If you’re just getting your feet wet into personal finance and don’t have much experience in investing, the term “mutual fund” may confuse you. Mutual funds are not that easy to explain to a beginner, but with time and as you read the financial pages of your newspaper more frequently, you’ll learn that mutual funds are one of the easiest and safest ways to invest your money. People choose them because:

• there are many types
• there is plenty of variety (they cover many industry sectors and many companies within an industry sector)
• they are not as volatile as stocks or commodities
• they can be held on a long term basis
• they are liquid

Mutual Funds Defined

Mutual funds are funds wherein a group of investors put their money into a common fund to achieve specific investment objectives. A mutual fund is managed by a manager. His function is to invest the monies of the investors into certain investment vehicles (like stocks or bonds) by prudently choosing those instruments that he believes have a good return on investment.

So when an individual buys a mutual fund, this means that he or she is buying a share(s) or unit(s) of the fund, making him a shareholder of that mutual fund.

One advantage of buying mutual funds is that they don’t cost as much as buying a stock (blue chip stocks, for example, cost an arm and a leg. Supposing you want to buy one share of Research in Motion, the Canadian company that makes the ever-popular Blackberry. You have to pay about $72.50 for one share at today’s price).

Another good thing about investing in a mutual fund is that if you are interested in becoming a shareholder of Research in Motion – just to take the same example one level up - you don’t have to buy shares from the company directly. What you do is look for a mutual fund that invests in technology companies. You ask the manager for the list of companies that the mutual fund invests in and if Research in Motion is one of them, you then buy into that mutual fund.

A second advantage of investing in mutual funds is you don’t suffer significant losses if the markets are down. Because mutual funds invest in several companies rather than in only one company, the risk is spread out throughout these companies. Hypothetically, if a mutual fund invests in say three technology companies – Microsoft, Research in Motion and Cisco – the fund value would decrease if Microsoft shares plunge, but then this loss would be offset by a jump in Cisco’s share price. This is the element of diversification. Mutual funds are diversified because they buy shares of companies in two or more industry sectors, or in two or more companies in the same sector. This way a mutual fund allows you to spread your money and hence spread your risk.

Types of Mutual Funds

In terms of risk, it is easier to invest in mutual funds for the reasons we discussed above. Choosing a mutual fund that will fit your investment goals can be tricky because there are over 10,000 types of mutual funds.

Despite the huge number of mutual funds, however, they generally fall under these major categories:

money market funds – these are considered safe investments and are ideal for parking your money. These types of mutual funds are invested in short term debt instruments which offer slightly more attractive interest rates than what you get from a term deposit or GIC (guaranteed investment certificate). Also, money market mutual funds allow you to issue cheques and are very liquid (they can be cashed immediately, unlike a term deposit where you’re locked in for a specific period of time). The only downside is that many money market mutual funds are not federally insured. Check with your broker or bank.

bond funds – these come in various forms. They are riskier than money market funds but they’re perfect if you’re looking to have a regular income stream. Bond funds can be government-backed (municipal bonds or government bonds like treasury bills) or backed by corporations (as in corporate funds). If you turn to the mutual funds section of your newspaper, you will notice that the mutual funds are either called “government” or “corporate.” Examples of corporate bonds are those issued by private utility or communications companies (e.g. Bell)

stock funds – these are high risk mutual funds. Recall that we mentioned Research in Motion and Microsoft earlier which are stock funds. The thing to remember is that while they carry a fairly high degree of risk, their returns can be potentially higher than money market or bond funds. When the Dow Jones or the Toronto Stock Exchange are enjoying a good day, notice how high and quickly the price of the stock goes up. During meltdowns or during a bad economic crisis (like the kind that we’re having these days), notice how much these stocks fall in their share price. For example, Research in Motion stock was down over $28.00 yesterday, September 26!

Mutual Funds: check with your local bank

Mutual funds are sold by brokers, investment firms, financial institutions and insurance companies. If you’re a beginner investor, you may want to ask your local bank first about buying mutual funds from them. They usually have their own portfolio of funds and can show you their fund prospectus which should contain the information you need to make a decision.

Many banks have “themed” mutual funds: you can choose from ethical funds, green funds (dedicated to the environment), index funds (e.g. industry sectors such as technology, transportation, health, etc), financial funds (invested in financial institutions), Asian funds, European funds, Latin American funds, Middle East funds, commodity funds (gold, coffee, aluminum) or agricultural funds (invested in farming and food products). We just mentioned a handful – there’s more.

Your local bank’s mutual funds are usually conservative. Being a bank, they don’t want to speculate with their customers’ money so they are not as aggressive as say, the mutual funds established by investment firms.

The type of mutual fund that we think produce high rates of return over the long term is a mutual fund that invests in private companies – what we call equity funds. When your bank sells you an equity-based mutual fund, they can tell you which companies they have bought shares from and the percentage of the shares.

The investment breakdown of an equity mutual fund would look something like this (just an example):

Company A (health care) 25%
Company B (software developer) 23%
Company C (road transportation) 20%
Company D (hotel) 17%
Company E (internet marketing) 15%

Total 100%

It pays to know the details of a mutual fund. Be aware that you don’t have a say as to where the mutual fund should invest in because that’s well…the manager’s job! You can always switch into another mutual fund if you think the rate of return is poor or if the manager is not doing a good job of picking stocks.