus major banks are among the issuers offering a family of mutual funds.
What Structures are Typical for Mutual Funds?
Some mutual funds are open-end funds. In an open-end fund, an investor would buy units of the fund directly from the issuer at the net asset value (NAV). NAV is the sum of all fund’s assets minus all of its liabilities divided by the number of shares issued by the fund. If the fund holds any illiquid assets, calculating NAV might become controversial. Thus the method for calculating NAV must be detailed in the fund’s prospectus. Later the investor would sell units of the fund at their NAV (at the end of the trading day when the sale order is issued) to the fund issuer. Open-end funds are the most common type of mutual fund.
Unit investment trusts created for a specific investment purpose for a particular period of time are another possible structure for mutual funds.
The third and last standard structure for mutual funds is a closed-end fund also called a non-redeemable investment fund. Units of a closed-end fund are sold to investors at the fund's inception and then listed on an exchange. Investors can trade units of the fund with each other. Units' prices are determined by supply and demand. Fund units might trade at a premium or a discount to their NAV. Closed-end mutual funds resemble exchange-traded funds (ETFs) in many respects.
How to Invest in Mutual Funds
There are different options for investing in a mutual fund. You can buy directly from the mutual fund sponsor, have your advisor buy them for you, or have your broker buy them for you. Beware that your costs are appreciably different with each option.
How Much is Invested in Mutual Funds?
By the end of May 2022, Canadian mutual funds had $1895B in assets, which includes $27.6B in money market funds and $1867B in long-term funds. Long-term funds include $933B in balanced funds (funds which hold both stocks and bonds), $674B in equity funds and $238B in bond funds. This is after $6400M of net redemption during May 2022. Net redemptions included net sales of $774M in money market funds and $7166M in long-term funds redemption.
Financial assets are valued based on the discounted cash flow they are expected to produce. As a result, the price of any lasting asset depends on the interest rate. The higher the interest rate, the larger discount would be applied to future cash flows, and the lower the asset price. The lower the interest rate, a smaller discount would be applied to future cash flows and the higher the asset price.
Currently, historically high inflation is forcing the Bank of Canada and the Federal Reserve to increase interest rates, which is, in turn, reducing the price of various long-term assets. While bond and stock prices are decreasing, people are withdrawing their money from long-term funds. Since short-term interest rates have risen fast since the beginning of 2022, people are moving more money into money market funds.
Benefits of Mutual Funds
Like many other activities, investment has many facets. Unlike quantum physics or abstract mathematics, there is nothing inherently complex about investment and finance, even though some complex models are used by some parties engaged in the financial world. But the world of finance is related to almost all aspects of human society.
Thus in the world of investment, you deal with many variables and data points, and each of them might be easy to understand. But successful investment decisions might require understanding the ever-changing relationship among different financial, political, and societal variables.
A large amount of detailed consideration needed for each investment decision gives a professional investor who has all their time devoted to investing a significant advantage over a do-it-yourself (DIY) investor who would have a very limited time after their day job to understand and relate all factors which might affect the outcome of their investment.
Thus using the services of a professional investor is very valuable. But if you are not a multi-millionaire, it is challenging to afford the services of professional investors. A mutual fund is a financial innovation allowing investors to pool their money and thus access affordable investment expertise.
The benefits of pooled investment go far beyond accessing professional investment services. Economists extensively study investment returns. Some of these studies concentrate on the risk born by investors, some on the returns earned, and others on the relation between risk and return.
A starting point for the study and analysis of investment risk is generally the division of risk into two components: a specific risk and a general market risk. By combining different assets, you can achieve a portfolio in which specific risks for different constituent assets of your portfolio partly cancel each other out. This is what we all know as diversification. Diversification is the closest you can get to a free lunch.
Benefit of Investing in Mutual Funds
Mutual funds allow you to divide your eggs amongst many different baskets.
Mutual Fund Costs
We invest in the hope of riches. Still, the only guaranteed result of the investment is the fees. After all, “the secret to getting rich in a gold rush is selling picks.” Let us review various expenses we might incur while investing in mutual funds.
Trading Fees
If you ask your broker to buy or sell units of a mutual fund, they might charge you a fee for this service. This fee differs from broker to broker and can be significant if you make a small purchase. This fee can be avoided if you purchase from the mutual fund issuer themself. Some discount brokers like CI Financial offer to sell you mutual funds for free. Though they would charge you a small trading fee when liquidating your mutual fund investment in the future.
Management Expense Ratio (MER)
Selling units of a mutual fund entails considerable marketing expenses; while running the fund, paying for the fund's board of directors (or board of trustees), the fund manager and their support staff would be a significant sum. In addition, satisfying regulatory requirements for a fund would entail considerable expenses, including accounting and bookkeeping expenses.
