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The Types of Mutual Funds, Why They’re Good, and Quick Buying Tips

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Most people think a mutual fund is just a tool to buy shares in the stock market in a lot of different companies. But mutual funds offer much more than just equity group buys. Mutual funds also invest in ways you may never have considered. For some types of investing, mutual funds are very useful indeed. But which funds are worth a very close look?

What Exactly is a Mutual Fund?

A mutual fund takes a pool of money and (usually) invests it in more than one business or financial holding or instrument. Investors can buy units in the mutual fund. Owning a unit gives the investor a fractional share of all of the investments that the mutual fund has purchased.

What Types of Mutual Funds are Offered for Sale?

Balanced Funds Bond funds Dividend Income Funds
Global Funds Gold and Silver Mutual Funds High Interest Savings Account funds
Income Funds Index Funds Money market funds
Preferred Shares Funds Stock funds T-Bill Funds
Wrap Funds

What Do These Mutual Funds Invest In and What Assets Do They Hold?

Bond Funds

In this type of fund, the fund manager invests in a selection of bonds. The bonds may be all government-issued bonds, corporate bonds, municipal bonds or a mixture. Bonds usually have a term at the end of which they mature or come due for payment. So bond funds can select bonds that are almost mature or that have terms of 1-50 years before they will reach maturity.

Bonds are bought and sold just like common shares. If you have a discount brokerage account, you can sign on and look for a bond for sale and buy it. The price, however, includes the commission charged by the seller. That makes it difficult to know if you are paying a good price for your bond. A bond fund can help you avoid this problem.

A bond fund buys many, many bonds and can negotiate for a lower commission on purchase. Bonds are often expensive, too, so by buying units in a bond fund you can buy a larger variety of bonds than if you were purchasing them individually. Bond funds will usually also have access to more bonds to purchase than an individual investor will. Your brokerage is unlikely to offer all of the bonds currently for sale. A bond fund, however, likely has access to almost all bonds currently on offer. (Can you tell I like bond funds better than buying individual bonds?)

PH&N is well known for its bond funds. The PH&N Total Return Bond Fund  invests in corporate and government bonds from Canadian, American and other foreign issuers. The average term to maturity for the bonds held in the fund is 7-12 years. It can hold up to 25% of the fund in cash. It has clearly defined rules for how much risk it will take when selecting bonds. (Bonds are rated with A and B ratings by independent rating companies.) This is an actively managed fund. Right now, all bonds are at risk if interest rates begin to climb significantly and quickly. (I wish!) If you look at the Current Holdings for this fund, you will actually be able to see them trying to mitigate this risk through careful selection of terms and yields.

Money Market Funds

These funds are often considered a “parking lot” for money waiting on an investment decision. They don’t offer much income but they are not at high risk of losing money. (They do lose money sometimes though.)

Money market funds invest in short term holdings. These can include federal and provincial government debt securities, bank issued deposit notes and other commercial paper.

The CIBC Money Market Fund https://www.cibc.com/ca/mutual-funds/no-load-savings/money-market-fund.html has typically earned less than a 1% annual return for the last 5 years.

High Interest Savings Account Funds

These funds mimic a high interest savings account. For example, you usually buy the fund in $1 or $10 increments. If you buy $1000 of a $1 fund, you get 1000 units. Interest payments are made monthly on the daily balance of the fund.

These funds were created for two reasons:

1. People did not like losing money in a money market fund and wanted a perfectly safe, interest-paying place to park cash.  HISAs are often CDIC insured just like bank accounts.

2. Financial institutions offering high interest savings accounts discovered this is another way to capture cash deposits.

There is another benefit for the issuer: If a person sells their entire holding before the monthly dividend, the issuer gets to keep the interest. This is the same as if you close a bank account before your interest is paid in. The difference is that many customers forfeit the interest on these funds because they want to re-invest elsewhere in a hurry. [UPDATE 2014: I’ve since discovered that in practice many institutions pay the interest earned to date if you sell all of your holdings mid-month. This is much better than I expected and I applaud them for it.]

Be aware that the “monthly” payment is not necessarily made on the last day or first day of the month. For example, DYN 500 has made payments to me on the 25 and when the 25 was a stat, on the 28 of the month. ATL5000 paid on the 4 th.

CIBC Investor’s Edge customers can buy units in ATL5000 the Renaissance high interest savings account fund. (For details, please see ATL5000 High Interest Savings Account Fund at CIBC Investor’s Edge Online Discount Brokerage.) BMO InvestorLine customers can buy units of AAT770. RBC Direct Investing customers can buy units of RBF2010.

