Advantages of Mutual Fund Investing
One in three Canadians own mutual funds, because it's an
easy, convenient way to invest. If you're thinking about
investing in mutual funds, here's why you should consider
taking the next step - and how to make sure you enjoy all
The Advantages of Mutual Funds
Convenient, built-in diversification
When you invest in a mutual fund, you're investing in a
diversified portfolio of investments, such as stocks, bonds
and cash. Instead of building your own portfolio from scratch,
you can join other investors who pool their money to invest
in a professionally-managed portfolio.
Why diversification is important
As most experienced investors understand, diversification
reduces risk by spreading assets among various geographic
regions and industrial sectors. When there's a downturn in
any given region or sector, it could be balanced by strong
performance in other regions or sectors.
Easy access to your money
Mutual funds are a very liquid investment, allowing you
to buy and sell with ease.
Professional investment management
Mutual funds are an easy way to take advantage of professional
investment management at an affordable price. By investing
in a mutual fund, you delegate all aspects of portfolio management
to a professional money manager.
- Selecting the investments that comprise
- Structuring the portfolio's asset mix.
- Monitoring specific investments.
- Adjusting investment mix in response to
ever-changing market conditions
Seven Principles of Mutual Fund Investing
Whether you currently invest in mutual funds or are considering
them, read the advanced investment strategies below, brought
to you by the Canadian Securities Institute.
Each of the seven principles contains essential tips to
help you invest with confidence. You'll discover:
- Why it's more important to evaluate the
fund manager's track record, and not necessarily the fund's
- How to avoid investing in yesterday's "hot" fund.
- When you should sell an underperforming
mutual fund-and when you should hold it..
- How to create a personal investment blueprint
to help you choose funds with investment objectives that
match your own.
Principle #1: Select the Right Mutual Fund Manager
When deciding whether to invest in a particular mutual fund,
your first step is to evaluate the fund's management - the
professionals who select and monitor the investments that
comprise the fund. To evaluate a fund manager, you need to
consider four main areas: experience, style, discipline and
Here are the key points to keep in mind when analyzing a
manager's past experience:
- A manager should have at least five year's experience.
Over this time, most short-term aberrations in performance
resulting from a manager's particular style generally balance
- A manager should have experience managing a fund over
a full market cycle - at least five years. This way, you
can get a better idea of how well the manager does in all
- A manager should have at least five year's experience
managing funds with comparable investment mandates. For
instance, compare growth funds with growth funds.
What if the mutual fund has switched investment mandates
in the last five years?
In this case, check into the manager's previous experience
with a fund that has a mandate similar to the new mandate.
Remember - a manager's prior experience is only relevant
when it relates to a fund with similar objectives.
What if the mutual fund has a new manager?
You should not overlook a mutual fund simply because it
has a new manager. In this situation, you need to investigate
the new manager's previous experience, rather than focusing
on the record of the mutual fund.
Each fund manager has a distinct sense of style when it
comes to investing. Some managers prefer to invest in equities
with upward momentum. Others prefer to buy under-valued equities
at bargain prices. In fact, there are dozens of different
investment styles. When evaluating a fund, it's important
to recognize that these various styles go in and out of favour
with the stock markets, but tend to balance out over a full
A fund manager's "discipline" refers to the ability to stick
to an investment approach consistently through varying market
and economic conditions. An undisciplined manager will sometimes
stray from the fund's stated investment approach in pursuit
of greater short-term gains. However, managers with strong
discipline typically enjoy greater success over the long
How stable is the fund's management? Some turnover in personnel
isn't uncommon, but if there's high turnover, it can be a
warning sign, especially if it occurs abruptly. Whenever
there is a change in a fund's management, remember to evaluate
the new manager's track record.
Principle #2: Invest According to your Objectives
Before choosing a mutual fund, it's essential to understand
your investment needs and goals. This helps you select funds
with objectives that match your own. But to gain this understanding,
you need to create a personal investment policy statement,
which is your "blueprint" for investing in mutual funds.
Here are three steps to creating your personal investment
1. Identify your investment needs and goals: List
the reasons why you're investing. This includes your fundamental
financial needs, as well as your personal goals. Do you need
safety of principal, income or growth (through capital gains)?
Will you need to get access to your money in the short term,
or can you leave it invested for several years?
2. Set your investment time horizons: How
long do you have to achieve your investment objectives? Generally,
you can divide your investment time horizons into three periods:
- Short-term objectives, such as saving for a vacation
or a new car.
- Medium-term objectives, such as saving for a house or
a child's education.
