Mutual Funds, Explained — The Tilted Gent

Concepts in this lesson

NAV: Net asset value per share: a fund's assets minus liabilities, divided by its shares, set once a day.
MER: The Canadian measure of a fund's yearly cost: management fee plus operating expenses and taxes, as a percentage of assets.
Sales load: A sales charge some mutual funds take when you buy (front-end) or sell (back-end), on top of the yearly fee.

01The pool

A hundred people each put $1,000 into a pot, and one professional invests the $100,000 for all of them. Each owns 1% of the pot, whatever it grows or shrinks to. That's a mutual fund: investors buy units (or shares) of the fund, the fund owns the stocks or bonds, and a manager decides what to buy within the fund's stated rules.

Some funds are active: the manager picks investments, trying to beat a benchmark. Others are index funds that simply copy one, at a much lower cost.

You make money two ways: the fund's distributions (the dividends and interest its holdings pay, plus any gains it realizes by selling, passed through to you) and the rise in the unit price. In a taxable account, realized gains are distributed, and taxed, whether or not you sold anything yourself.

02Priced once a day

Unlike a stock or an ETF, a mutual fund doesn't trade on an exchange during the day. You buy from and sell back to the fund itself, at its net asset value (NAV) per unit, worked out once a day after the market closes. An order placed at 10 a.m. gets that evening's price, whatever happens in between.

Because the fund buys and redeems units directly, its price can never drift from the value of its holdings, the problem that creation and redemption solves for ETFs.

03Mutual fund or ETF?

	Mutual fund	ETF
How you trade	With the fund, once a day at NAV	On an exchange, any time it's open
Typical style	Often actively managed	Mostly index-tracking
Typical fee	Higher, especially active funds	Lower, especially broad index funds
Automatic monthly purchases	Easy, in exact dollar amounts above the fund's minimum	Depends on the broker

The line between them has blurred: index mutual funds can be as cheap as ETFs, and active ETFs exist. The real question isn't the wrapper but the strategy and the fee inside it.

04The fees, all of them

The yearly fee: the expense ratio, or the MER in Canada. It pays the manager and the fund's running costs, and comes out of the fund's value every day.
Sales loads: a commission on buying (front-end load) or on selling within a few years (back-end load or deferred sales charge; no longer allowed on new purchases in Canada since June 2022). A 5% front-end load means $500 of every $10,000 goes to the seller before a dollar is invested.
Advice fees built into the MER: in Canada, many funds pay the dealer who sold them a yearly trailing commission out of the fund's fee; in the US, similar 12b-1 fees pay for distribution.

Fund documents must list every one of these. They are worth reading before buying, because they come out whether the fund does well or not.

05How much skill the fees demand

An active fund charging 1% a year starts every year nearly a full point behind a cheap index fund holding the same market. The manager has to make that up, and more, just to tie.

Worked example: $10,000 for 25 years, markets return 7% a year

An index fund at 0.05% a year grows to $53,644.

An active fund at 1% a year with no sales charge, whose manager exactly matches the market before fees, grows to $42,919. To tie the index fund, the manager has to beat the market by about 0.95 points every year for 25 years.

Add a 5% front-end load and a 2% yearly fee and the same fund ends at $32,170; the hurdle rises to 2.17 points a year. Over long periods most active funds fall short of their benchmarks after fees, one reason index funds have grown so fast.

Try it: an active fund against an index fund

With JavaScript on, this box grows the same amount in an index fund and an active fund with a load and a higher fee, and shows how much yearly skill the active fund needs just to tie.

Amount ($) Market return a year (%) Index fund fee (%) Active fund fee (%) Front-end load (%) Manager's skill before fees: +0.0% Years: 25 years

Index fundActive fund

At the table

Paying an active manager is backing a pro: you hand over a share of every pot for their skill. A real edge can be worth it. But the cut comes off every hand, and a pro who only plays even with the table costs you money. Ask whether the edge is bigger than the cut, and how you'd know.

06If your workplace plan only offers funds

Many retirement plans offer a short menu of mutual funds and nothing else. The questions are the same: find each fund's yearly fee in its Fund Facts or prospectus, see whether an index option is on the menu, and ask whether an active fund's record after fees has earned the difference.

07What can go wrong

The market falls, and the fund falls with it.
Fees compound against you every year, in good years and bad.
Underperformance: an active manager can trail the benchmark for years.
Sales charges can make it costly to leave a fund early.
Style drift: a fund can end up owning something different from what you bought it for.

Previous lessonETFs: the whole table in one bet Next lessonREITs: the landlord's share

The fine print, lesson edition. This page explains how mutual funds work. It is education, not advice to buy or sell any fund. The returns, fees and loads in the examples are round numbers for the arithmetic, not any fund's actual figures; a fund's prospectus or Fund Facts sets out its real costs.