Mutual Funds, Segregated Fund and Hedge Funds

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Mutual Funds, Segregated Fund and Hedge Funds

• What are they and how do they work?

Business 4179
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Important Chapter Terms

• Fund
• Mutual fund
• Hedge fund
• Pension fund
• RRSP
• RESP
• Wealth management
• Clone fund
• Load fund
• No-load fund

• Bond funds
• Equity funds
• Balanced funds
• RRSP-eligible
• Marked-to-market
• NAVPS
• Open-end mutual fund
• Closed-end mutual fund
• REIT
• MER

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What is a Mutual Fund?

• Is a separate, legally incorporated,
  equity-financed investment vehicle managed by an
  asset manager for the benefit of the equity
  investors.
• Unit holders the equity investors can
  receive, on demand, their proportionate share of
  the value of the funds assets. (except in
  closed-end funds)

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Important Terms

• Mutual fund
• MER (management expense ratio)
• NAVPS (net asset value per share)
• Open-end fund
• Closed-end Fund
• Clone funds

• Marking to Market
• Load fund
• Soft dollars

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Important Terms Defined

• Clone Funds mutual funds that mimic the cash
  flows of a portfolio of foreign stocks using
  foreign equity index futures and domestic bonds.
• NOTE since the removal of the foreign content
  limits on RRSPs and RPPs, clone funds are now
  being wound done here in Canada

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Important Terms Defined

• Marking to Market adjusting asset and balance
  sheet values to reflect current market prices.
• Note most mutual fund NAVPS are marked to
  market at the close of each business day. This
  allows the open-ended funds to sell additional
  units without diluting existing unit holders
  interests.

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Important Terms Defined

• Load Fund a mutual fund with a sales commission
  that has to be paid by the investor upon either
  the purchase or the sale of the fund units.

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Important Terms Defined

• Soft dollars a service seller uses gains from
  an overpriced service to give the service buyers
  investment dealer a free or underpriced service.
• Here, for example, the investment fund manager
  (who is also an investment dealer) uses mutual
  fund revenue to purchase advisory, data, or other
  services in return for the sellers commitment of
  the services to divert a certain volume of
  brokerage transactions to the investment fund
  manager.

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Where can Mutual Funds Be Purchased?

• Mutual funds are sold by most financial
  institutions
• Credit unions (ethical funds)
• Banks
• Insurance Companies
• Investment Companies
• Brokerage Houses
• Trust Companies
• Independent Mutual Fund Dealers
• You can usually set up a regular savings plan
  through your own financial institutionsaving as
  little as 25.00 per month.
• You can invest in mutual funds outside or inside
  your RRSP.

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Who Can Sell Mutual Funds?

• The organization that markets (sells) mutual
  funds must be licensed in the province where it
  offers these products.
• In addition, the person working for the licensed
  organization must also be licensed under either
• MFDA (Mutual Fund Dealers Association)
• IDA (Investment Dealers Association) now IIROC
• In order to qualify for licensing, the individual
  must complete an accredited course of studies,
  have completed a supervised 90 day training
  program and have satisfied the accrediting body
  of their personal integrity through a thorough
  background check. For example
• the MFDA will expect you to have completed the
  Canadian Investment Funds Course through the
  Investment Funds Institute of Canada, or the
  Investment Funds in Canada Course through the
  Institute of Canadian Bankers or the Canadian
  Securities Course through the Canadian Securities
  Institute.

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What is a Mutual Fund?

• A financial organization that accepts funds from
  hundreds, if not, thousands of investors, pools
  these funds and invests them in bonds, stocks,
  real estate, precious metals or other investments.

Mutual Fund
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What is a Mutual Fund?

• It is a pooled investment
• Pooled investments are managed portfolios that
  groups of investors invest in.
• Other examples include pension funds, labour
  sponsored venture capital corporations,
  segregated funds, etc.

Mutual Fund
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What is a Mutual Fund?

• A mutual fund is a financial organization that
  accepts funds from numerous investors, pools
  these funds and invests them in bonds, stocks,
  real estate precious metals and other
  investments. It then issues shares or units to
  investors in proportion to the funds each
  investor contributes.
• Conceptually, it is not a stock or bond, its a
  way of investing.