- Long-term objectives, such as saving for retirement.
For your long-term objectives, equity funds are usually
your best choice. Equity funds hold a larger proportion of
stocks, which have more short-term ups and downs than other
types of investments, such as bonds and cash. But over the
long term, stocks have significantly outperformed bonds and
As a rule, the longer you have to achieve your objectives,
the higher the proportion of equity funds you should have
in your portfolio. Conversely, when you have less time to
achieve your objectives, you should commit less of your portfolio
to equity funds and more to bond and cash-equivalent funds,
which have lower risk.
Determine your comfort level for risk: While
your investment time horizons largely determine the best
types of funds for your portfolio, your tolerance for risk
is also an important factor. If you find it difficult to
handle price fluctuations, consider investing a greater percentage
of your portfolio in more conservative funds, such as income
or balanced funds.
Principle #3: Have a Sense of Style
Every mutual fund has its own investment philosophy or "style".
Generally speaking, equity funds are categorized into either
growth or value styles, or a blend of the two. Just like
fashions, these investment styles can be "in" or "out" at
any given time. The chart (below) shows how difficult it
is to accurately predict what styles will provide top performance.
Because of this, a good strategy is to include a blend of
styles in your mutual fund portfolio. This strategy is called "diversification
by style" and, like other diversification strategies, it
can help you reduce risk.
Here are descriptions of the different investment styles
used by fund managers:
Value: Fund managers select companies they
believe are undervalued by equity markets. To identify a
potential bargain, value managers compare a company's stock
price to its earnings, or profits. If the company's price-to-earnings
ratio is lower than other comparable companies, it could
be a good buy, assuming there aren't other factors hurting
its stock price.
Growth: Fund managers focus on companies
offering greater potential for superior earnings growth over
the long term. They look for companies with earnings that
are growing at a faster rate than the general economy or
benchmark equity indexes like the S&P/TSX Composite Index.
Blend: Sometimes, fund managers follow
a blend of both value and growth investing styles, called "growth
at a reasonable price" or GARP.
Momentum: This approach is based on the
belief that stocks that have outperformed in the past are
likely to outperform in the future. With momentum investing,
fund managers look for companies with rising stock prices
and a consistent track record of exceeding analysts' expectations
for earnings growth. The idea is that investors tend to gravitate
towards outperforming stocks, establishing a trend of continued
Sector rotation: This approach is based
on the movement of entire industrial sectors through their
business cycles. With sector rotation investing, fund managers
commit a greater proportion of assets to companies in sectors
on the upswing of their business cycles, while reducing their
commitment to companies in sectors on the downswing.
Theme: The fund manager chooses a specific
theme as the basis for investment decisions. Often, theme-based
managers focus on certain sectors of the economy, such as
technology, health sciences or resources. Sometimes they
focus on large-scale social, economic or political themes.
For example, there are funds that invest in companies poised
to benefit from the aging baby boomer generation. There are
also "ethical funds" that only invest in environmentally
Growth versus Value: (Russell 300 Growth
Index returns minus Russell 300 Value Index returns).Annual
Returns (period ending December 31):
Principle #4: Don't Chase Performance
When evaluating a mutual fund, it's essential that you look
beyond its recent past performance. Otherwise, you can end
up "chasing" performance - and never catching up - because
many mutual funds post unusually impressive results one year,
only to post sub-par results the next. What's more, that
one great year can skew the fund's compound returns - and
make it appear as if it has provided consistently superior
results. But that may not be the case.
Evaluating a fund's consistency
To find out how consistent a fund is over the long term,
your best strategy is to examine a mutual fund's annual performance
in addition to its compounded annual performance. Compounded
annual returns can obscure the true consistency of a fund's
performance. For example, a fund may have a five-year compound
rate of return greater than a comparable fund, but only one
of those five-year returns may have been above average. As
a result, the performance may be skewed with a good one-year
number (see example below).
To evaluate the consistency of a fund's performance and
its ability to perform in a variety of market conditions,
take a look at the fund's year-over-year returns.
Remember, even when you've analyzed past performance in
an intelligent way, it's still just one consideration when
deciding whether to invest in a fund. And as it says in the
advertising, past performance is no guarantee of future results.
There are a variety of other factors that affect a fund's
future performance, such as a change in management or investment
objectives. As discussed in the first three principles, it's
also important to consider how the fund's investment objectives
and style fit into your personal investment blueprint.
Which fund is a more consistent performer?
