Mutual fund
A mutual fund is a type of professionally-managed collective investment arrangement that pools money from many investors to purchase securities.[1] Mutual funds typically cover specific asset classes, such as Canadian bonds, Canadian equities, foreign equities, and so on. Other mutual funds are meant as complete portfolios, for example balanced funds.
By purchasing units of the chosen fund, the investor gains exposure to a basket of securities. Many different investment styles are available, but most funds are actively managed, i.e. they aim to beat their benchmark. A small minority of mutual funds are passively managed, and these are called index funds.
Filters to aid in mutual fund selection can be obtained from Globefund and Morningstar.
At the end of 2011, the mutual fund industry managed $762 billion in assets on behalf of Canadians.[2] Mutual fund assets were $1.58 trillion at the end of September 2019.[3]
Mutual fund investors should be aware of the impact of fees on long-term performance. Canadians primarily incur two kinds of fees and expenses to invest in and own mutual funds: sales charges and ongoing fund fees. Sales charges are transaction-based fees that investors pay directly either when they buy the fund or when they sell or redeem from the fund. Ongoing fund fees, which include the management fees and fund expenses (expressed together as the management expense ratio or MER), are paid from fund assets, which means that investors pay these fees indirectly. Embedded within the management fees of most Canadian mutual funds are ongoing trailing commissions paid to advisors.[2] The MERs of exchange traded funds (ETFs) and index funds is typically much lower than those of actively managed funds.[4]
Definition
While there is no legal definition of mutual fund, the term is most commonly applied only to those collective investment arrangements that are regulated, available to the general public and open-ended in nature.
Investopedia defines a mutual fund as:
- An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.[5]
Hedge funds are not considered a type of mutual fund.
Legal structure and regulatory framework
In Canada, mutual funds are generally structured as either a unit trust (which generally qualifies as a mutual fund trust) or a corporation qualifying as a mutual fund corporation.[6]
The regulatory framework that governs mutual funds falls under the jurisdiction of the provinces of Canada and there is no federal framework. Each province and territory has its own securities regulatory standards. Provinces and territories regulate the distribution and sale of mutual funds and other securities in their jurisdiction through a government agency, usually known as a securities commission.
A fund must be separately registered in each province or territory in which it wishes to market.[7] Although the legislation varies as between provinces, national policies (instruments) have been established which are applied in all provinces. The standards relate to the marketing and administration of mutual funds as well as the permitted investment activities. In addition, the Investment Funds Institute of Canada (IFIC) publishes guidelines and rules to which its members are expected to adhere.
It is important to remember that securities law may differ among jurisdictions.[8]
Types of mutual funds and how to buy them
Open-end funds
Open-end mutual funds must be willing to buy back their shares from their investors at the end of every business day at the net asset value (NAV) computed that day. Most open-end funds also sell shares to the public every business day; these shares are also priced at net asset value. A professional investment manager oversees the portfolio, buying and selling securities as appropriate. The total investment in the fund will vary based on share purchases, share redemptions and fluctuation in market valuation. There is no legal limit on the number of shares that can be issued.[1]
Open ended funds can be purchased or sold by DIY investors through a discount brokerage account, or directly from the fund company. They can also be accessed through investment advisors, in which case investors should watch costs very carefully (see below).
Closed-end funds
Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.[1]
Categorization
Mutual funds are categorized according to their investment objective. Since 1998 this role has been undertaken by the Canadian Investment Funds Standards Committee (CIFSC) with the self-imposed mandate to standardize the classifications of Canadian-domiciled retail mutual funds.[9]
The CIFSC tracks investment funds on a comprehensive security-by-security holdings basis. For purposes of the category assignment, security types will be grouped into five broad asset classes: Cash, Fixed Income, Equity, Commodity, and Other.[10]
In detail, there are dozens of different categories.
Fees structure
Surveys show that consumer/investors are generally not aware of the fees, charges and expenses that they pay with respect to investing in investment funds. Part of the reason why consumer/investors are not aware of the fees, charges and expenses that they pay is because the amount they pay is “deducted at source” and all returns are stated on a net basis.[11]
Mutual fund investors should be aware of the impact of fees on long-term performance, which can be examined with the Investor Education Fund's[note 1] Mutual fund fee calculator. A lower-cost alternative to mutual funds can often be obtained with an exchange-traded fund.
All of the fees and charges should be detailed in the mutual fund's prospectus, which a prudent investor should review before making an investment decision.