Mutual Fund
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Legal Structures of Canadian Mutual Funds
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The Mutual Fund Complex

• A series of organizations and individuals
  responsible for the day to day administration of
  the mutual fund, its investment strategies, the
  safe keeping of unit holders contributions and
  investments held by the fund and the selling and
  redemption of fund units.

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Typical Mutual Fund Complex

• Consists of four things
• The mutual fund itself
• The mutual fund manager portfolio advisor
• The custodian
• The distributor

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About The Mutual Fund

• Can be organized in two ways
• As a corporation
• As a unit trust

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Mutual Fund Complex
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The Mutual Fund Complex

• Behind every mutual fund is a series of
  organizations and individuals that are
  responsible for the day-to-day administration of
  the fund, its investment strategies, the
  safekeeping of unitholders contributions and
  investments held by the fund, and the selling and
  redemption of fund units.
• Together, we refer to this series of
  organizations and individuals as a mutual fund
  complex. A typical fund complex consists of
• the fund itself
• the mutual fund manager and portfolio advisor
• the custodian
• the distributor

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The Mutual Fund ComplexThe Fund Organization

• Mutual funds may be organized as either a unit
  trust or as a corporation.
• Some funds may operate in isolation, while others
  are part of a family of funds that includes a
  variety of mutual funds that specialize in
  different financial markets or have different
  investment objectives.
• Corporate Form of Organization
• an incorporated fund is subject to the Canada
  Business Corporations Act or similar provincial
  legislation.
• Certain types of income (e.g. interest income)
  earned by an incorporated fund may be taxable
  first as income to the fund, and then in the
  hands of investors in the fund.

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The Mutual Fund ComplexThe Fund Organization

• Unit Trusts
• is the most common form of open-ended mutual fund
  organization today (largely because of a 1972
  change in tax laws which permitted income earned
  by unit trusts to flow through to investors
  without being taxed in the hands of the trust.)
• organizational structure formed by a declaration
  of trust and is subject to trust laws
• the right to vote on certain matters concerning
  the fund is guaranteed in the legislation under
  which the fund is created, through National
  Policy Statement No. 39
• a trustee or a number of trustees act as the
  governing body.
• Trustees may be individuals or a corporate entity
  that has the power to act as a trustee (such as a
  trust company)
• Trustees are responsible for the supervision of
  the funds operations and adherence to its
  investment policies. They have the power to
  enter into contracts on behalf of the fund for
  any required services.

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The Mutual Fund ComplexThe Fund Manager and
Portfolio Advisor

• Regardless of organizational structure, directors
  and trustees are ultimately responsible for the
  management of a mutual funds investment
  portfolio as well as the day-to-day operations of
  the fund.
• To assist with this latter task, the directors or
  trustees of the fund may enter into a contract
  with a management (investment) company to provide
  management services, rather than hiring staff to
  perform day-to-day administration. A firm that
  provides these services is commonly known as an
  administrative manager. Trustees and managers
  are often the same company.

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The Mutual Fund ComplexThe Custodian

• To protect investors and as a part of internal
  control mechanisms, the administrative and
  custodial functions of mutual funds are kept
  separate.
• The custodian is responsible for the safekeeping
  of all the funds investments.
• National Policy Statement No. 39 requires that a
  mutual funds cash and securities be deposited
  with, and held by, a custodian.
• The custodian must be a Canadian chartered bank,
  a Canadian trust company having shareholders
  equity of not less than 10 million, or in some
  cases a subsidiary of a Canadian Chartered bank
  or trust company that meets prescribed financial
  qualifications.
• The custodian also holds all income earned by the
  fund until it is reinvested or distributed by the
  fund. The custodian makes all payments for the
  funds investments.

