The Ontario Securities Commission Investor Office recently commissioned a study to understand the financial literacy of Canadians. In a questionnaire to Canadians, a series of 27 multiple choice questions were asked. On average, investors answered just over half (53%) of the questions correctly. In this weekly Series, we answer some of the questions, and explain why they’re important.
Question: Do equity or bond mutual funds pay a guaranteed rate of return?
Answer: No (34% of Canadian investors got this correct)
This question hit us like an arrow through the heart, as only one-third of investors answered this question correctly. An additional 20% answered “bond mutual funds do” and 30% said “I don’t know.” Based on the phrasing of the question and the tilt of answers, we thought that new investors might wonder, “If a mutual fund invests in bonds, and bonds are guaranteed, why wouldn’t the mutual fund guarantee returns?”
Bond Mutual Funds Don’t Guarantee Returns
There is some truth to this statement, in that bonds are in a way, guaranteed. Bond holders are indeed entitled to their principal investment when the bond reaches maturity. However, bonds can be traded before their maturity, and their prices can fluctuate based on interest rates, currencies, and liquidity. The price of a bond will increase if the value of the income provided via coupons is higher than prevailing interest rates. Inversely the value of a bond will decrease if an investor can find higher interest being paid by the market.
Bond mutual funds are simply a collection or portfolio of bonds and are structured in a way that allow units (aka ‘shares’) of the portfolio to be bought or sold as the investor wishes. When an investor chooses to ‘sell’ units of a mutual fund, they are receiving the net asset value of those units, which reflect the current value of the bonds in that portfolio. The value of these bonds can be more, or less than what the mutual fund manager paid for them.
But I Was Given to Understand My Returns Were a Given!
Mutual Funds almost never guarantee returns but there are some areas in which investors could reasonably expect some portion of their money to be guaranteed.
- Fixed Income Funds: These funds are generally less risky than those that contain stocks, but the returns of these funds are far from guaranteed. The riskiness of a bond portfolio is heavily influenced by its exposure to interest rates, a measure known as ‘duration.’ If a portfolio holds many bonds with a long duration (high sensitivity to interest rates), it will inherently be riskier than one with short duration. Money market funds (which invest in very short duration bonds), are the least risky of this bunch and though not completely riskless, are often used as a proxy for cash holdings.
- Segregated Funds: There are also insurance linked products (in Canada known as segregated funds) which do offer some sort of a principal guarantee at an added cost to the investor. This guarantee is a function of the product wrapper as opposed to the investments being held, which are very similar to a traditional mutual fund.
- Guaranteed Investment Certificates (GICs): GICs are not a mutual fund product and treated as a deposit to the bank, which is insured. Here, an investor would consider the advertised guarantee as reasonable.
What Should You Do?
When in doubt, always ask for a fund facts sheet (which is a regulatory document required by law to be provided to an investor prior to the sale of the mutual fund, or shortly afterwards at discount brokerages). Usually somewhere on that first page you’ll see text along the lines of “this fund does not have any guarantees” printed in plain language.
In short, no. Mutual Funds – either equity or bonds – do not guarantee returns.
This article does not constitute financial advice. Investors are always urged to conduct their own research before buying/selling any security.
