A mutual fund is a great way to create wealth in the long run. You can reach life’s important milestones, such as creating wealth for retirement purposes or your child’s education or funding their higher studies in foreign universities.
Mutual funds started 230 years ago in Holland to diversify risk by investing in bonds in foreign economies. In the United States, the idea of pooling money together for investments in common stocks aimed to earn profit.
With this fair idea, we will do a thorough analysis of mutual funds and their types. A mutual fund is a bouquet of investments put together in a fund that invests in various money market instruments and asset classes, like shares, bonds, securities, etc.
In mutual fund investment, a large group of people invests money to buy units. These units of investments create a vast pool of money. They put this pool of money into an investment fund that is invested and managed by professional managers on behalf of the people who hold the units.
An investment fund, therefore, is a collection of investments in various money market instruments.
From the investment cap point of view, mutual funds are of two types, closed-ended and open-ended.
Closed-ended mutual funds are those in which you get a fixed number of units after investing. You can redeem those units at the end of the investment term in mutual fund schemes.
Large companies offer closed mutual fund investments through the initial subscription of a new fund offer (IPO- Initial Public Offer). When all the units of IPO are sold, companies stop further subscription or purchase of units.
Open-ended mutual funds are those where, as people keep investing, more units are added. The fund thus issues more units or shares to the investors.
The mutual funds we are going to talk about here are open-ended mutual funds.
Depending on the market you want to invest in, the mutual fund types include:
- Money Market – Short-term investments with low yield. For example, Treasury bills are fixed-income securities.
- Bond/fixed income – The safer investments like government and corporate bonds.
- Growth & income/asset allocation/equity – Equities like stocks shares of Canadian companies.
- Balanced – Proportionate distribution of investment among equities and fixed-income securities.
- Global/international equity – Investing in Foreign equities and fixed-income securities.
- Sector Funds – Investment in the shares and stocks of a specific sector like health care, automotive, technology, etc.
- Specialty funds – Investing in equities and fixed-income securities in a specific region or sector.
- Index – Investing in equities or fixed-income securities to follow an underlying index.
- Funds of funds – Other mutual funds.
The above order reflects the risk associated with each type of mutual fund investment, with the money market being at the lowest risk and specialty funds, index, and funds of funds standing at the highest risk quadrant.
A mutual fund comprises 3 main asset classes: money market, fixed income, and equity. If you revisit the earlier classification of mutual funds above, you can see these 3 predominant asset classes, money market, fixed income/bond, and the rest of the instruments falling under equity/share market investments.
Balanced funds are a custom blend of two or more asset classes. You can regulate the risk in this mutual fund investment category.
Each category of mutual fund has components, including investment policy objectives, risks, and rewards. If you want to create wealth in the long term (provided it is your aim), your fund manager will invest your money in common shares of Canadian companies.
But if you aim to earn income in the short term, you need to invest your money in bonds with fixed income/yield and mortgages.
We have established the foundation to understand mutual funds for you. Let us delve more into each type of mutual fund to understand some key concepts of mutual fund investment. This will make you knowledgeable enough to make informed investment decisions.
You might also be interested in buying a mutual fund based on your needs.
Money Market funds
This has the least risk on your investments. This combines investment avenues like short-term debt funds, focusing primarily on the Canadian or the USA markets. Since it provides an elevated level of safety for your money, it offers minimal return potential.
Fixed Income Funds
The primary purpose of this fund is to generate income. This fund offers the stability of income rather than the growth of your investment. This is a more conservative and safer form of investment than our next asset class, i.e., equity funds. But the quality of credit varies within the instruments of this fund and risk profile may also vary significantly.
For example, investment in a high-yield bond is riskier compared to a government bond that invests in government debt. We segregate fixed income funds based on the duration of maturity.
- Less than 3 years is a short term.
- 3-10 years is medium term.
- Over 10 years is a long term.
These are high-risk, high-return funds invested primarily in Canadian companies’ stocks and shares. Some funds that include Canadian-focused small/mid-cap equity funds focus on the size of the company.
Others may focus on a specific country or sector, like Japanese equity or health care equity. These funds focus on long-term wealth creation via growth and capital appreciation. Funds like Canadian Dividend and Income Equity focuses on dividend income generation.
Some equity investment follows and replicates the performance of an underlying index. These are Index funds.
This fund offers a mix of safety, income, and capital appreciation in a pre-defined blend. The investment is done in a combination of securities to achieve a perfect concoction. The balance funds will hold your investment as fixed-income securities and a variety of common stocks at a proportion. They will provide you income with stability and diversification, growth, and capital appreciation along with dividend income.
Canadian Fixed income, Global neutral, Global Equity are examples of balanced funds in the Canadian market.
Other Fund Types
Sector D - It comprises mutual funds selection covering a wide range of different asset classes from various fund companies. This fund is available in Series D for RBC Direct Investing clients. These funds have significantly lesser fees and offer you a higher return, eventually.
Funds of funds – It is a balanced fund, also called a portfolio fund. These mutual funds invest in a wide range of other mutual funds. Thus, offers diversification by asset class, location/region, and sector. Select Choices Funds come under these fund classes offered by RBC (Royal Bank of Canada).
Managed pay-out funds - If you want an income from your investment, you might go for a managed payout fund. These funds offer regular cash flow back. The cash flow includes capital gains, dividends, and interest.
Target date funds – A type of balanced fund that adjusts its target asset allocation over time as it reaches the maturity date. ‘RBC Target Education Funds’ to fund their child’s post-secondary education is an example.
Specialty funds – These funds do not fall under a traditional mutual fund category of investment. They rely on the strategies of alternative investment and venture capital.