Investing in mutual funds for beginners: Here are some of the best ways to do it—and also what to avoid

We think that mutual funds are okay to hold if you already own them, but we have moved away from recommending them in favour of lower-fee exchange-traded funds (ETFs). We feel that most fund investors should shift into ETFs wherever possible. (For that reason, we shifted our focus in our Canadian Wealth Advisor newsletter to ETFs.)

However, here’s a look at investing in mutual funds for beginners:

A mutual fund is a portfolio with holdings in equities, bonds and other investments in which small investors can easily invest. These portfolios are comprised of a pool of money collected from many investors.

Mutual funds let small investors access professionally managed, diversified portfolios that would be difficult for them to create on their own. Individual shares of mutual funds are called units.

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Investing in mutual funds for beginners: Five types of mutual funds to avoid

We think that mutual fund investors will profit the most if they stick with well-managed “plain vanilla” mutual funds. These funds hold well-diversified, high-quality stocks and have a long-term focus.

On the other hand, here are some types of mutual funds to stay out of:

Bond mutual funds: Investing in a bond mutual fund exposes you to the risk of rising interest rates.

Bonds are unlikely to perform as well in the next few years as they have in the past, if only because interest rates may hold steady or, more likely, rise. That means bond mutual funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could generate capital losses.

Mutual funds that trade in derivatives: Some funds are set up to profit by trading in derivatives, based on studies of what would have paid off in the past five years, for example. But other market participants can also access that information. So, things are unlikely to work quite the same way for the mutual fund’s performance over the next five years.

In the long run, derivatives trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is another’s loss, minus commissions and other costs. In the end, mutual funds trading in derivatives costs you money.

Mutual funds with anonymous managers: The trouble here is that the brains of the mutual fund may leave, and investors would never know it until they saw the drop in their mutual fund’s performance. Leaving the investment decisions to an anonymous group of people is never good for the health of long-term mutual funds. This includes buying mutual funds run by committees.

Mutual funds with wide disparities between what they say they invest in, and what they actually hold: Many mutual fund operators describe their investing style in vague terms. It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect.

Theme mutual funds: Theme funds with themes snatched from the headlines—such as cryptocurrencies–face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices —perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad dies out, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

Why ETFs may be even better than investing in mutual funds for beginners

As mentioned earlier, mutual funds may have a place in your portfolio, but at TSI Network we generally advise investing in ETFs. Here are some reasons:

1. ETFs are less expensive to hold. ETFs give you a low-cost way to invest in a narrow market segment. That’s typically cheaper than investing in a mutual fund with a similar focus. With fees as low as 0.10% a year for ETFs vs. mutual funds that can charge you 2% to 3% or higher on their fund. ETFs can save you a lot of money and boost your return if you are investing over time.
2. ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.
3. Low turnover. Shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.

In what situations have you chosen to invest in mutual funds over ETFs?

What kind of experiences have you had with mutual fund investments?