T-Bill Funds

As the name suggests these funds usually invest in federal government issued Treasury Bills. Now, while interest rates are incredibly low, T-Bill funds are out of favour. However, in the past they have been an extremely safe place to park cash for a short term with a small return on investment. T-Bill funds can lose money.

The RBC Canadian T-Bill Fund http://fundinfo.rbcgam.com/mutual-funds/rbc-funds/fund-pages/rbf262.fs returned an annual average return of less than 1% for the past 5 years.

Preferred Shares Funds

Some companies offer two types of shares for sale: common shares and preferred shares. There are bond funds that invest only in preferred shares. The fund manager may pick preferred shares depending on the dividends, the term to maturity (if applicable), the price versus the call back price and other factors. They may select preferred shares only in certain industries, such as banks or insurance companies, or they may select preferred shares from a wide variety of business types.

The Manulife Preferred Income Fund http://pricesandperformance.manulifemutualfunds.ca/manulife/profiles/en/72129/fund/html/ is invested 95 96% in Canada and holds preferred shares in companies such as Talisman Energy, Bell Aliant, Enbridge Cooperators, Power Financial and the Bank of Nova Scotia. It targets an annual return of 5% to investors. (Note: the return is not guaranteed, and the value of the units in the fund can rise or fall.)

Gold and Silver Mutual Funds

These funds can invest in either metal gold and silver or in companies that mine, produce and distribute gold and silver. It may be very difficult for you to own gold or silver metal. You may find a precious metals fund gives you the benefits you want without the risks and storage costs of personally owning metal.

The BMG Bullion Fund http://www.bmgbullion.com/reg_1/fid_1cad/tab_1/BMG_Fund_-_Class_A  says it provides investors with a convenient way to hold gold, silver and platinum in bullion form. It purchases the actual metals and holds them. The bullion is then held in insured storage. As you might expect, the fee for holding this fund is fairly high due to the actual storage costs among other fees.

It’s important to know there are no dividends paid by funds investing directly in physical metals. If you are looking for dividends, you will need to look for a precious metals fund that invests in companies that mine, produce or trade in precious metals.

Stock Funds

The most widely known type of mutual fund holds shares in dozens, hundreds or thousands of companies. The holdings are managed by a fund manager. This manager decides when to buy more shares in a specific company, when to sell holdings in another company and how much money to keep in cash reserves in the fund. This type of manager is actively controlling the fund’s investments.

An example might be the Dynamic Power American Growth Fund http://funds.dynamic.ca/fundprofile.aspx?f=PW2K&lang=EN . [UPDATE: All of the following facts date from January 2013. The fund has changed again since then.] It is invested 89% in common shares of US stocks, 3% in foreign stocks, 4% in Canadian stocks and 4% in cash. The stocks it holds are 47% information technology stocks, 34% consumer discretionary stocks and 15% health care stocks. (The missing 4% is the cash.) Examples of its holdings include Google, Whole Foods Market, Regeneron Pharmaceuticals and Amazon.com. A single unit of this fund costs $8.41. A single share of Amazon.com costs $265.56. By buying units of this fund you can invest in many companies even if you don’t have hundreds of thousands of dollars.

Index Funds

Another type of fund buys the same assets in the same proportion as listed on a specific index. For instance the S&P/TSX 60 Composite (http://www.standardandpoors.com/indices/sp-tsx-60/en/us/?indexId=spcadntx–caduf–p-ca-l– ) is a list of 60 large capitalization companies traded on the Toronto Stock Exchange. An index fund that stated it was directly matching the TSX Composite 60 should hold shares in each of those 60 companies.

Be aware that in recent years a large number of new “indexes” have been created. Some of these are no different than if you sat down and wrote a list of company names. For example I could make the Crooks’ Household Index and say it included Metro, Canadian Tire and Shoppers Drug Mart. But, you exclaim, what about the dozens of other stocks that would fall into that type of category? Why aren’t they listed? Simply because I didn’t pick them!

If you buy an index fund, check which index it represents. Then go and research what is included in that index and why. Make sure the index makes sense.

The CIBC Canadian Index Fund https://www.cibc.com/ca/mutual-funds/no-load-growth/can-index-fund.html for example, says it “is managed to obtain a return that approximates the performance of the S&P/TSX Composite Index. If you read that closely, you will realize it is not a true index fund. A true index fund is not actively managed; it just holds the same stocks as the index it represents.

Balanced Funds

These funds invest in a blend of financial choices. They may have money invested in short term commercial paper (money markets), bonds, preferred shares, common shares, gold, precious metals and other options.

