What is a mutual fund?

Essentially, a mutual fund is a pool of money gathered from people who want to invest in a basket of stocks and bonds.

The advantage for the average person is straightforward: With $1,000 to invest, you may able to afford one or two shares in Google. But if you put that same $1,000 into a mutual fund, you join a group of investors that owns a basket of investments.

This reduces your risk because you have a more diversified investment. Mutual funds also are easy to cash in if you need money. But, more than anything, if you’re new to investing or simply can’t devote time to selecting stocks, a mutual fund gives you access to professional stock-pickers who can make the investing decisions for you.

Active vs. passive management

Mutual funds are managed in two basic ways: actively and passively. An actively managed fund uses a manager who strives to outperform various market indexes like the S&P/TSX composite by choosing stocks and other investments that generate better returns.

A passively managed fund (an indexed fund), by contrast, uses a computer program to choose stocks in an effort to mirror the performance of a particular index. Think of it as investing on autopilot.

Fees

So, why choose a passively managed fund over an actively managed fund? In short: fees.

There are costs to having a team of managers toil night and day to choose which investments go into a fund – you’ll generally pay a management expense ratio (MER) ranging between 1.5% and 2.5%. Those fees pay the management team’s salaries, along with research and administration; but, they can eat into returns.

Index funds, by contrast, tend to have lower fees: often in the range of 0.35% to 1%, simply because they require less tending.

The upshot: If a particular actively managed fund has a great long-term performance record you think is likely to continue, it can be worth paying additional fees. If you’re simply after some diversification, index mutual funds can provide it at a lower cost.

Think about which fund types are best suited to your time horizon and life stage.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.