Investing & Planning

If a friend told you over coffee that she had just invested in a new fund, would you know what she was talking about?

A lot of people wouldn’t have a clue. Others might have only a mushy idea of what she was referring to.

I give several seminars a year to members of defined contribution pension plans. They are designed to help attendees make the best investment choices from the smorgasbord of options available.

At the beginning of every session, I ask how many people know what a mutual fund is. It’s a critically important question because mutual funds are the cornerstone of almost all of these pension plans. Invariably, only a few hands go up.

In fact, it’s a simple concept. Suppose all the readers of this column gave me $5 each to invest on their behalf. They authorized me to make the buy/sell decisions and to report results to them periodically. That pooled money, let’s say $500,000, becomes a mutual fund with me as the manager. If I make good decisions, the unitholders (as they are called) will share the profits. If I make bad ones, the fund, and by extension each individual participant, will lose money and I will probably get fired.

That, in very simplified form, is how a fund works. But that’s just the start of the story. There are really five types of funds with different structures, costs, benefits, and shortcomings. It’s important to understand the differences between them so that you can make the right investment choice. Here’s the lowdown.

Mutual funds: These are the most common, by far. They are sold by banks and other financial institutions, brokers, mutual fund dealers, and, in a few cases, directly by the sponsoring companies. New units are created from the company’s Treasury and are usually priced according to the market value of the fund’s portfolio at the close of trading each day (some funds are only valued weekly or monthly). This is known as the net asset value (NAV).

Mutual funds operate under specific investment mandates. For example, the manager may only be able to invest in U.S. stocks, or in high-yield bonds, or in money market instruments. So when you visit your bank and ask about mutual funds, you’ll be presented with a long and confusing list. That’s why many people rely on financial advisers to help them make a decision.

There are low-risk and high-risk funds and you need to clearly understand which kind you are getting before you buy. Some are sold without sales commissions (no-load funds) while others require you to pay a fee either when you buy or sell. Some funds have outstanding long-term records while others are chronic losers.

Segregated funds: These are mutual funds in an insurance wrapper. They come with several bells and whistles such as creditor protection and guarantees that partially or fully protect you against loss of capital. They may be sold as part of an insurance contract, such as a universal life policy, or on a stand-alone basis. They are often more costly to own than regular mutual funds because of the additional features. Segregated funds are sold by life insurance agents.

Exchange-traded funds (ETFs ): These funds have become increasingly popular in recent years because they are relatively cheap to own and, in theory at least, easy to understand. They are traded on stock exchanges so you must buy them though a broker and pay a commission.

The original concept of an ETF is that it should track the performance of a widely-followed index such as the Dow or the S&P/TSX Composite. Whatever the index did, the fund’s returns would reflect those results, less expenses. Thus the funds are described as “passive” — no one makes buy/sell decisions; the only time there is a portfolio change is when the components of the underlying index change. (There are a few mutual funds that use the same approach; they’re known as index funds.)

The growing popularity of ETFs has led to the creation of funds that track obscure indexes (sometimes created specifically for the fund). We have also seen the development of leveraged funds, which generate double or triple an index’s return, and bear ETFs which profit when the benchmark index drops. There are now even some actively managed ETFs, which runs completely counter to the original concept.

Basic ETFs are much cheaper to own than mutual funds but the ongoing annual cost of more specialized funds has been rising in the past couple of years.

There is no limit to the number of ETF units in circulation and new ones may be issued from the fund’s Treasury as needed, under a complicated formula. Most ETFs trade at or near their net asset value.

Closed-end funds: Like ETFs, these also trade on stock exchanges. However, they are “active” funds. As with most mutual funds, a manager decides which securities will be bought or sold and is responsible for the fund’s performance.

These funds are created by subscriptions to an initial public offering (IPO). The money is then invested and the units are listed for trading. In theory, the fund is then “closed” — no more units are issued. In fact, many companies make subsequent share offerings to raise more capital.

Unlike ETFs, closed-end funds tend to trade at a premium or discount (usually the latter) to their net asset value. Sometimes the discounts can be very deep, perhaps more than 25 per cent. An example is Canadian General Investments (TSX: CGI ) which was created in 1930 and is believed to be the oldest fund in Canada. As of May 7, it had a net asset value of $21.78 but was trading at only $16 for a discount of 26.5 per cent.

Hedge funds: Only the super-rich need apply in most cases. These funds typically require a very high entry fee (often $100,000 or more) and are suitable only for “sophisticated investors”. The managers employ a range of complex techniques to make money including leveraging (using borrowed money to invest), short selling (selling a stock in advance in anticipation it will drop in value), arbitrage (simultaneously buying and selling an asset to profit from a difference in the price), and more.

Some hedge funds have proven to be highly risky and a few have required U.S. government bailouts to avoid a collapse that would have rocked financial markets. Most people should avoid them.

As you can see, the fund world is complex and growing more so. Don’t venture into it without careful research or get some sound advice before you buy.

Gordon Pape is editor and publisher of the Internet Wealth Builder newsletter. His website is www.BuildingWealth.ca

Image: DREAMSTIME PHOTO.