Why is diversification essential when investing in mutual funds? First, they provide instant diversification: when you own units of a mutual fund, you maintain exposure to the securities in which the fund invests. The problem is that if, for example, your portfolio only contains equity funds, you make yourself vulnerable to events such as a stock market crash.
If you build your mutual fund portfolio by spreading your investments – across different asset classes (stocks and bonds), sectors and regions – you reduce your risk.
If you can use asset allocation to diversify your mutual fund portfolio, it’s because there are many different types of funds and it helps create a diverse mix of assets. Common types of mutual funds are:
Equity funds. Equity funds are popular funds that invest in stocks with good long-term growth potential.
Fixed Income Mutual Funds. Fixed income mutual funds invest in securities or debt instruments that offer regular income and modest potential for capital growth, for example in bonds, such as government or corporate bonds.
Money market mutual funds. Money market mutual funds invest in short-term, liquid money market instruments, such as treasury bills (also called treasury certificates). Although they generally do not generate high returns, they are relatively low risk.
Balanced Mutual Funds. Balanced mutual funds offer a balance between income generation and long-term capital growth by investing in a mix of stocks and bonds.
Portfolio solutions. Portfolio solutions combine various mutual funds into one convenient investment. The funds in a portfolio solution are carefully selected, combined and continuously managed by an investment professional.
Other options. You can also buy funds specializing in a sector of the economy or a market. For example, if you want to invest in environmentally friendly businesses, Scotiabank offers a variety of low carbon funds . And if you prefer a passively managed fund, you can invest in index funds. ScotiaFunds offers a rangeof index funds that track the performance of Canadian and foreign indices.
Determining the ideal asset allocation to diversify your portfolio can be difficult. Ask your financial advisor to help you choose the allocation that best suits your personal situation.
Find out how you can invest in mutual funds
Be aware of the tax consequences
It’s important to understand how mutual funds are taxed in order to see your return reduced by a larger than expected tax bill in April.
The first rule to follow? Consider maximizing your contributions to tax-advantaged savings plans before you start investing in non-registered accounts. By contributing to a mutual fund held in your registered retirement savings plan (RRSP) , for example, you will reduce your taxable income. And you won’t be taxed on the growth of your investments until you make retirement withdrawals. But by then your income will likely be in a lower tax bracket.
In addition, the after-tax income you invest in a mutual fund held in your tax-free savings account (TFSA) will grow tax-free.
Investment income generated by mutual funds held in a non-registered account is subject to tax. The amount of tax payable varies depending on the type of investment income. In general, mutual fund income is taxed as one or more of the following types of income:
Interest income. You will earn interest income if you have units of a fixed income mutual fund that holds bonds.
Dividend income. If the mutual fund you’re investing in holds stocks that pay dividends (only if they’re stocks of Canadian companies), the money you earn will be taxed as dividend income.
Capital gains. When your mutual fund sells a security for more than its purchase price, the difference is considered a capital gain.
Each type of income generated by mutual funds has a different tax treatment. Tax can be confusing, so don’t hesitate to discuss with your accountant the possible consequences of distributions (income paid out by funds) from your investments.
Be aware of mutual fund fees
The fees charged to you when you buy units of a mutual fund vary depending on the fund you choose. It is important that you find out about the fees you will have to pay, as these can reduce the return on your investment.
Management expense ratio (MER). A mutual fund is actively managed by a team of investment professionals who do the research and make the decisions necessary to find and buy the best investments for the fund. The expenses of maintaining this team (including trailing commissions) make up the bulk of a fund’s MER. The other components that make it up include operating costs and
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