Chapter 3 Investment Funds

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Chapter 3Investment Funds
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Learning objectives

• Distinguish between direct and indirect
  investing.
• Define open-end and closed-end investment funds.
• State the major types of mutual funds and give
  their features.
• Define exchange-traded funds (ETFs).

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Indirect Investing

• Refers to buying and selling the shares of
  intermediaries that hold a portfolio of
  securities
• Shares are ownership interest in the underlying
  portfolio
• Shareholders are entitled to portfolio income
• Shareholders also pay expenses

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Investment Fund

• Financial company or trust fund that sells shares
  to the public and uses the proceeds to invest in
  marketable securities
• Acts as conduit for distribution of dividends,
  interest, and realized gains
• Offers the benefits of diversification
• Offers professional management

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Fund Types

• Unit Investment Trust an unmanaged, fixed-income
  security portfolio put together by a sponsor and
  handled by an independent trustee
• Passive investments designed to be bought and
  held with capital preservation as a major
  objective
• Currently represent a very small part of total
  investment company assets

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Fund Types

• Closed-end investment fund No additional shares
  sold after initial public offering
• Share prices determined and traded in a secondary
  market
• Price may not equal Net Asset Value of the shares
• Net Asset Value (NAV) Total market value of the
  security portfolio divided by total shares

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Fund Types

• Open-end investment fund Shares continue to be
  sold to the public at NAV after initial sale that
  capitalizes the company
• Shares may be sold back (redeemed) to the
  company at NAV
• Capitalization constantly changes
• Popularly called mutual funds

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Types of Mutual Funds

• Money Market Funds
• Objectives of income and liquidity
• Short-term money market instruments
• Low risk and high liquidity
• (a) Mortgage Funds
• Investment terms may be ? 5 years
• Riskier than money market (more interest rate
  risk), but less risky than bond funds (shorter
  maturities)
• (b) Bond Funds
• Objectives of income and safety
• Subject to capital gains/losses due to interest
  rate risk

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Types of Mutual Funds

• (a) Balanced Funds
• Objectives of safety, income and capital
  appreciation
• Min./max. rules apply for percentage invested in
  each asset class.
• (b) Asset Allocation Funds
• Similar objectives as balanced funds, but
  typically not restricted by asset class
  percentage rules
• Equity/Common Stock Funds
• Objective of capital gains
• Bulk of assets are in equity, but other assets
  held for liquidity, income and diversification
  purposes
• May vary greatly in degree of risk and growth
  objectives

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Types of Mutual Funds

• Growth Funds
• Tend to invest in small-cap stocks, i.e. small
  companies with growth potential
• Riskier than equity funds (small firms pay no
  dividends)
• Specialty Funds
• Objective of superior capital gains (through
  minimal diversification)
• Tend to focus on one industry, market, or segment
• International/Global Funds, for example, invest
  in foreign securities (and carry the risk of
  foreign exchange exposure)

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Types of Mutual Funds

• (a) Real Estate Funds
• Invest in income-generating properties for
  long-term growth and capital gains
• Portfolio valuation is based on infrequent
  external appraisal
• Less liquid than other funds investors may need
  to give advance notice when selling
• (b) Ethical Funds
• Relatively new type of fund
• Investments are guided by moral criteria (e.g.,
  not investing in tobacco-related firms)

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Types of Mutual Funds

• Index Funds
• Objective is to mirror the performance of a
  market index (e.g., SP/TSX 60)
• Generally lower management fees than other funds.
• Dividend Funds
• Objective of tax reduction through favourable
  treatment of dividend
• Inappropriate for RRSPs or RRIFs
• Price changes are driven by interest rates and
  market trends

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Types of Mutual Funds

• Each type of fund has different risk-return
  characteristics. In general, they can be ranked
  from lowest risk/return to highest risk/return as
  follows
• Money market
• Mortgage
• Bond
• Balanced
• Dividend
• Equity
• Real estate
• Specialty

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Mutual Fund Categories

• Money market mutual funds invest in a portfolio
  of money market securities
• Treasury bills
• Commercial paper
• Short-term government bonds
• Low risk
• Not insured by the federal government