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The Mutual Fund ComplexThe Distributor

• The distributor is the sales and marketing arm of
  the mutual fund organization.
• It is responsible for bringing in assets to the
  fund in the form of new fund units.
• Securities laws require each mutual fund to
  designate a principal distributor to assume the
  distribution responsibilities, usually under
  contract with the funds administrative manager.
• In many cases, the administrative manager will
  assume the role of principal distributor, and
  will distribute or arrange for distribution by
  carrying out its distribution responsibilities
  through its employees or by subcontract with one
  or more of the following distribution channels

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The Mutual Fund ComplexThe Distributor

• the following distribution channels
• Proprietary (in-house) selling organizations that
  market only the funds offered by one mutual fund
  group. (eg. Investors Group)
• Mutual fund specialists employed by a mutual fund
  dealer who is not aligned or affiliated with any
  particular fund.
• Stockbrokers employed by investment dealers.
• Employees of financial institutions such as
  banks, trust companies, credit unions, and
  caisses populaires or their securities
  subsidiaries.
• Employees of mutual fund groups that deal
  directly with the public and exclusively market
  their proprietary funds.

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The Mutual Fund ComplexThe Registrar and
Transfer Agent

• This entity carries out two duties
• Registrar the role of the Registrar is to
  safeguard against excess distribution of units or
  shares which would dilute the value of the fund.
  This is particularly important when share or unit
  certificates are reissued. Since issuance of
  share or unit certificates is now the exception
  rather than the rule, the role of the registrar
  is decreasing in importance.
• Transfer Agent maintains the register of owners
  of units or shares of the fund and records all
  transfers of ownership of units. This register
  is constantly changing as investors buy and
  redeem units. The transfer agent may also
  provide dividend distribution services.
• These functions are usually provided by a trust
  company or other third-party service provider.
  In many cases, the same trust company that acts
  as the funds custodian will perform these duties.

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Management Fees

• The costs of managing the fund are borne by the
  fund itself.
• These include
• Bank charges
• Commissions
• Investment analysis costs
• Salary and bonuses for the portfolio manager
• Investors need to be advised of the management
  fees
• Easiest way to compare management expenses is by
  using the management expense ratio (MER)

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MER

• The Management Expense Ratio is reported in
  annual percentage terms.
• For example
• 2.5 or 250 bps (basis points)
• If the fund earned a gross return of 10 and it
  incurred an MER of 2.5, then the net return to
  the unitholder is 7.5
• If the fund earned a gross return of 0 and it
  incurred an MER of 2.5, then the net return to
  the unitholder is -2.5

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Standard Costs - MERs

• Range from .2 to gt 3, depending upon the
  type of fund.
• The lowest MERs are for money market mutual funds
• The highest MERs are typically for balanced
  mutual funds
• Consists of management salaries and
  administrative expenses
• May contain a 12B-1 fee to cover the funds
  advertising expense
• High MERs dont necessarily translate to above
  average returns

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Standard Costs - Loads

• There are no-load fundsbut remember, there will
  still be MER expenses borne by such a fund and
  potentially, back-end feesbe sure to check the
  fine print!
• Front-end load
• Back-end load (often decreasing)
• These loads or fees equate to a sales
  commission paid to the financial intermediary
• They reduce/inhibit the investments liquidity

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NAVPS

• Net asset value per share is the price of the
  mutual fund.
• It is calculated at the end of each business day
  on a unit basis and then reported in the press.
• It is like the share price that you see
  reported for a common stock.

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Advantages of Mutual Funds Over Direct Investment

• Professional Management
• Broad Diversification
• More Reliable Estimates of Risk and Return
• Past Performance Record
• Record Keeping and Safekeeping
• Flexibility of Purchase and Sale
• Automatic Reinvestment Plan

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Disadvantages of Mutual Funds Over Direct
Investment

• Management Fees
• High Cost for Short-term Investment
• Vulnerable to Massive Redemption
• Professional Management is Not Infallible
• Tax Implications

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Mutual Fund Types

• Open-ended vs. Closed-ended
• Vary by Asset Classes, Investment Strategy, etc.
• Examples include Sector, Index, Regional,
  Growth, Balanced, Socially-Responsible

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Recent Trends

• The mutual funds industry enjoyed explosive
  growth as falling interest rates made bank
  deposits less attractive than the returns
  available from mutual funds.
• As the baby boom generation entered its
  high-savings years, demand for long-term
  investment vehicles increased.
• In-house money market mutual funds of banks and
  trust and loan companies offered higher interest
  plus easy transfer to and from bank accounts,
  while bond funds and equity funds offered the
  promise of participating in capital gains.
• Mutual fund aggregate assets (at cost) grew more
  than 11 fold over the 1990s.