Five-year compound returns to 2002
Fund A has outperformed Fund B by an average of 3.6% each
year for five years. But before deciding which fund has a
brighter future, consider the simple returns for each calendar
Wind the clock back to 2001, you add Fund B's exceptional
61.0% return in 1997, and the five-year returns compare much
more favourably for Fund B.
Principle #5: Know When to Sell
As a mutual fund investor, you should generally take a long-term
approach. Sometimes, during periods of short-term market
volatility, you may be tempted to sell your funds in favour
of more conservative investments. As explained in Principle
Three, this can result in unnecessary losses, which is why
it's important to create a realistic investment plan and
stick to it over the long term.
While short-term market volatility is rarely a good reason
to sell a fund, there are times when you should consider
- When a fund has a prolonged, inexplicable period of underperformance.
- When the fund's approach or management changes.
- When your personal investment objectives change.
- When it makes sense to take advantage of a new investment
Prolonged underperformance: Before selling
an underperforming fund, find out if other funds are also
experiencing poor performance. Compare funds within the same
peer group - that is, funds sharing a similar objective and
approach. Often, funds within the same peer group underperform
simply because their style is currently out of favor.
If you discover that your fund is lagging behind its peers,
find out why. Perhaps a few disappointing stocks hurt the
fund. Maybe the fund's exposure to a country or sector is
taking longer than expected to pay off.
A change in the fund's approach or management: When
you invest in a mutual fund, you're hiring a manager to administer
a portfolio of financial assets on your behalf. If a fund
manager leaves, it's only fair to reassess the situation.
If there is a competent, proven replacement, you might consider
taking a "wait-and-see" approach. However, if the fund's
management style or approach changes significantly, consider
selling the fund, especially if the new investment style
is already represented in your portfolio.
A change in your personal investment objectives: Selling
a fund might also be necessary to adjust for your changing
investment needs. As your personal situation changes, so
do return objectives, risk tolerance, income needs and time
horizons. You might find a fund that suits your investment
objectives better than an existing fund. Or, if a fund no
longer fits your objectives, you should consider selling
A new investment opportunity: To take advantage
of a new investment opportunity, you may need to sell a fund.
For instance, you may need to redeem part of your mutual
fund investments to buy a home or start a business.
Principle #6: Bigger is not Necessarily Better
When it comes to mutual funds, bigger isn't necessarily
better. But neither is smaller. In fact, both small and large
funds have unique advantages.
The advantages of small funds: Greater
flexibility is one of the key benefits enjoyed by smaller
funds, as they are generally more liquid than larger funds.
If the manager of a small fund wants to sell the fund's stake
in a particular equity, especially a thinly-traded equity,
it's usually less difficult to find buyers than it is for
managers of larger funds. That gives managers of small funds
more flexibility to invest in a broader range of equities.
For example, the manager of a large $1-billion fund trying
to sell a position that comprises 1% - or $10 million - of
the fund's portfolio could have difficulty finding buyers.
Depending on the stock, it could take days, weeks or even
months to find enough buyers. Furthermore, as the manager
sells the stock, the bid price could also decline - and it
could decline sharply if the stock has particularly low trading
As a result, managers of large funds generally don't commit
a large portion of their portfolios to thinly-traded stocks,
even when they would like to. On the other hand, the manager
of a smaller $100-million fund would just have to move $1
million worth of stock, providing more flexibility in selecting
An often-cited benefit of smaller funds is that they offer
superior returns, but studies have shown that this is a not
The advantages of big funds: While smaller
funds have greater flexibility, large funds are often more
efficient and, in turn, administrative costs are relatively
lower. Most large funds also have a reputation for better
research, since larger organizations can often absorb the
costs. What's more, larger size also contributes to the creativity
and innovation of the management team. Both points have a
bearing on the quality of the fund's investment strategy.
In addition, larger funds tend to attract the most promising
Principle #7: Do not Over-Diversify
One of the great advantages of investing in mutual funds
is built-in diversification. With diversification, you can
reduce risk by spreading out your investments among various
asset classes and investment styles. But do you run the risk
of over-diversification by having too many different mutual
Each Canadian fund holds an average of 40 different companies
and many international funds hold an average of 200 companies.
In a portfolio with too many funds, you are likely to have
duplication of companies, as well as representation in the
same region or sector. As well, you may be duplicating investment
styles. Instead of having two different value funds, you
may only need one. This redundancy could mean you are paying
management fees on two funds with similar holdings and investment
Bottom line: invest in as many funds as you need to achieve
your investment objectives. If you find you are over-diversified,
assess your holdings and consider selling less attractive
Open a RBC Direct Investing account now.