BY FAZAAD BACCHUS
In the last issue of our mutual funds discussion we examined components such as: diversification, start-up costs, access to your money, geographic spread and risk.
Today, we will discuss how you make money from your mutual funds. There are typically three ways in which you can make money investing in mutual funds.
The first and number one is Capital Growth, simply meaning that the money you have invested which is called your capital has now grown. The portfolio manager, who is responsible for making profitable investments on your behalf, buys and sells securities. These securities have a Net Asset Value per Share (NAVPS) or commonly referred to as a unit cost. If the manager buys a security for $12 per share and then six months later the share value is $14, this means your investment has gained $2 for every share you own. If you decide to sell, then you will have a realized a taxable gain representing your profit on your investment. For many this would be the main source of their retirement income. It should be noted that any gains or losses are not real unless you dispose of your shares.
The second is Capital Gains Distribution. Your fund manager would on many occasions decide to sell various securities because they may have reached its peak growth or because of certain trends affecting the underlying security. If he or she is selling for more than he paid, then there would be a profit. This profit is called a capital again and is distributed to you at the end of the year. You have the option to take this capital gain which was distributed to you by the fund manager, in the form of cash or reinvest it by purchasing more units into your portfolio. The fund manager doesn’t always make a distribution even if a sale realized a profit. Of course any distribution paid to you is a taxable gain except in the case of an RRSP where taxation is deferred or a TFSA where there is no taxation on gains.
The third way to make money from a mutual fund is through Income Distributions. The very fund that you have invested into earns interest and dividends all throughout the year, albeit at different times. For example, bond funds pay very frequent interest distributions during the year, which is different from equity funds. Equity funds tend to pay income distributions if the stock themselves pay dividends. Any income distribution paid is done only after the fund has covered all of its expenses. And again, any distribution is taxed in the year of receipt except for RRSP which is deferred and TFSA which is not taxed.
These are the three main ways in which an investor makes money from investing, but investing as you know is much more complex. It involves, understanding why you are investing, when you will need your money, how much risk are you willing to take etc, to be able to find a suitable investment for you. Mutual funds are a very popular form of investment but you are better off sitting with a qualified financial advisor to decide on the right type for you. You will need to decide on whether an RRSP or TFSA is better for you for example. Find an advisor you believe can help and work closely with him. Stay with the post as we get ready for Part 3 where we will talk about fees.