Posted by Anjali Kaur on Jul 03, 2022

Types of Mutual Funds

Mutual funds can be structured in two ways: closed-end mutual funds and open-end mutual funds.

Closed-end mutual funds

The earliest mutual funds were closed-end mutual funds. These mutual funds issue a fixed number of units when the mutual fund is organized through an initial public offering (IPO). That number remains set until more units are authorized and issued.

After the IPO, investors can buy and sell units of a closed-end mutual fund through a secondary market such as the Toronto Stock Exchange (TSX). This process does not normally involve the issuing company. Instead, transactions occur between buyers and sellers.

The price of a closed-end mutual fund is subject to the market conditions of supply and demand. As a result, the market price of the units may not reflect the fund’s underlying net asset value per unit (NAVPU). It may be higher or lower than the NAVPU.

Open-end mutual funds

In contrast to closed-end mutual funds, open-end mutual funds are offered continuously. There are no restrictions on the number of units issued by the investment fund manager. Rather, the investment fund manager will issue more units as investors’ demand increases and redeem the units when investors want to sell them.

Unlike closed-end funds, open-end funds are bought and sold through the investment fund manager. As a result, the market price of open-end mutual funds always reflects their NAVPU.

Benefits of Mutual Funds

Mutual Fund Categories

Mutual funds are collections of different securities, such as equities or bonds, selected by a portfolio manager to meet a given fund’s investment objectives. There are a number of different types of mutual funds; each one intended to address different investment goals.

As a dealing representative, you must be familiar with the different fund types so that you can help your clients to choose suitable investments.

Canadian Investment Funds Standards Committee

Mutual funds consist of a collection of different securities, such as equities or bonds that are hand-picked by a portfolio manager in order to achieve a particular investment objective.

To help investors make sense of the multitude of mutual fund offerings, the Canadian Investment Funds Standards Committee (CIFSC) sets the standards used to classify mutual funds into specific categories. Its classification of mutual funds is based on the mutual fund’s investment mandate and the securities it holds. Understanding the different fund categories will help you as a dealing representative to evaluate and identify suitable mutual funds for your clients.

For our purposes, we will discuss these major types of mutual funds and the more common categories within the types.

Cash Holdings and Mutual Fund Categories

It is important to note that all mutual funds hold a portion of their portfolio in cash. The cash is not an investment, but rather a reserve to meet the cash flow needs of the fund, such as fulfilling client redemption requests and buying additional securities. As the cash portion does not typically play a part in positioning the mutual fund to achieve its investment objective, it does not affect how the fund is categorized.

As well, the portfolio manager has some discretionary over of the portfolio and may hold securities that are outside the primary mandate of the fund. For example, an equity fund may hold a portion of its assets in fixed-income securities. For our purposes, we will simplify our discussions to concentrate on the main types of securities in each mutual fund category and the primary sources of income.

Income Generated and Distributed by Mutual Fund

As a dealing representative, it is important that you be able to differentiate between the types of income earned and distributed by mutual funds. This will help you to understand:

  1. the likelihood the income will be earned
  2. the frequency of the income
  3. the tax implications of the income

You need to consider all these factors when determining whether a mutual fund is suitable for your client. The table below lists the types of income distributed by mutual funds and their characteristics.

Mutual Fund Summary

The risk classification of mutual funds is measured by the fund’s historical price volatility, which is the amount and frequency of the net asset value per unit (NAVPU) fluctuations over time. Funds with high volatility experience a significant rise and fall in their NAVPU over a short period while funds with low volatility have stable NAVPU.

Risk Return Relationship

Another consideration to keep in mind when evaluating mutual funds is the relationship between risk and return.

More conservative mutual funds typically have lower returns in exchange for lower risk. More growth-oriented or aggressive mutual funds have the potential for higher returns but at a higher risk which can translate to potential losses.

The following graph shows the risk return relationship of the mutual fund types in relationship to cash and each other.

Conservative Mutual Funds

Conservative mutual funds address the needs of those clients that require the safety of capital and income. In some cases, there are opportunities for capital appreciation but the growth tends to be moderated by the lower level of risk taken in these portfolios. Investors with a lower risk tolerance will typically seek a more conservative mutual fund such as a money market, fixed income, or balanced fund. Money market and fixed income mutual funds focus primarily on the safety of capital and steady income while balanced funds aim for a combination of income and growth.

How Money Market Funds Work

Money market funds are safe investments that are typically used as a temporary place to deposit money. The investment objectives are safety of principal (i.e. protection of investor’s money) and income.

How Money Market Funds Work

A money market fund invests in low-risk, high quality fixed income securities with terms to maturity of one year or less. By law, the average weighted term to maturity of the portfolio must not exceed 180 days which makes the fund very stable. Although the investments within the fund fluctuate with general interest rate levels, money market funds are managed in such a way that the fund price remains constant, typically $1 or $10. Under rare circumstances, the net asset value per unit (NAVPU) may fluctuate.

Money market funds pay interest on a monthly basis. You can reinvest the interest automatically or receive it as income. The investment returns move in the same direction as general interest rates and are usually better than the return received from a traditional bank account.