The purpose of a balanced fund is usually to provide the customer with a single purchase that provides exposure to a variety of investments. Often the balanced fund seeks to ensure a steady profitable return by actively managing where the money is invested. Bonds, for example, help protect a fund from a drop in the value of common shares.

Shares, in turn, help protect a fund from a drop in bond values if interest rates rise. These balanced funds are often suitable for long-term investing in RRSPs and TFSAs.

The Fidelity Canadian Balanced Fund http://www.fidelity.ca/cs/Satellite/en/public/products/mutual_funds/asset_allocation/cdn_asset_allocation/bl  is an example. It holds shares in 71 81 equities and 967 927 bonds. About 41 43 % of the fund is in Canadian equities, 34 37 % in Canadian bonds, 11 7 % in Foreign equities, 11 10 % in Foreign bonds and 3% in cash.

Wrap Funds

Be a bit cautious about the differences between a balanced fund and a wrap fund. A typical wrap fund is a fund that buys units in other mutual funds. So while a balanced fund might buy 3 issues of bonds, and 7 common stocks, a wrap fund might buy units in a bond fund and units in an equity fund.

The problem is that a wrap fund may charge another MER (fee) on top of the fees already charged by the funds it is buying into. In the above example, the wrap fund might have a MER of 1% and the bond fund it owns might have a MER of 1.25% and the equity fund it owns might have a MER of 3.5%. That’s a lot of fees.

The balanced fund will typically have only one fee as it is investing directly in the bonds and stocks it holds.

If you are not sure if the product you are being offered is a wrap fund, ask! Ask for a clear written explanation of the fees and MERs before you agree to purchase anything.

In general, wrap funds are less profitable for the investor (you) than for the seller (the bank or finance company.) Be wary.

That said, some balanced funds are also actually investing in funds not directly in assets. They may or may not have high fees and MERs. You have to check the details carefully.

Income Funds

Income funds can be any of these other types of funds. There is no “one” type of investment in an income fund. You could have a fund that holds 100% common shares; 100% preferred shares; or 100% bonds and it could be named an income fund.

Don’t try to compare income funds without closely examining what’s held inside them. You can’t compare the past annual return of an “income” fund that holds 75% stocks with an “income” fund that holds 95% bonds. The returns will be significantly different because the asset classes and the risks are significantly different.

Global Funds

Similarly, Global Funds can hold equities, bonds or even just foreign cash. The name is meaningless. You will have to look at the holdings to decide what type of fund it really is. Even the name “global” can sometimes be misleading. Some “global” funds hold 25-50% Canadian equities!

Dividend Income Funds

Again, these are funds that could hold a variety of assets. The name implies they are invested in equities that pay good dividends. Check though! Some funds have misleading names.

Why Buy Mutual Funds? Quick Tips to Consider and 4 Types Worth Buying

Mutual funds can help with specialized investing goals. It’s worth considering buying the following types of funds:

Bond funds

(Also consider Bond ETFs)
Bond funds have access to more bonds than individual investors. Bond funds pay lower purchase commissions, too. Buying a bond fund gives you greater bond diversity than buying a single issue or two. An actively managed bond fund can also reduce risk due to rising interest rates. Look closely at the PH&N bond funds.

HISA funds

Most brokerage accounts are not paying any interest on cash holdings. If you can, you may want to park your cash in a high interest savings account fund while you wait to re-invest. InvestorLine, unfortunately, requires a minimum holding of $25,000. [UPDATE: As of April 11, 2013 the minimum for the BMO HISA AAT770 is $5,000.] Investor’s Edge has a minimum of only $1,000. Check out DYN500 and ATL5000 among other funds. Look for early redemption fees and minimum holdings as these can change periodically.

Precious Metals funds

(Also consider Precious Metals ETFs)
Gold bugs may want to invest in a fund that stores physical bullion safely. The BMG Bullion fund might be worth a look.

Preferred Shares funds

(Also consider Preferred Shares ETFs)
Investors looking for reliable income without much if any chance of a capital gain but with a pretty high degree of safety for an equity investment may wish to hold a preferred share fund. Look for income funds that invest in preferred shares such as the Manulife Preferred Income Fund.

Major Index funds

For investors who cannot, for one reason or another, buy ETFs an index fund with a low MER (fee) that mirrors a major stock index such as the S&P/TSX Composite or the American S&P 500 might be worth considering. Check whether the fund actually buys the index. A true index fund is not actively managed and moves up and down daily with the market it mirrors.

Whole websites have been written on the benefits of Couch Potato investing. You may want to read through one.