When the fund buys or sells securities, it has to pay commissions; last but not least, the fund issuer needs to make some profit. For all these items and other costs of a fund not mentioned here, the fund issuer would take a portion of the total assets of the fund on a daily basis. The annualized portion of the assets the issuer takes is reported as the management expense ratio (MER). The fund issuer shine or rain takes this money; in other words, the charge is taken whether the fund makes or loses money.
Load
Load is a common term for sales commission. Not all mutual funds would charge a load; those which demand a load might charge it when you purchase units of the fund or when you dispose of them. Some funds might charge their load during a period of holding the fund.
Active vs. Passive, which way to go?
In an active mutual fund, the fund manager selects the stocks and bonds the fund purchases, while a passive mutual fund outsources this task to its index provider. Generally, funds that follow an index, like S&P 500 Index or S&P TSX Composite Index, boost a much lower MER than actively managed funds
The idea of investing in index funds gets a boost from the efficient market hypothesis (EMH). EMH is a theory in financial economics which claims that the competition amongst many investors for buying undervalued assets and selling overpriced securities results in an efficient market where it is impossible to beat the market.
Considering the results of academic studies, we should note that these studies mainly concentrate on ideal efficient markets. By an ideal efficient market, we mean a market in which no one is trading based on insider information, and any relevant information is disseminated to all market participants simultaneously. This market always has liquidity, and there are such a large number of participants in the market that the action of no single market participant can materially change prices.
It is easy to conclude from the EMH that it's best to save in MER by using low-cost index tracking funds. It is a very bizarre theory since its acceptance by investors can render it wrong! Based on current evidence, we feel that the market for large and publicly listed companies in most western democracies, especially the US and Canada, is most of the time efficient.
Thus we suggest using a low-cost index fund for investing in large-cap North American stocks or investment-grade bonds, while we suggest actively managed funds for investing in less efficient markets.
How to Invest in Mutual Funds?
There are several channels through which you can invest in mutual funds. For example, you can acquire mutual funds via your investment advisor, your broker or the mutual fund issuer themself. When you acquire mutual fund units via your investment advisor or broker, the fund might pay them a recurring compensation called a trailing commission or another form of compensation.
If the fund adds this cost to its MER, it risks losing more prominent and cost-conscious investors. Thus similar to many other businesses, Mutual Funds engage in price differentiation. To execute price differentiation, mutual funds divide their units into different classes and denote them by a letter at the end of the mutual fund name. Each class is distributed through a different channel, and the difference in distribution cost is often reflected in each class’s load.
Mutual Fund Alphabet Soup
Stock classes are often associated with the number of votes associated with each share. In the case of mutual funds, class, often referred to as series, relates to the number and type of fees charged.
Mutual funds have different distribution channels, and each channel has its associated costs. So the same fund often has different series. All series have the same underlying assets with the same proportions but differ in how you acquire them and their costs.
In Canada, for example, many mutual fund issuers include a series I in their funds, where the letter I stands for institutional. These issuers charge a smaller management fee on their I series but require a much more significant minimum investment. But TD mutual funds consider I to stand for “investor series” and offer the I series to its retail investors.
Some issuers like TD use the letter O for their fund’s institutional series, which are no-load funds with relatively high minimum investment. Also, TD uses its e-series to offer its brokerage clients no-fee funds. RBC has invented a series D which it uses to target self-directed investors. A series (advisor series) of funds are often distributed through investment advisors. They usually pay a trailing commission to the advisor or broker who sold them. The trailing commission is often 1% for equity or balanced funds and 0.5% for bond funds. This commission naturally results in a higher management expense ratio.
In series F, the letter F stands for “fee-based.” They are designed for situations where the customer pays a fee to their advisor, and the fund is not needed to compensate the advisor. Advisor fees are typically in the range of 1% to 1.5% annually of the assets in the account advisor is managing. T series include funds with large fixed distributions. Their distribution is so large they often include part of your initial investment.
In the US, the alphabet soup meaning is quite different. A series are often facing a sales commission called a front-end load. Class A shares often face lower marketing and distribution costs and have several breakpoints. By increasing the size of your investment to each breakpoint, you get a discount on your front-end load.
The other common feature of class A is the right of accumulation. Right of accumulation Means that if your subsequent contribution brings your investment over a breakpoint, you would still get the discount on the front-end load. Class A shares are suitable for those investing relatively large sums or those with very long time horizons.
B shares often have a deferred sales charge called a back-end load. These shares are suitable for long-term investors as the sales charge will be paid after you liquidate your investment, and you get to keep the compounding growth for your sales charge. Further, these charges might decrease the longer you hold onto your investment. After some extended period (typically 5 to 8 years), these shares should convert into A shares to enjoy no back-end load and lower management fees.
Class C shares generally have no front-end load and a modest back-end load (typically 1%) if redeemed in a period shorter than a threshold (typically a year). Class C shares often have expense ratios higher than class A but lower than class B.