Mutual funds are the investment of choice these days, it seems, even for the very conservative investor. Unfortunately, mutual funds are considerably more complicated than GICs and CBSs. The vast majority of lay investors do not understand these complexities.

The first key difference is that mutual funds do not carry the security of guarantee of safety of principal. Government debt issues carry the strength of government backing. GICs typically carry backing by CDIC or its equivalent (up to certain limits).

The value of your mutual fund holding varies daily with the success of the fund itself with its various investments. This is reflected in the net asset value (“NAV”), commonly reported in the financial pages of the newspapers. Simply put, the NAV is the value of the net assets of the fund divided by the number of units issued. As the prices of the fund’s investments (hopefully) go up, so does the NAV. Note that these increases in NAV are based upon “paper” — unrealized — gains in the fund. As the fund manager sells specific investments at a profit, the fund has more wealth to reinvest in other things, which in turn may go up or down in value. If the fund invests in things which pay out income — dividends or interest — then again the wealth of the fund increases, thus increasing NAV.

Most funds “draw off” their books near December 31st, when they calculate what wealth was generated by interest, dividends and realized gains and losses. These amounts are allocated to the unit holders of record at year-end. This “dividend” typically is reinvested in more units of the fund. If you invested in the fund to generate cash flow for your own purposes, then you would convert this year-end distribution into real money by cashing out your newly acquired units.

The allocated income of the fund is reported to you for tax purposes (assuming non-RRSP holding) on a T3 slip. It is important to pay attention to the characteristics of the allocation of income from the fund. While it is called a “dividend”, it is not the same as a dividend from, say, MacMillan Bloedel shares. In fact, the allocation on the T3 slip may include interest, regular dividends, foreign interest and dividends and realized net capital gains. Each of these goes some place different on your personal tax return. Canadian dividends will carry dividend tax credits, foreign income may carry foreign tax credits and capital gains likely will qualify for preferential capital gains tax treatment.

After distribution date, the NAV of the fund will decrease precisely by the amount of the year-end allocation. At a seminar we gave recently, we helped a fund investor understand the significance of this precise point. He had bought mutual fund “X” in the Spring for $29, and dutifully followed its NAV in the newspaper. It had gone up nicely for a while (as high as $36), according to him, but had plummetted since the new year (to below $29). Frustrated and fed up, he was going to sell it soon. What he hadn’t appreciated was that at year-end the fund had allocated its income and paid “dividends” totalling $6.17 per unit. Thus, the NAV dropped by this amount on January 1st. When comparing the current NAV to his original purchase price, he had to mentally add $6.17 to assess the fund’s performance. His misunderstanding led to an uninformed decision.