If mutual funds make up the bulk of your investment portfolio, you're not alone. Mutual funds have grown to become a popular investment choice for most Canadian investors: In 2021, mutual fund net sales in Canada totaled $112.6 billion, a record-breaking amount greater than the total mutual fund net sales from 2017 to 2020 combined.1
It's not hard to see the reasons behind their popularity. Not only are mutual funds easily accessible — they can be purchased through banks, financial planning firms, brokerages, credit unions and other investment firms — but they also offer investors an easy way to diversify their portfolios.
And mutual funds, other than index funds, are actively managed. This means professional portfolio managers, supported by a team of research analysts, do the heavy lifting of identifying and buying investment opportunities for the fund, and selling securities that no longer meet the fund's investment objectives.
A refresher: What is a mutual fund?
Each mutual fund in your portfolio pools money from different investors. Depending on the fund's investment objectives, this money is then used to purchase stocks, bonds or other securities, such as money market instruments. The mutual funds you're holding in your portfolio enable you to invest in a diverse selection of assets without the need to purchase each asset individually.
Wonder how you can make the most of your mutual fund investments? Become a more savvy mutual fund investor with our 10 tips for beginners to the mutual fund world.
1. Know your investment goals
Before you begin investing in mutual funds, you need to know what your investment goals are. Are you investing for your retirement? Or maybe you want to fund your child's post-secondary education or save for a down payment to purchase a house.
How you invest depends on the goals you want to meet and what your timeline looks like, for example planning for retirement (long term) vs. saving for a down payment on a home (shorter term).
The first step to knowing your investment goals is to have a financial plan. A Scotiabank advisor can help you build a financial plan that assesses your current financial goals, including your investment goals. Once you have your plan in place, you'll be able to see how you can best achieve these goals.
2. Invest automatically with pre-authorized contributions
One of the best ways to fuel the growth of your mutual fund investments is to invest consistently. Pre-authorized contributions (PACs) help you do just that. With PACs, you’re in control of how much you save and how often you save it. The amount you choose will be automatically be deducted from your savings or chequing account and deposited into your investment account.
But the best part? Investing automatically with PACs lets you take advantage of an investment strategy known as dollar-cost averaging. This simple strategy is based in part on the principle of “you can't time the market" (timing the market is a strategy where you actively try to buy low and sell high).
With dollar-cost averaging, you invest the same amount consistently, typically monthly, regardless of any fluctuations in the markets. This means that when there's a dip in the market, your investment dollars end up purchasing more mutual fund units, because during a dip, each unit costs less. This, in turn, lowers your average cost per unit.
Check out this interactive PAC video to see how you can leverage the power of PACs to grow your investments.
3. Understand your risk tolerance
Do you know your risk tolerance? Investing always comes with risks as different factors can have an impact on the markets like inflation, recessions, financial crises and global events like the COVID-19 pandemic.
One of the keys to successful investing is to know your risk tolerance. A lot of factors go into determining how well you tolerate risk. Some are psychological: for example, how would you react if a severe dip in the market caused your portfolio to drop by 30%? Would you step back and ride out market volatility, or would you be more inclined to sell off your investments so you could lock in your losses (often a move you'll regret)?
Other factors include the time horizon of your investment and financial goals, and your personal financial circumstances, like whether you have an emergency fund to draw from should the unexpected happen, like a layoff or a car repair.
Figuring out your personal risk tolerance can be tough. Your Scotiabank advisor can help assess your risk tolerance and then build the right portfolio for you.
4. Use asset allocation to build a diversified portfolio
Why do you need to focus on diversification when investing in mutual funds? After all, mutual funds give you instant diversification: When you hold a mutual fund, you are maintaining exposure to the securities the mutual fund invests in. The challenge is, if for example, your portfolio only holds equity mutual funds, you would leave yourself vulnerable to events like a stock market crash.
When you use asset allocation to build your mutual fund portfolio, you reduce your risk by spreading your investments across different asset classes (think stocks and bonds), sectors and regions.
You can use asset allocation to diversify your mutual fund portfolio because mutual funds come in many different types, allowing you to create a diversified mix of assets. Common types of mutual funds include:
Equity mutual fund. Equity mutual funds are popular funds that invest in stocks that can provide you with long-term growth potential.
Fixed income mutual fund. A fixed income mutual fund invests in securities or debt instruments that offer regular income and potential for modest capital growth by investing in bonds, such as government or corporate bonds.
Money market mutual funds. Money market mutual funds invest in liquid, short-term investments, such as government Treasury bills (also known as T-bills). While they typically don't generate high returns, they provide relatively low risk.
