What are mutual funds and how do you invest in one?
By ATB Financial 19 November 2020 5 min read
It’s a common misconception that mutual funds are complex and confusing. In reality mutual funds are a simple and accessible option for people who may not know a lot about investing or don’t want to spend hours managing their own investments.
But before you jump into investing in a mutual fund, you should understand where your money is going and how it would earn returns. In this article we’ll review what a mutual fund is, how it works, and the benefits of investing in one.
What are mutual funds?
In the simplest sense, a mutual fund holds a collection of securities (like stocks, bonds, and other assets) managed for a group of investors by a financial professional.
Instead of purchasing individual securities on your own, mutual funds allow you to access a wide variety of securities by pooling your money with other investors. When you buy into a mutual fund, you own a portion of each of these investments. You can choose from different mutual funds based on your risk tolerance and ability to weather the ups-and-downs of the market.
A mutual fund's riskiness depends largely on its underlying holdings, including the ratio of stocks (also called equities) to bonds and cash or cash equivalents.
- Bonds are debt instruments offered by governments and corporations. They are considered safer and less volatile than stocks. Bonds offer fixed-rate interest payments over a period of time, and promise investors their initial investment back at the end of the term.
- On the other hand, stocks represent ownership in a company and the price of a stock will fluctuate with the changing value of the company. Stock prices are affected by a variety of factors, including (but not limited to) business profits, economics, politics and even natural disasters. If a fund contains a higher proportion of stocks it is considered riskier or more aggressive, but the chance for reward is also higher.
Regardless of the composition of a particular fund, all mutual funds will carry risk such as market risk, sector risk, interest rate risk and political or geographical risk. These risks are managed by a financial professional, generally called a portfolio manager, on your (and the other investors’) behalf for a fee. The portfolio manager is responsible for ensuring that you receive the best possible return based on your risk appetite. Learn more about the role and value of a portfolio manager.
Who should invest in mutual funds and why?
A mutual fund investment is an excellent opportunity for anyone that is just learning to invest. This is particularly true if you don't have a lot of money available to invest but still want to have diversity in your portfolio.
A mutual fund may also be a good option for someone who is unable, or unwilling, to spend time and effort understanding current market conditions. Unlike an exchange-traded fund (ETF), mutual funds are professionally managed, which means your investments are taken care of for you.
Mutual funds are an excellent option for all ages, and you can purchase a mutual fund investment as young as 18 years old. If you have long-term goals, like buying a home or retirement, a mutual fund investment is a great way to invest without having to be an expert on investing.
How do you earn money from a mutual fund?
Like any investment, the purpose of a mutual fund is to earn money for your future self. Mutual funds grow in a few different ways.
- Dividends— Within a mutual fund, income is earned through dividends on stocks and interest on bonds. The amount that each individual investor within the mutual fund earns is referred to as the distribution. Usually, these distributions are reinvested for you (the cash is used to purchase more of the mutual fund) or they can be paid in cash to your investment account.
- Capital gains— When a fund manager sells securities that have increased in price, it results in a capital gain. This happens within the fund and behind the scenes. These gains are usually passed on to investors in the form of a capital gain distribution, which is different than a dividend distribution.
- Fund share price—If the fund’s shares increase in price and you sell your mutual fund units, you will have made a profit!
How do you invest in a mutual fund?
It used to be that the only way to purchase a mutual fund was to go directly through a financial professional. Nowadays, things are much less complicated, and you can invest in a mutual fund online. You can purchase a mutual fund investment from a brokerage, an investment company or a financial institution.
Are mutual funds safe?
With any investment there are risks. But you can select from different funds based on your risk tolerance, which is a measurement of how comfortable you are with market volatility. If your first instinct is to sell your investments during a dip in the market, you may want to consider a fund that contains less risky investments, such as investment-grade bonds. Learn more about investment risk with this helpful writeup.
When comparing different mutual funds, it's important to review their performance and management fees. Consider using Morningstar to compare mutual fund investment options. Before you compare, be sure the mutual funds you review have similar risk levels.
Will I be charged fees?
Because your fund is being professionally managed, a management expense ratio (MER) and trading expense ratio (TER) fee will usually be deducted before your net asset value and returns are calculated. Check out this breakdown of investing fees for more.
When comparing funds, we recommend looking at the MER and any other fees to see whether it's a reasonable cost. In Canada, management fees typically range from 0.1–2%.
How can I get started?
To start investing in a mutual fund, you must begin with the initial investment minimum specified by the fund company. For example, you can start investing in a Compass Portfolio mutual fund through ATB Prosper with $100 and subsequent contributions can be as low as $25.
No matter where you are in your investing journey, our licensed ATB Prosper financial advisors are always happy to answer your questions and help you to make decisions that will bring you closer to your goals. Get in touch with us by calling 1-855-541-4387 or emailing firstname.lastname@example.org
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