In 2011, the Global Fund Investor Experience 2011[12] study gave Canadian funds an overall score of C, but on Fees and Expenses the score was F, the lowest of all countries. The 2019 edition of same report shows that out of 26 countries, Canada has the highest fees for balanced ('allocation') funds, and ranks 24/26 for equity funds.[13]
Sales charges
Mutual funds sales charges typically are one of no-load, front-end load or deferred sales charge (DSC) (also known as back-end load), but there are other classifications, low-load, fee-based and high net worth/institutional.
No-load
A mutual fund that does not charge a fee for buying or selling its units.
Note however that even if the fund company itself is not charging for transactions, some discount brokers might levying commissions on mutual fund transactions.[14]
Front-end load
A sales charge is levied on the purchase of mutual fund units. The charge is generally a fixed percentage of the gross dollars invested. This charge can be as high as 9%, although most fund companies recommend a maximum of 5% or 6%. The amount is negotiable with your mutual fund representative.
Deferred sales charge
A DSC fund is a mutual fund series that has no commission to purchase but is subject to a fund company charge upon redemption. Typically DSC charges start at around 5% to 7% in the first year, and will decline towards 0% over the next 5 to 7 years.
The Canadian Securities Administrators banned deferred sales charges (DSCs), effective June 1, 2022. The ban prohibits investment fund companies from paying upfront sales commissions to dealers.[15]
Investors are generally allowed to redeem up to 10% of their DSC funds annually without charge. Investors should also note that although they don't pay a sales commission, their advisor typically receives a commission of 5% of the amount purchased.
| Sales charge | % of assets |
|---|---|
| No-load | 31 |
| Front-end load | 23 |
| Back-end load | 19 |
| Institutional | 19 |
| Fee-based | 3 |
| Low-load | 5 |
Management fees
A Management Expense Ratio (MER) is the percentage of a mutual fund’s average net assets paid out of the fund each year to cover the day-to-day and fixed costs of managing the fund.
Specifically, the MER represents the combined costs of two main services: investment management services provided to the fund and its investors by the fund company; and financial advice and planning services provided by the investor’s advisor. Management fees comprise approximately 40 percent of the total MER, while the dealer advisor compensation (also known as trailer fees) comprises another 40 percent. The fund company’s administrative costs--including legal and accounting fees, brokerage fees and interest expenses--as well as HST/GST costs comprise the remaining 20 percent of MER fees.
MERs range from less than one per cent per year (usually for certain low risk investments such as some money market funds) to more than three per cent (usually involving equity funds primarily comprising Canadian and international stocks).[16]
| Asset class | Median fee | Average fee (asset-weighted) |
|---|---|---|
| Money market | 1.00 | 0.89 |
| Fixed income | 1.50 | 1.38 |
| Balanced | 1.95 | 1.82 |
| Equity | 2.00 | 1.91 |
Series or classes
The same mutual fund may exist in different versions, called series or classes, with different MERs. These series, designated by letters like A, D, F and I, typically correspond to different minimum investment levels[17] and "different compensation arrangements for the advisors that sell the fund".[18] The money from all the classes of the same fund is pooled and invested together, but the net returns of different classes will be different due to variable fees.[17]
The most common series are:[18][19]
- Retail series (Series A): these have low minimums but the highest MERs, due to commissions being paid back to the advisors who sell them
- Discount series (Series D): these are for DIY investors using discount brokerages; lower MERs than series A
- Fee-based series (Series F): those are "available to investors who have fee-based arrangements with their advisor"[18]. The MERs are much lower than for the A series, but investors pay a separate fee directly to their advisor
- Institutional and high net worth series (Series I): these have low fees but high minimum investments
As an example, the RBC Canadian Equity Fund has the following MERs for different classes: A = 1.87%; D = 1.04%; F = 0.77%; I = 0.25%. This fund also offers three additional classes.
Chasing performance
Investors often select actively managed funds based on past performance. In doing so, they hope that good performance of the selected funds will continue in the future. Unfortunately this is rarely the case over the long term. For example, in one Vanguard study, Canadian equity funds were ranked in terms of excess returns versus their stated benchmarks, over five years to 2008. Then the fate of the funds in the top quintile (the "best" 20%) was examined over the next five years (to 2013). Only 23% remained in the top quintile, whereas 17% fell to the bottom quintile (i.e. the worse 20%). [4]
Impact of dividends on NAV (net asset value)
What happens to the dividends paid to the mutual fund by companies whose shares the mutual fund holds? Those dividends form part of the income of the mutual fund, and increase the fund's net asset value (NAV). They are usually aggregated, the fund is paid its MER, and the remainder is then paid out to holders of the mutual fund in the form of dividends from the mutual fund.
