The Wide World of Mutual Fund Categories
An Introduction to Investment Planning – Part 5.4
Diversification is one of the main benefits of mutual funds. With one purchase you can buy a piece of a wide variety of securities. Nevertheless, some mutual funds are quite narrowly focused and should probably be complemented by the purchase of one or more additional funds, while other mutual funds seek to provide one-stop solutions.
The creation of a new mutual fund can be just as much about marketing as providing a category of investment that has not yet been provided. Given that mutual fund companies would like to get all your investing business, many of them provide a fund for each category so that, no matter your particular investment interest, there will be a fund that suits your need.
Digging into these mutual fund categories is what today’s post is all about.
Canadian Investment Funds Standards Committee (CIFSC)
The CIFSC sets the categories and definitions for retail investment funds. This body came into being in 1988 in order to standardize the classification of mutual funds. Prior to that date, mutual fund categories were proliferating, causing little more than confusion among investors and making comparisons difficult. The voting members of this committee are made up of firms involved in the publishing and analysis of mutual fund data: Fundata Canada, Morningstar Canada, CANNEX Financial Exchanges, Thomson Reuters/Lipper and Strategic Insight.
The following are upper level categories and the associated definitions, according to a CIFSC publication dated March 2019
|Alternative Funds||Alternative funds employ strategies such as short selling and other forms of leverage.|
|Money Market Funds||Funds in the Money Market group must invest at least 95% of their total net assets in cash or cash equivalent securities and otherwise comply with the legal definition of Money Market funds as outlined in National Instrument 81-102.|
|Fixed Income Funds||All funds in the Fixed Income group must invest at least 95% of their Non-Cash Assets in fixed-income securities.|
|Balanced Funds||Funds in the Balanced Funds group must invest between 5% and 90% of their non-cash assets invested in equity securities and between 10% and 95% of their non-cash assets in fixed-income securities.|
|Target Date Funds||Funds in the Target Date fund group comply with the Balanced fund category criteria but have specific, pre-determined maturity dates and a stated mandate to adjust their target asset allocation weightings over time as they approach their maturity dates. Upon maturity, funds in the Target Date fund group will be moved out of the Target Date group and included in the appropriate Fixed Income or Balanced fund category.|
|Equity Funds||Funds in the Equity fund group must invest at least 90% of their non-cash assets in equity securities.|
|Commodity Funds||Funds in the Commodity category must invest primarily in physical commodities or gain exposure to commodities using derivatives. The commodity exposure must be primarily long and must not be greater than 100% (i.e., not leveraged).|
|Specialty Funds||These include: Retail Venture Capital; Passive Inverse/Leveraged; and Miscellaneous – Income & Real Property, Miscellaneous – Other, and Miscellaneous – Undisclosed Holdings. Funds in one of the three Miscellaneous categories should not be considered homogenous and data providers will not rank, quartile, or apply similar relative comparisons to the sub-category constituents.|
Alternative, Commodity and Specialty Funds
Although they may appeal to some investors, for the most part, funds in the Alternative, Commodity and Specialty categories have a relatively smaller share of the mutual fund market. Perhaps the one exception here is the Miscellaneous – Income & Real Property category.
Money Market Funds
This can be a good place to set aside otherwise uninvested cash and gain some interest. If you have a US dollar account, you can hold US cash in your US dollar money market fund.
Fixed Income Funds
Various mutual funds fit in this category. Perhaps the most commonly owned is the Canadian Fixed Income category. This type of fund has an average duration of greater than 3.5 years and less than 9.0 years. Duration is a complex term but for our purposes, the greater the duration, the greater the inverse response to changes in interest rates. An illustration of duration: all else being equal, a fund with a duration of 5 years will, in response to a decrease in interest rates of 1 percent, increase in value by 5 percent. Conversely, an increase in interest rates of 1 percent will lead to a decrease in value of 5 percent.
Balanced funds mix equities (stocks) and fixed income (bonds) in various proportions. They can be a single fund solution. The more aggressive investor will tilt more to the equity side, while the more conservative investor will tilt more to the fixed income side.
Target Date Funds
These are similar to the Balanced Funds category except that they have a maturity date. For example, a 2035 Target Date Portfolio will have a more aggressive mix of equities to fixed income now in late 2019, perhaps in the 70 percent equity range. As 2035 approaches, the fund managers will gradually shift the balance to fixed income. These funds may be useful in preparing for retirement as the general rule is to invest more conservatively as you approach retirement. They are also suitable for investing for your children’s education, ideally in an RESP, since as your children begin their post-secondary education, they will begin to spend down the account, which is when as much risk as possible should be eliminated.
These are your stock mutual funds. Typical categories are Canadian, U.S., Emerging Markets, Global and International. The difference between Global and International Equity mutual funds is that the former can include investments in Canada and the U.S., while the latter only invests outside Canada and the U.S.
Which do I choose?
Personally, I am a fan of broad-based categories. Diversification is often said to be the only free lunch in investing. How you mix up these mutual funds to get the diversity you want depends on several considerations. How old are you? How much risk can you tolerate? What is your net worth? What are your goals for your investments?
These considerations are not resolved in a single blog post, but if you are interested in digging into these matters further, click here to contact me for an appointment.
In my next article, which I will post in the new year – Merry Christmas and Happy New Year 2020, by the way – we will look at the somewhat-related world of Exchange-Traded Funds.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.