Disclaimer

I’m not a financial advisor and have no training in providing investment advice. In fact, I’ve been known to make some spectacularly bad investing decisions. Please use your own native wit and seek professional advice where appropriate.

Related Reading

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Are there other types of mutual funds I’ve missed? If you have invested in a different type of mutual fund to serve some investing goal, please share your experiences with a comment.

When Commissions Clash With Customer Service at Banks and Financial Institutions

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Overheard at the Bank Branch: “I Don’t Handle GICs.”

Yesterday, while waiting at the bank branch I overheard a conversation between two staff. Frankly the one Advisor was so loud the entire branch had to hear him whether they wanted to or not. Anyway, what caught my ear was he was basically refusing to see a client as requested by the Receptionist because “I don’t handle GICs. I don’t believe in them. I can’t get behind them.”

After feeling a bit sorry for the Receptionist, who wasn’t asking his religion but was just asking if he was available to meet with a customer, I wondered why he was pontificating so loudly. A peek as I passed his door later confirmed he had an audience. A new hire was being trained. So likely he was bragging and trying to score himself some points.

He lost big points with me. Which is too bad for him because we actually have quite a lot of money to invest and could have involved him if we’d wanted to. He may have also lost a few other customers who heard him dissing a Receptionist to make himself sound more important.

Why Would a Bank Advisor Not Want to Handle GICs?

The answer to those of us who are cynical is painfully obvious. There is no direct financial benefit to an Advisor for selling a GIC to a bank customer. The bank makes money on GICs. And some financial institutions and brokers make money on selling GICs offered by other financial institutions because there is a referral commission. However, for an Advisor at a bank branch there is (usually) no direct personal compensation for selling a GIC from that bank.

What Does the Bank Advisor Want to Sell to Customers?

There is, however, a big personal incentive for selling a mutual fund. Bank advisors earn personal commissions for selling mutual funds. The commission is part of the “trailer fee” paid by the mutual fund each year. Many bank advisors earn part of the trailing commission on a mutual fund for as long as the customer owns the fund. They even make the commission if the fund loses money, which is more than the customer does.

Lack of Fiduciary Interest and Bad Customer Service Combined

The problem with this difference in compensation is that the Advisor now is in a position where he or she makes more personal income if he or she recommends one product instead of another. This means that they may be tempted to recommend a product not because it is the best fit for the customer but because it is the most lucrative for them.

This is a horrible situation. It gets worse when the customer genuinely needs financial advice.

Case Scenarios for Guaranteed Income Certificates (GICs)

Saving for a Short Term Goal with No Income and No Way to Regain a Loss

Imagine an elderly person comes into the bank wishing to invest $5000 for one year. She just inherited the money from her sister. They need all of it next year (14 months from now) to pay for an electric scooter and a ramp into their home that they have been saving diligently to buy. Her husband is getting his hip replaced in three years but the doctors have warned them he will be wheelchair bound soon and for months after the surgery.

This person wants her money to be completely safe. She needs it. She just wants to earn a few dollars more than if she left it in her chequing account which pays no interest at all. She has banked here for forty years and has no personal computer, nor the interest or aptitude to get one.

What do you think she should invest her $5000 in?

There really aren’t many options that suit her needs. The obvious one is a GIC. It won’t make much interest, but even 1.7% is better than nothing. (If you don’t think $85 is important, you are not old, infirm and living on a very small income. Many people are.)

With the high probability of interest rate hikes, a bond fund could lose money in the short term. A money market fund probably pays less right now than a GIC and it carries a (small) risk of loss.

What do you think this Advisor is going to recommend she invest the money in?

Saving for Education Which Starts Next Year

Here’s another possible scenario. A person walks in with $5000 to contribute to their only child’s RESP. The child is starting his last year of high school in the fall and plans to start university in just over one year. Although the parents contributed $100 a year to the RESP each year till now, they have never had a chance to save more. They just got a bonus from work and decided to put it in the RESP to get the 20% matching CESG ($1000!) for their child.

Should this person’s money be invested in equities? Probably not. This family is looking for the 20% grant, not for a potentially huge capital gain. And a mutual fund with a high MER isn’t a great choice for them either.

A GIC may be boring and very low paying but it’s easily understood, easily managed, and safe. A bank advisor should be at least presenting it as a sound choice to the client.

Further Reading

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What do you think of a bank Advisor that won’t talk about GICs when clients ask for investment advice? Do you think the compensation structure for Advisors needs to be changed so they receive the same amount no matter which product the client purchases? Please share your opinions with a comment.