Investing for Young People Part 3: Differentiating Mutual Funds

Mutual fundMagnifying glass

Perhaps jumping into the stock market has turned out to be more of a chore than you and your child anticipated. If savings bonds and GICs are not offering the rates of return you and your child would like to see their savings yielding, mutual funds are a promising alternative.

At current Canadians have well over 1,200 different mutual funds to select from. How do you know which is right for you? Here is some general information on the various types of mutual funds available in Canada.

Money market and treasury bill funds: These funds are well suited to the conservative investor seeking a safe return that beats those offered by high interest savings accounts or locked in guaranteed return investments by two to three per cent. Money-market funds invest in short-term debt securities such as T-bills – meaning the investment is going toward short-term loans for various governmental bodies. With that kind of clout behind them, money-market funds can be fairly well relied on to generate a modest return. They are a good place to invest when other funds or products appear volatile, or when wishing to keep a safety sum liquid. Unlike other funds, money market funds keep the unit price fixed, meaning only the fund’s return fluctuates.

Fixed income funds: These funds also invest in T-bills, as well as debentures, bonds and mortgages. The aim of fixed income funds is to provide solid, high income payments with the potential for some capital gains. These funds are preferred over money market funds for longer term investing.

Equity funds: These funds are recommended for long term growth, as they generate capital gains from their investment in the common and preferred shares of Canadian companies. Ordinarily, this is where you put your money if you are planning to leave it for at least five years.

Balanced funds: These funds offer the investor a mixed bag investment in common stock, preferred shares, cash and bonds.

Special equity funds: These are funds that specialize, or focus, in specific markets, such as natural resources, precious metals or real estate. Because of their narrow scope in one sector, their value will spike and fall on the basis of that sector’s performance. Most investors will only allocate a controlled portion of their investment dollars toward this type of fund, and watch those dollars carefully.

Dividend funds: These funds invest in the dividend-paying preferred shares of Canadian or U.S. corporations as well as the common shares projected to generate a solid level of dividend income. Dividend returns are usually taxed at a lower rate than other returns, one bonus to this type of fund. Like equity funds, dividend funds offer the potential for long-term capital growth and thus are usually better invested in for longer terms.

Global funds: These are funds that invest in international money-market securities, bonds and stocks. Investors will often allocate some dollars to these funds to offer a greater range of diversification to their portfolio. If stocks are down in Canada, they may be faring better in Germany or one of the BRIC emerging markets. Most investors will not put all of their eggs into the global fund basket, but will allocate an egg or three depending on the predicted growth potential of the particular global fund.

Tips for Investing in Mutual Funds

Like a stock broker’s commission, mutual fund managers will also charge their piece of the pie for managing the fund you invest in. Try to find funds where this fee is reasonable. If that fee is 2.5%, that is 2.5% worth of growth you will loose out on. In addition, remember that returns on investment are taxed, unless they are investments located within you Tax Free Savings Account (TFSA) or RRSP. An investment that earns return within an RRSP will not be taxed until the year it is withdrawn, but return earned within a TFSA will not be taxed at all.

You’re annual contribution limit within a TFSA is $5,000 per annum. That means each year you could allocate $3,000 to an equity or balanced fund for long-term growth, and play with the remaining $2,000 in specialized or dividend funds.

When you research specific funds you should ensure you understand the fund’s particular objective and risk level. If these are dollars you cannot afford to loose, the majority of your monies should be put in low risk funds that state their objective as long-term, steady growth.

Most financial experts suggest that the younger the investor, the more risk they can afford to take. That is purely your child’s decision. While more risk opens the door to greater reward, a moderate investment plan may better suit your child’s goals.

Each fund will be attributed a volatility rating indicating the risk they present. For instance, a money-market fund may garner a rating of 1 while European Equity is stated at 3.8. Remember that though Canadian Equity funds might average 3.6, the individual funds can range from 2 to 8. Examine the ratings attributed to the specific fund you are interested in and determine together if it suits the child’s risk tolerance.

Diversification almost always gives the best results and minimizes overall losses. Should one investment sink, another will most likely prosper. Spend a good amount of time in the office of your financial planner or online reading how the funds you are interested in are managed, what they project to earn, and how they have been doing over time. Try to pick funds that look like they’re on their way up after a brief dip; funds that make sense to you; and most important of all, don’t select just one.

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