Balanced mutual funds. Balanced funds provide a balance between income generation and long-term capital growth by investing in a mix of equities and bonds.
Portfolio solutions. Portfolio solutions offer a diversified mix of mutual funds into the convenience of a single investment. The mutual funds within the portfolio solution are carefully selected, combined and continuously managed by an investment professional.
Other options. You can also purchase specific sector- or market-based funds. For example, if you want to invest in environmentally sustainable companies, Scotiabank offers a variety of low carbon mutual funds. And if you prefer a passively managed fund, you can invest in index funds. ScotiaFunds offers a variety of index funds that track Canadian and foreign markets.
Determining the ideal asset allocation mix to diversify your portfolio can be difficult. Ask your financial advisor for guidance on the asset allocations that make the most sense for your unique personal circumstances.
5. Understand the tax consequences
It’s important to understand how mutual funds are affected by taxes, since the last thing you want is to have your return reduced by a larger-than-expected tax bill come April.
The first rule of thumb? Consider maximizing your contributions to tax-advantaged savings plans before you begin making investments held in non-registered accounts. Contributing to a mutual fund held in your Registered Retirement Savings Plan (RRSP), for example, will reduce your taxable income. You aren't taxed on your investment growth until you withdraw the money in retirement. By this time, you'll likely be in a lower income bracket and taxed at a lower rate.
Your investment of after-tax income in a mutual fund in your Tax-Free Savings Account (TFSA) will grow on a tax-free basis.
Investment income generated by mutual funds held in a non-registered account, however, will be subject to tax. The amount of tax varies depending on the type of investment income. Generally, the income mutual fund generate will be taxed as one or more of the following income types:
- Interest income. For example, you'll earn interest income from a fixed income mutual fund that holds bonds.
- Dividend income. If the mutual fund you're investing in holds stocks that pay out dividends (this is only the case if they are from Canadian corporations), the money you earn is taxed as dividend income.
- Capital gains. When your mutual fund sells a security at a higher price than its purchase price, the difference is considered a capital gain.
Each type of income generated attracts a different tax treatment. Taxes can get confusing, so it's always a good idea to talk with your accountant about the potential consequences of distributions from your mutual fund investments.
6. Understand mutual fund fees
The fees you incur when investing in a mutual fund will vary depending on the mutual fund you select. It's important to understand what fees you'll pay, as these fees effectively reduce the return you'll get from your investment.
Management expense ratio (MER). A mutual fund is actively managed by a team of investment professionals who do the research and decision-making necessary to identify and purchase optimal investments for the fund. The expenses of maintaining this team, including trailing commissions, form the main part of a fund's MER. Other elements of the MER include operating expenses and GST/HST.
Did you know?
A Trailing Commission covers the cost of the advice and service that you receive from your financial institution and your advisor. It varies among funds and depends on financial institutions.
A fund's MER is calculated as a percentage of the total value of the fund's assets. For example, a mutual fund that's valued at $10 million with annual expenses of $150,000 has an MER of 1.5%.2
Loads. A fund's load is essentially a sales commission paid to the advisor or broker. Not all funds have a load. If a load is charged when the fund's purchased, the fund has what is called a front-end load. If a fee is charged when you sell fund units, it's a back-end load. Mutual funds that don't have a load are called no-load funds.
There may also be other fees associated with the purchase of mutual fund shares, such as transaction fees, trading fees and brokerage fees.
7. Focus on the long term and avoid excessive trading
Your money is like a bar of soap – the more you handle it, the less you’ll have.
Once you've invested in a mutual fund, market conditions may tempt you to sell your mutual fund shares. For example, if there's a dip in the market, you might worry about holding on to your equity mutual fund and wonder if you should sell and purchase a fixed income fund instead.
While it’s sometimes tempting to act on a hot investment tip or constantly revise your portfolio, the key to successful investing is to keep your focus on the long term. Remember, the best way to stick to your financial plan and meet your investment goals is to stay the course with a long-term mindset. By having a long-term mindset, you can focus on the big picture, instead of trying to respond to every short-term market event.
8. Invest with advice
With so many mutual funds to choose from, the world of mutual fund investing can get confusing at times. This is where your Scotia advisor can help. Financial advisors have the knowledge and expertise to help you work towards realizing your investment goals. The benefits of getting financial advice is backed up by the research: According to a recent study, investors who worked with a financial advisor for more than 15 years had on average 2.73x more assets than those who didn't.4
Even if you prefer to apply a DIY approach to investing and select your own investments, a financial advisor can provide specialized services you'll find helpful. From assisting you in building or adjusting your financial plan to highlighting the pros and cons of tax-efficient investment vehicles, financial advisors can help you meet your financial goals.