What is a Mutual Fund?

One of the primary reasons I got into this business in the first place was that I had identified that there were a lot of people out there who were investing money using mutual funds, though they didn't really understand what a mutual fund is or how it works. This troubled me deeply, as I felt very uncomfortable with the idea of so many people trusting so much money to a system they understood very little about. As I learned more about financial markets and how they worked, I came to understand that a great deal of financial anguish on the part of individual investors was the result of a poor understanding of the behaviour of their investments. As such, I decided that my life's work would be to educate, advise, and assist regular folks in making wise investment decisions.

So, what is a mutual fund?

The simple answer is that a mutual fund is a pool of investors' money, managed by a professional money manager. The manager will usually have a team of people working for them, including analysts, traders, and other professionals. The manager's job is to grow that pool of money by making wise investment choices.

An mutual fund will usually have a specific mandate, which means that they will choose their investments based upon the "mission" of the fund. First and foremost, the fund will either be an "equity" fund or a "fixed income" fund. An equity fund will buy stocks of publicly traded companies. A fixed income fund will usually purchase bonds and other types of debt securities. Generally speaking, equity funds are considered to be "riskier" or more volatile than fixed income funds.

Equity mutual funds will usually have a geographic mandate, which means that they'll only invest in a certain geographical region such as Canada, Europe, US, Asia, etc. Sometimes they will have a sector mandate, meaning that they'll concentrate on a certain economic sector such as materials, retail, infrastructure, financial companies, etc. They may also choose to invest in companies based upon their size.

Usually, an equity mutual fund will also have a certain investment philosophy as well. They will seek out companies based upon a value approach, or a growth approach. The value approach seeks to identify companies that are trading at a price less than a professionally calculated "intrinsic" value, usually based upon their financial performance and the value of their assets. The growth approach seeks to identify companies which have the potential to grow at a rate superior to their peers, based upon a particular competitive edge in their market.

What does all this mean to you? Well, the fact that mutual funds have these investment mandates means that you're able to build a diversified portfolio of investments. You're able to own different funds that represent different sectors of the economy, and that represent different geographies. This is important, because these different sectors and regions experience different economic conditions and circumstances. By spreading your money around a bit, you reduce the risk that the value of your portfolio will experience wild swings up and down. Of course, its the wild down swings that we're trying to avoid.

Something else to note: it costs you money to own a mutual fund. The cost of owning the fund will be reflected in the Management Expense Ratio (MER), which is expressed as an annual percentage of the fund's total assets. This amount may be anywhere between 1 and 5% per year, or more sometimes. These days, average MERs tend to run in the neighbourhood of 2 - 3%. The thing to remember about the MER is that the fund's performance is reported to you NET of the MER, which means that if the fund reports that it returned 8% last year and had an MER of 2%, it actually returned 10% but kept back 2% for expenses, thereby passing along a net gain of 8% to the investors.

Mutual funds are an affordable and reliable way for the passive, every day investor to participate in equity and fixed income investing. Because direct investing in stocks and bonds is expensive and requires a great deal of very specific knowledge, mutual funds can provide opportunities to grow your pool of money, helping you to plan for prosperous future.