Distributions
Mutual funds distribute their capital gains at year end, typically in December. The exact date varies by fund company and year-over-year. The Income Tax Act (Canada) states that mutual funds must distribute their net income and any net realized capital gains earned within the fund to unitholders in order to prevent the fund itself from incurring a tax liability.[20]
If you buy the fund shortly before the distribution is declared, you’ll be required to pay the taxman, even though you didn’t own the fund while it was earning those gains during the year. Keep in mind, this is only an issue if you’re investing in a taxable account; if you hold your funds inside a Registered Retirement Savings Plan or Tax-Free Savings Account, the question is moot.[21] By deferring your investment decision until after the distribution, you may be missing out on the market movement while not invested.[22]
What happens to the distributions paid out by the mutual fund to its unit holders? The NAV of the fund decreases by the amount of the distribution paid out. Some unit-holders choose to DRIP, i.e. use the distributions to buy more units. The extra number of units just cancels out the drop in NAV, and the unit holder is left as before, except for some accounting.
Size of the industry
There are approximately 117 fund companies and 2946 available funds, with total assets under management of over one trillion dollars as of January 31, 2014.[23]
See also
Notes
- ^ Investor Education Fund develops and promotes unbiased, independent financial information, programs and tools to help consumers make better financial and investing decisions. It was established as a non-profit organization by the Ontario Securities Commission (OSC) and is funded by settlements and fines from OSC enforcement proceedings.
References
- ^ a b c Wikipedia, Mutual fund, viewed July 27, 2012.
- ^ a b c d CANADIAN SECURITIES ADMINISTRATORS DISCUSSION PAPER AND REQUEST FOR COMMENT 81-407 MUTUAL FUND FEES. Viewed December 13, 2012.
- ^ The Investment Funds Institute of Canada, Monthly Statistics - September 2019, viewed October 26, 2019
- ^ a b Philips et al., The case for index-fund investing for Canadian investors, Vanguard Research, July 2014, viewed February 3, 2015
- ^ Investopedia, Mutual Fund Definition, viewed July 27, 2012.
- ^ KPMG Canada Taxation FUNDS AND FUND MANAGEMENT 2010, viewed December 15, 2013.
- ^ KPMG Survey Report, [Fund management survey: Canada – Regulation | KPMG | GLOBAL, dated 6/25/2013, viewed December 15, 2013.
- ^ Investment Funds Institute of Canada, IFIC - Regulation of Mutual Funds, viewed July 27, 2012.
- ^ Canadian Investment Funds Standards Committee, About CIFSC, viewed July 27, 2012.
- ^ Canadian Investment Funds Standards Committee, 2019 Category Definitions_Revisions, viewed October 26, 2019.
- ^ Glorianne Stromberg, Investment Funds in Canada and Consumer Protection: Strategies for the Millennium., viewed July 30, 2012.
- ^ Morningstar, Global Fund Investor Experience 2011, viewed July 27, 2012.
- ^ Morningstar, Global Investor Experience report 2019, viewed October 19, 2019
- ^ Financial Wisdom Forum, Discount brokerages to start charging customers for mutual fund trades, topic started in Macrh 2022.
- ^ "Types of Fees". Canadian Securities Administrators. Retrieved January 24, 2024.
- ^ IFIC, IFIC - Media Backgrounder on Management Expense Ratios, viewed July 30, 2012.
- ^ a b MoneySense, Decoding the mutual fund alphabet soup, August 16, 2012, viewed January 22, 2024.
- ^ a b c Ontario Securities Commission, Mutual fund series, updated September 26, 2023, viewed January 22, 2024.
- ^ Julie Cazzin, FP Answers: How do I unscramble the alphabet soup of mutual fund classes?, Financial Post, July 9, 2021, viewed January 22, 2024.
- ^ Phillips, Hager and North, Understanding the Mysteries of Mutual Fund Taxation, published August 14, 2006. Viewed December 15, 2013.
- ^ The Globe and Mail, Hidden pitfalls of that year-end gift from your mutual fund, viewed July 30, 2012.
- ^ The December dilemma: Should you buy funds before or after the year-end distribution? from National Post by Jamie Golombek, viewed July 30, 2012.
- ^ Canadians build financial security with one trillion dollars in mutual funds | IFIC.ca, viewed February 20, 2014.
External links
- Canadian Securities Administrators Understanding Mutual Funds
- Mutual fund - Bogleheads