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Mutual Funds

What are mutual funds?
Determining the value of a mutual fund share
Open-End versus Closed-End funds
Investment advantages and disadvantages
Types of mutual funds
Mutual funds are not insured or guaranteed


What are mutual funds?

Stocks are pieces of a company. For many people, mutual funds are the best way to invest. The ultimate example of diversification, a mutual fund is a pool of investments that is owned by many people and managed by professional portfolio managers. Investors own part of these pools, also known as investment funds, by buying shares or units of the fund. The money from the purchase of units is invested by professional fund managers in a variety of assets with the expectation of increasing the value of the fund. At any point, the investor can redeem his or her units for their portion of the asset pool. If the manager has been successful in increasing the value of assets in the fund then the individual investor's portion of the fund will likewise increase in value.

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Determining the value of a mutual fund share

Buying units of a mutual fund is similar to buying shares of a company. Essentially, you own a portion of the combined investments that the fund has made. This share has a specific value which will vary from day to day depending on the value of the investments in the fund. The term used to define this value is NAVPS or Net Asset Value Per Share. The formula for determining this value is as follows:

NAVPS = total market value of assets less liabilities
total number of shares (units)

The number of shares available to fund purchasers depends upon the type of fund it is.

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Open-End versus Closed-End funds

Most Canadian funds belong to one of two groups: open or closed-end. The vast majority of mutual funds are open-end. Open-end funds are like their closed-end brethren in one respect: they allow an investor to own a piece of a diversified portfolio of securities managed on a full-time basis by professional investment managers. Open-end funds sell units upon demand. When an investor invests money in an open-end fund, new units are issued directly by the fund. There is no limit to the number of units available. Units of an open-end fund can always be redeemed for the NAVPS. Keep in mind that this is rarely the price at which the units were purchased. One hopes it will be more, but it can also be less.

There is also an assortment of closed-end funds available for purchase. However, unlike open-end funds, closed-end funds have a fixed number of units which are generally traded like shares on a stock exchange. Closed-end funds also have a NAVPS but a distinguishing feature of this type of fund is that they do not necessarily trade at the NAVPS. In fact, their trading value is frequently less than their NAVPS. In this instance, when a closed-end fund is trading at a "discount", an investor may be able to buy a fund for less than the sum of its parts.

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Investment advantages and disadvantages

The chief advantages of mutual funds are:
- diversification
- professional management
- variety of types of funds
- variety of purchase plans
- liquidity and transferability
- convenience
 
Among the disadvantages are:
- perceived costs
- professional investment management is not infallible

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Types of mutual funds

Stocks are pieces of a company. Mutual funds come in a variety of types, each with its own investment objectives. Depending on the mandate, there are different risks and different rewards. The money raised from issuing new shares is invested according to the fund's investment policies and objectives. For example, a fund with the goal of long-term growth within the framework of the Canadian economy would invest in common shares of Canadian companies.

A fund whose objective is to earn current income might hold bonds or mortgages. A mutual fund's returns consist of the dividends and interest it receives on the securities it holds and the capital gains it may generate in trading its investment portfolio.

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Mortgage Funds
Goals are income and safety. Not as risky as bond funds because mortgage terms are usually relatively short (five years or less).
 
Bond Funds
Income and safety of principal are the main objectives. However, investors should recognize that they will be subject to capital gains and losses, depending on interest rate movements.
 
Dividend Funds
Has a goal of tax-advantaged income with some possibility of capital appreciation. These funds invest in preferred shares and high quality common shares that consistently pay dividends. The income from these funds qualifies for the dividend tax credit, an advantage to investors.
 
Balanced Funds
These funds provide investors with a mixture of safety, income and capital appreciation. The fund will hold fixed income securities for stability and income, as well as a wide variety of common stocks for diversification, dividend income and growth potential. Balanced funds enable investors to "get their feet wet" in the world of stocks while providing income through bond holdings.
 
Equity Funds
The primary objective of equity funds is capital growth, although dividends may contribute to the total return. In general, the basic distinction among equity funds is their level of aggressiveness - the more aggressive the investment approach, the higher the risk and the greater potential for capital growth.
 
Specialty Equity Funds
Some investors like to diversify into specialty areas that they feel will have the potential to outperform the overall markets. These types of funds invest in specialized markets or industries, such as natural resources, real estate, science & technology, which, although subject to volatility, may provide increasing opportunities for growth over the long term.
 
International Funds
As more and more investors are realizing that the best investment opportunities often lie outside of Canada, international funds are gaining in popularity. These types of funds allow investors to access stocks on a worldwide, regional and/or even country basis.

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Mutual Funds are not insured or guaranteed

One of the questions most frequently asked by investors is, "Are mutual funds insured or guaranteed?" The answer is "no". There are several safeguards in place to protect the mutual fund investor, but investors have to keep in mind that mutual funds differ from other types of investments. Unlike Guaranteed Investment Certificates and savings accounts, mutual funds are not insured and the investment is not guaranteed.

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