How Mortgage Funds Work

Mortgage funds invest in mortgage securities, which are pools of mortgages combined together so they can be packaged as securities to be sold in the secondary market.  Most mortgage securities hold National Housing Act (NHA) mortgages, which are fully insured mortgages, guaranteed by the Canada Mortgage and Housing Corporation (CMHC), a Government of Canada agency primarily involved in providing mortgage loan insurance.

The portfolio will also be invested in some short-term bonds for liquidity. Compared with mortgage securities, short-term bonds can be converted into cash more quickly and simply, to meet the cash flow needs of the fund.  

Mortgage funds typically pay higher income than money market funds because mortgage rates are usually higher than the interest rates on money market securities.

Income from mortgage funds is a combination of principal repayment and interest payments on mortgages.  The principal repayment is retained in the fund and used to purchase new mortgages while the interest is distributed to the fund’s unitholders.  

Like other fixed-income securities, the fund’s price is affected by interest rates. If interest rates increase, the fund’s price will decrease. Conversely, when interest rates decrease, the fund’s price will increase.

Mortgage funds are low-risk investments, but not risk free. The fund experiences lower price volatility than bond funds because its average term to maturity is usually under five years, which is lower than the average term to maturity of bond funds. Longer maturity typically involves higher risk because there is greater uncertainty in the long term (e.g. interest rates may go up in the future).

Another reason the fund is lower risk than bond funds is that the mortgages held in the fund are guaranteed by the Government of Canada.

How Bond Funds Work

Bond funds can be classified in many different ways. Two basic ways in which bond funds are classified:

  • by the creditworthiness of the bond’s issuer
  • by the average term to maturity

Generally, investment-grade bonds involve lower risk and therefore pay lower interest rates, while bonds with higher risk pay higher income to compensate investors for the additional risk. The mandate of the bond fund will specify whether a portfolio manager is restricted to investment-grade bonds or is able to obtain higher rates of return with lower-quality issuers.

Bond funds can also be classified according to the average maturity of the bonds held in the fund (maturity refers to the length of time before the bond expires and the issuer is required to repay the principal).

  1. short-term bonds – bonds maturing within five years
  2. intermediate-term bonds  bonds maturing in five to 10 years
  3. long-term bonds  bonds maturing in 10 plus years

Interest rate changes have a great impact on bond prices. When interest rates go up, the value of bond funds goes down. Conversely, when interest rates fall, the value of bond funds goes up.

How Balanced Funds Work

The bond holdings in balanced funds offer a measure of stability and income, while the equity portion provides some income through dividends and long-term growth, in the form of capital appreciation.

With the combination of bonds and common shares, balanced funds have the potential to provide a higher return than a bond fund but with lower volatility than an equity fund.

Balanced funds are required to have a fixed asset allocation. This means a fund must hold a minimum percentage of bonds and common shares according to the objectives set out in its prospectus. For instance, a balanced fund may be required to hold an asset allocation of 60% equities, 35% bonds, and 5% cash. Instead of exact percentages, there is usually a range specifying the minimum and maximum limits for each asset class.

Balanced Funds Profile

The investment goal of the mutual fund will determine its asset allocation. To achieve the goal, the portfolio manager can use:

  1. strategic asset allocation – The portfolio manager analyzes the long term expected returns and risk levels of each asset class to set a target asset mix that would match the requirements of the balanced fund. From time to time, the value of the securities in the mutual fund may change and cause the assets held in the fund to deviate from the fund’s strategic asset allocation. When this happens, the portfolio manager must rebalance the mix, to return to the strategic asset allocation.
  2. tactical asset allocation – Tactical asset allocation is when a portfolio manager temporarily changes the asset allocation from its strategic asset mix, in order to take advantage of short term opportunities in the market. In balanced funds, this is usually a short-term strategy with the portfolio manager returning the mutual fund to its strategic asset allocation once the market opportunity has passed.

How Tactical Asset Allocation Funds Work

While balanced funds must stay within a set asset mix, tactical asset allocation funds generally have no restrictions on the allocation of assets within the portfolio. The portfolio manager has the flexibility to change the asset allocation of the fund to adjust to changing market conditions and economic forecasts. For instance, the portfolio manager can change the asset allocation from 65% equities, 35% bonds, and 5% cash to 80% equities, 15% bonds, and 5% cash.

Asset Allocation Funds Profile

The risk of asset allocation funds varies according to the individual fund mandates and objectives. They may be higher risk than balanced funds since the portfolio manager does not have to invest a minimum percentage of the portfolio in fixed income.

How Target Date Funds Work

Target date funds (also known as life-cycle funds) are a kind of asset allocation fund that focuses on a specific future date and changes the asset mix throughout the life of the fund. The investment objective of target-date funds is to provide a balance of income and long-term capital growth, relative to the target date.

How Target Date Funds Work

The purpose of a target-date fund is to meet an investment goal at a specific time in the future, such as the start of an investor’s retirement or a child’s post-secondary education.

The investor purchases a target date fund that matches a significant life event. In the early stages, the mutual fund portfolio holds a greater percentage in equities. Over time, the asset mix is adjusted away from equities and towards fixed income, thereby reducing risk exposure as the target date approaches.

Thank You!

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