Although mutual funds have been around for a long time and are simple in concept, the details and complex explanations in most mutual fund prospectuses still leave investors with an incomplete understanding of their investments. Here’s a quick summary of what mutual funds are, the fees attached to them, and how they are taxed.

When you purchase stocks or bonds directly through a broker or online account, you will pay a sales commission and trading fee when you buy the investment. You will also pay these fees to sell the stock at some later date, and yet another commission when you reinvest the proceeds from that sale. In order to obtain even minimum diversification, you need at least 20 positions. Even so, you will likely want to broaden your exposure in foreign markets and maybe invest in specific sectors, such as resources or health care. You can wind up with a lot of individual positions to research, lots of trades, and lots of fees paid.

When you invest in a mutual fund you are making a single investment into a pool. Each mutual fund is managed by a professional money manager, who typically invests in 20 to 50 positions in the market identified in the prospectus. Each mutual fund is therefore diversified, and you select a number of different mutual funds to represent the different markets you wish to be invested in (e.g., Canadian equity, U.S. small cap, global resources). Most stock and bond prices fluctuate daily, thus the “per unit” value for most mutual funds fluctuates daily. If the investments owned by the mutual fund go up in value, then your mutual fund goes up in value as well. Moreover, you have great flexibility in managing the amount of fees and how and when they are paid. Here’s how it works.

You can buy a mutual fund with a front-end commission of up to 5%. The fee is deducted from your deposit and only the remainder actually gets invested (just as with direct stock and bond purchases). You can redeem your investment (that is, sell it back to the fund company) at any time. The mutual fund company is obligated to buy it back from you at the prevailing market value, and no further trading commissions or fees are involved. (The fund company pays trailer fees to your advisor for management of your portfolio).

You can also buy a mutual fund with no front-end commission charged. You may still redeem the investment at any time, but now the mutual fund company will charge you a redemption fee, commonly referred to as a deferred sales charge (DSC). The DSC is applied on a declining rate basis according to the schedule identified in the prospectus for that fund (typically six or seven years). If you withdraw monies from your mutual fund before the deferred sales charge schedule is completed, some fees will be withheld. This is really a contingency fee. If you don’t withdraw your funds, you never have to pay this fee. Because of this, most investors choose this purchase method and avoid the commission altogether.

Mutual fund companies also give the fund owner a little bonus each year: you are allowed to move 10% of the units annually out of a deferred sales charge fund without any fee, even if those funds are not mature. These are called the 10% free units. However, if you do not redeem or move those 10% free units, you lose them on December 31. At Fraser Financial, we commonly move 10% free units from deferred-sales-charge funds to front-end funds on an annual basis. That way, if you ever need to make a withdrawal, there are units available without any fees attached to them. This often also helps with the process of rebalancing your portfolio and adjusting the foreign content in RRSPs.

There is no taxation of mutual funds within registered plans (RRSPs, RRIFs, RESPs). Tax is only applied on withdrawals. However, if you hold mutual funds outside of a registered plan, you need to be aware of the following taxation issues.

When you sell your mutual fund, you will incur capital gains if the fund increased in value since you bought it. If the fund has gone down in value, you will incur capital losses. These capital gains or losses must be reported on your tax returns. You will not receive a T3 or T5 from the fund company for these gains or losses, but almost all mutual fund companies report your capital gains/losses on the annual statement. It is your responsibility to ensure that you check your statements for capital gains/ losses. You will, however, receive T3s and T5s from the mutual fund company for transactions generated by the mutual fund managers.

Mutual fund corporations pay no tax themselves, but flow through income earned within the corporation to the unitholders (i.e., investors). Thus, if the mutual fund company is paid dividends and interest, or incurs capital gains on the stocks it buys and sells, those dividends, interest and capital gains will be taxable to the unitholders. As such, you may occasionally need to pay tax on your mutual funds, even though you have made no transactions and even if the fund has gone down in value. Sorry, but the taxman doesn’t care. You are responsible for including your T3s and T5s in your tax return. The capital gains reported on your T3 or T5 is not the same as the capital gains you incur if you sell your fund.

We hope this has been of help to you in sorting out some of the questions you may have concerning mutual funds. Should you have any additional questions, please ask your advisor. We believe strongly in investor education and would be happy to help you.