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Mutual Fund Categories

• Equity, bond, and income funds invest in
  portfolios of securities consistent with the
  objectives of the particular fund
• Objectives set by the funds board
• Disclosure of objectives to investors through a
  prospectus

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Equity Funds

• Most mutual fund assets are in equity funds
  rather than bond or income funds
• Most equity funds are either
• Value funds, which invest in undervalued stocks
  as determined by fundamental financial analysis
• Growth funds, which invest in stocks of firms
  expected to show future rapid earnings growth

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Equity Funds

• Closed-End Funds
• NAV gt market price, selling at a discount
• NAV lt market price, selling at a premium
• If the value of the portfolio remains unchanged,
  an investor can gain or lose if the discount
  narrows or widens over time
• Trade at premiums and discounts across time, and
  variance is great

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Exchange-Traded Funds (ETFs)

• Units of these trusts hold shares of firms in
  market indices in proportion to their weights in
  the index
• Differences from traditional mutual funds
• Traded throughout the day on exchanges
• Lower management fees (e.g., 0.08 to 0.25
  versus 2.5 average for active equity funds
  versus 0.75 average for Index funds)
• Lower portfolio turnover reduces capital gains
  income and taxes payable
• Permit short-selling
• May be purchased on margin

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Canadian-Based ETFs

• I-60s
• Represent units in the SP/TSX 60 Index
• Trade on the TSX (ticker XIU). units are valued
  at 1/10th the value of the SP/TSX 60 Index for
  example, if index is valued at 450, each unit is
  valued at 45
• Dividends are paid every quarter MER is 0.17
• DJ40s
• Represent units in the Dow Jones Canada Index
  Participation Fund, which hold stocks that mimic
  those of the Dow 40 Index MER is 0.08

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Canadian-Based ETFs

• TD SP/TSX Index Fund
• The SP/TSX Composite Index is the underlying
  index MER is 0.25
• There are now a growing number of small-cap,
  mid-cap, industry-based, style-based, and bond
  ETFs available
• There are now a growing number of small-cap,
  mid-cap, industry-based, style-based, and bond
  ETFs available

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Differences between ETFs and Mutual Funds

• ETFs
• Trade all day on exchanges, can be bought on
  margin, and can be shorted
• Currently passive in nature
• Can be traded at discount or premiums.
• Offer an important advantage over funds with
  regard to flexibility on taxes
• Mutual Funds
• Bought and sold at the end of the trading day
  when the NAV is calculated
• Most are actively managed
• Trade at NAV
• Mutual fund mangers may have to sell shares to
  pay those who want to leave the fund, thereby
  generating capital gains

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Other Funds

• Segregated funds
• Provide death benefits
• Must guarantee a minimum percentage (75 is
  required, 100 is usually offered) of investors
  payments will be returned at fund maturity (or at
  death of owner)
• Structured to prevent fund assets from being
  seized by creditors if investor declares
  bankruptcy
• Upon owners death, assets may be transferred to
  beneficiaries without being subject to probate
  fees

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Other Funds

• Labour Sponsored Venture Capital Corporations
  (LSVCCs)
• No 10 maximum ownership restriction
• Restrictions on transferability and redemption
• Valuation may not be based exclusively on market
  prices
• Tax advantages federal provincial tax credits
  offered

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Performance

• Reported on a regular basis (usually daily) in
  the popular press
• Measured over a given time period as a percentage
  of initial investment
• Total returns include reinvested dividends and
  capital gains
• Average annual return reflects the mean compound
  growth rate of investment over a given time period

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Performance

• Investors relate the performance to some
  benchmark to judge relative performance
• An important issue is expenses funds with low
  MERs provide better returns in the long run
• Mutual fund ratings best known rating system is
  provided by Morningstar

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International Funds

• Some mutual funds specialize in international
  securities
• Canadian investors can participate in emerging
  market economies
• International diversification
• International funds or global funds emphasize
  international stocks
• Single-country funds concentrate assets
• Actively or passively managed

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New Directions in Funds

• Mutual fund supermarkets
• Various mutual fund families can be purchased
  through a single source
• Brokerage account may provide access
• Supermarket managers earn fee
• On-line investment services
• Internet used to provide mutual fund information
  and to make transactions