Welcome to our beginner investor education program. This is the second of a six-part series. You can read the first part .
For investors who are just getting their feet wet, mutual funds have several advantages.
They're easy to buy and sell. They offer instant diversification. And they provide the peace of mind that comes with having a professional at the wheel, so you can get on with your life while someone else sweats over what stocks to invest in.
The wide selection of funds is another plus. You can choose funds that focus on Canada, others that invest only in precious metals or energy stocks, and still others that focus on fast-growing BRIC economies of Brazil, Russia, India and China. If there is an investment theme out there, chances are there is a mutual fund to go with it - or soon will be.
For investors who want an all-in-one solution, balanced funds - which invest in a mix of stocks and bonds - are a popular choice. But beware of the high fees, as the Globe's Rob Carrick points out in this column.
One of the biggest attractions of mutual funds is that there are (usually) no charges for buying additional units in the fund. So investors who make regular contributions can add to their positions without racking up hefty trading costs. What's more, most mutual funds allow investors to automatically reinvest their distributions in more units, which turns the mutual fund into a dividend reinvestment plan. This is a huge plus, allowing investors to benefit from the magic of compounding.
Learn more about investing from John Heinzl The 2010 Investor Education series for beginner investors:
The 2010 Investor Education series for advanced investors:
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For all their benefits, mutual funds have some drawbacks, however. One of the biggest complaints from investors is that mutual fund fees are too high in Canada. Expenses for fund management, marketing, administration and other day-to-day costs are included in the management expense ratio (MER), which measures these costs as a percentage of the fund's net assets. You can find the MER in the fund's prospectus or on websites such as Globefund or Morningstar.
In Canada, MERs of 2.5 per cent or more are not uncommon. Expenses are even higher when you add in trading costs, which aren't included in the MER. Then there are front- and back-end loads, which are sales commissions paid to the adviser who sells the fund. All of these costs come out of the investor's pocket, and they can exert a considerable drag on returns.
For a discussion of how expenses affect fund performance over the long term, read my recent column on fund fees.
Then, to see the impact of fund fees for yourself, try this mutual fund fee impact calculator.
For all of the above reasons, if you're planning to buy mutual funds it's important to keep your costs down. The good news is that it's possible to find high-quality funds that don't charge an arm and a leg.
The TD Monthly Income Fund, for instance, has an MER of 1.4 per cent and provides diversified exposure to Canadian common stocks, government bonds and corporate bonds. Through Aug. 31, it posted a 10-year average annual return of 8.4 per cent, which is nearly double the average for balanced funds as a group.
Another example of a low-MER fund that's provided exceptional returns is the Mawer Canadian Equity Fund. This fund, which has a puny MER of 1.2 per cent and invests in mid- to large-capitalization Canadian stocks, has generated a 10-year average return of 8.7 per cent, beating the 6.7-per-cent return of the S&P/TSX total return index.
Another way to keep your costs down is with index mutual funds. Index funds are so-named because they track broad indexes of stocks such as the S&P/TSX composite index and S&P 500 index. Because there's no manager actively trying to pick stocks and beat the market, the expenses are lower than actively-managed mutual funds.
In Canada, the cheapest index mutual funds are TD's e-Series units, which the Globe and Mail's Rob Carrick called "one of the seven best investing deals around."
If you want to cut your costs even further, you can consider exchange-traded funds. ETFs are the topic of the next article in this series.