Risks of mutual funds
Like most investments, mutual funds have risk — you could lose money on your investment. The value of most mutual funds will change as the value of their investments goes up and down.
The level of risk in a mutual fundMutual fund An investment that pools money from many people and invests it in a mix of investments such as stocks and bonds. A professional manager chooses investments that match the fund’s goals for risk and return. You can redeem your fund units at any time.+ read full definition depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be. For example, stocks are generally riskier than bonds, so an equityEquity Two meanings: 1. The part of investment you have paid for in cash. Example: you may have equity in a home or a business. 2. Investments in the stock market. Example: equity mutual funds.+ read full definition fund tends to be riskier than a fixed incomeFixed income An investment that pays regular income to you. Examples: Guaranteed Investment Certificates, Canada Savings Bonds and types of other bonds.+ read full definition fund.
Some specialty mutual funds focus on certain kinds of investments, such as emerging markets, to try to earn a higher return. These kinds of funds also tend to have a greater risk of a larger drop in value.
6 common types of risk
| Type of risk | Type of investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition affected | How the fund could lose money |
|---|---|---|
| 1. Market riskMarket risk The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.+ read full definition | All types | The value of its investments decline because of unavoidable risks that affect the entire market |
| 2. Liquidity riskLiquidity risk The risk of being unable to sell your investment at fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases it may not be possible to sell the investment at all.+ read full definition | All types | The fund can’t sell an investment that’s declining in value because there are no buyers. |
| 3. Credit riskCredit risk The risk of default that may arise from a borrower failing to make a required payment.+ read full definition | Fixed income securities | If a bondBond A kind of loan you make to the government or a company. They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well. If you sell…+ read full definition issuerIssuer An organization that offers securities for sale to investors. Examples: corporations, investment trusts and government bodies.+ read full definition can’t repay a bond, it may end up being a worthless investment. |
| 4. Interest rate riskInterest rate risk Interest rate risk applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate.+ read full definition | Fixed income securities | The value of fixed income securities generally falls when interest rates rise. |
| 5. Country risk | Foreign investments | The value of a foreign investment declines because of political changes or instability in the country where the investment was issued. |
| 6. Currency riskCurrency risk The risk of losing money because of a movement in the exchange rate. Applies when you own foreign investments.+ read full definition | Investments denominated in a currency other than the Canadian dollar | If the other currency declines against the Canadian dollar, the investment will lose value. |
Assessing risk
One way to assess a fund’s level of risk is to look at how much its returns change from year to year. If the fund’s returns vary a lot, it may be considered higher risk because its performance can change quickly in either direction.
How your investment is protected
Because mutual funds are securities — and not deposits — they’re not protected by the Canada Deposit Insurance Corporation (CDIC) or other deposit insurance. But other safeguards are in place to protect investors:
- third-party custodian – holds the assets of a mutual fund. This is usually a trust company or chartered bank
- independent auditor – reviews and reports on the fund’s financial statementsFinancial statements Reports that sum up a company’s financial data and tell you how it is doing. The four basic statements are: the statement of financial position (balance sheet, statement of profit or loss (income statement), cash flow statement, and statement of changes in equity.+ read full definition each year.
If a firm goes bankrupt
Your mutual funds may be covered by one of two investor protection funds. You must file a claim within 180 days after the firm declares bankruptcy.
These investor protection funds do not cover losses from other causes, such as changing market values of securities, unsuitable investments or the default of an issuer of securities.
1. Canadian Investor Protection Fund (CIPF)
The CIPF provides protection of up to $1 million to eligible customers of a firm that is a member of:
- Investment Industry Regulatory Organization of Canada (IIROC),
- Bourse de Montréal Inc., or
- TMX Group Inc.
2. MFDA Investor Protection Corporation (IPC)
The IPC is an investor protection fund of the Mutual Fund Dealers Association of Canada (MFDA). It provides protection of up to $1 million to eligible customers of MFDA members.
Key point
The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be.
Take action
Minimize your overall risk by holding a variety of investments. Before you decide on a mutual fund, figure out how it fits with the rest of the investments you own.