Mutual funds continue to increase in popularity, as they benefit both novice and experienced investors.
1) Professional Portfolio Management – Mutual fund managers are professional money managers with the knowledge and ability to continuously monitor individual performance and adjust the fund’s portfolio to benefit investors.
2) Cost Effective Diversification – Mutual funds take advantage of buying and selling volumes, giving investors the opportunity to diversify without having to pay several individual transaction fees. It lets investors make larger scale transactions for significantly less money!
3) Affordability – Mutual funds can be purchased with a lower minimum investment, making them more universally affordable and accessible.
4) Liquidity – Mutual funds let investors get in and out of their investment more easily in a shorter period of time, without a big difference between the sale price and most current market value. They can be easily converted into cash by redeeming them at their net asset value (NAV) – being the per share/unit price of a fund on a specific date or time.
5) Dollar Cost Averaging – Mutual fund purchase plans allow investors to set up pre-authorized contributions from their regular savings account and benefit from dollar cost averaging.
6) Regular Income Stream – Some mutual funds offer an automatic redemption plan that can pay out on a monthly basis.
7) Flexibility – Many mutual funds are organized in ‘families’ that one single organization may manage. In these cases, investors have the flexibility to transfer investments from one fund to another fund within the same family, at little or no charge.
8) Tax Preferred Income – Mutual funds allow investors certain tax advantages. Only 50% of the capital gain from a mutual fund is subject to income tax. Dividends from Canadian corporations also receive preferential tax treatment.
9) Record Keeping – Administration and record keeping of a diversified portfolio can be complex and time consuming. Mutual fund managers and your credit union does the work for you. They send you regular financial reports, tax receipts and statements.
There are different kinds and levels of risk associated with investing in mutual funds. A diversified portfolio with a variety of investment types can help reduce overall risk.
1) Stock Market – Stocks that are held in a mutual fund portfolio make the mutual fund subject to market risk. The risk of changing stock prices can make an investment less valuable at time of sale.
2) Interest Rates – Various risks are associated with an unexpected change in interest rates. Money market funds or funds invested in secure, short-term assets are less vulnerable to interest rate volatility. Bond-based funds perform well when interest rates decline since bond prices and yields move in opposite directions. However, rising rates make mutual funds less attractive due to the increased cost of borrowing.
3) Liquidity – A mutual fund must be able to meet its short-term shareholder redemption needs. Liquidity risk arises when the fund lacks ready cash and is unable to convert its assets to cash without a loss of capital or income.
4) Credit – Credit risk is associated with the chance that a portion of an investment’s principal and interest will not be paid back to investors. Individual bonds with high credit risk do well as their underlying financial strength improves, but weaken when their finances deteriorate.
5) Foreign Investment – Mutual funds that invest in foreign securities may be affected by foreign investment risk. This happens when the investment is made in a country where the exchange laws make the sale of the investment difficult.
6) Foreign Currency – Exchange rate movement or risk is associated with the purchase of funds containing foreign securities. For example, a depressed Canadian dollar can add to the returns of mutual funds holding foreign market investment, while a rising Canadian dollar can negatively impact returns in foreign investments.
7) Derivatives – A derivative is a contract between parties whose value is based on an underlying asset, such as bonds, stocks, etc. There are several types of risk associated with investment in derivatives. They include (a) Market risk, which is the general risk in any investment, (b) Counterparty risk, which is associated with one party defaulting on the contract, (c) Liquidity risk, which is associated with investors wanting to close out a trade before maturity, and (d) Interconnection risk, which is associated with how the interconnection between various instruments might affect the trade of the derivative.