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Total Net Assets by Mutual Fund Type
Source Investment Funds Institute of Canada,
December 1999.
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Top 10 Mutual Fund Companies in Canada by Assets
under Management
Source Dominion Bond Research Service, The
Canadian Mutual Fund Industry, February 2000..
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Regulation

• Mutual funds are sold under a variety of laws and
  regulatory agencies.
• As securities distributed by investment dealers
  and financial advisors, they fall under
  provincial securities laws.
• As bank, trust company, credit union, and
  insurance services, they fall under the Bank Act,
  Trust and Loan Companies Act, Insurance Companies
  Act, and/or various provincial statutes and are
  the responsibility of OSFI and the appropriate
  provincial FI regulators.

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IFIC

• The Investment Funds Institute of Canada is the
  national industrial association for both
  manufacturers and distributors of mutual funds.
• IFIC is NOT a SRO it is a trade association
• IFIC has no regulatory role.
• Its primary purposes are to disburse information
  concerning the industry and to reflect the
  industrys concerns to government and the public
  at large. (Advocacy)

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Mutual Fund Dealers Association

• Established in 2000
• MFDA is the SRO for the distribution end of the
  mutual fund industry.
• Mutual funds manufacture is essentially the
  creation of publicly traded securities. This
  activity is already fully covered under
  securities regulation so no additional SRO is
  required for it.

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Standards of Practice

• Standards of practice for mutual fund
  distributors are spelled out by both IFIC and by
  the Canadian Securities Administrators.
• CSA has adopted standardized disclosure in a
  format understandable to the average Canadiana
  simplified prospectus and annual information
  form. (see SEDAR)
• The simplified prospectus sets out in plain
  language the purpose and management of the fund.
• The annual information form gives such important
  information as appropriate benchmarks of fund
  performance (ie. the management expense ratio)

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Regulatory Violations

• The explosive growth of the mutual funds industry
  in the mixed regulatory environment has created
  opportunities for abuse
• Violation of best execution obligation. Here in
  the investment fund manager channels brokerage
  services through an affiliated investment dealer
  that charges higher commissions than competitors.
• Soft dollar arrangements. Here the investment
  fund manager uses mutual fund revenue to purchase
  advisory, data or other services in return for
  the sellers commitment of the services to divert
  a certain volume of brokerage transactions to the
  investment fund manager.
• In both cases, the investment funds manager is
  breaking her fiduciary obligation to act
  exclusively in the unit holders best interest.

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Market Timing and Mutual Funds

• Involves short-term trading of mutual funds that
  seeks to take advantage of short-term
  discrepancies between the price of a mutual
  funds shares and out-of-date values on the
  securities in the funds portfolio.
• See page 132 of your text and Table 5-11 that
  addresses mutual fund investigations in the early
  2000s in the U.S.
• A number of mutual funds came under investigation
  in Canada and were found guilty of
  permitting/aiding market timing practicesthis
  included Investors Group, C.I. Funds

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The Investment Advisor

• The investor is confronted with a myriad of
  choices among stocks, bonds and derivatives.
• Mutual fund companies continually add to the
  number of bewildering choices available to the
  retail investor.
• To meet the personal financial planning needs of
  savers, financial institutions now employ
  financial advisor (financial consultants) etc.
• Abuses are common, so responsible financial
  planners have tried to raise their professional
  standards and public awareness of their service.
• Professional organizations (for example,
  Financial Planners Standards Council of Canada)
  have created professional designations such as
  CFP (Certified Financial Planner)in order to
  improve education and training.
• The CSA has decided that the title planner in
  the context of financial planner or mutual
  funds planner and insurance planner become a
  restricted title that will require accreditation
  before a salesperson can use it.

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Fund Links

• Talvest Mutual Funds
• CI Funds
• Investors Group
• Franklin Templeton Investments
• Morningstar an organization dedicated to
  following and reporting on mutual fund
  performance
• Please note these are just samples of
  organizations there are thousand of others like
  these organizations.

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Segregated Funds

• Segregated funds are often viewed as mutual
  fundshowever, they do have special features that
  distinguish them from a common mutual fund.
• Nevertheless they are pooled investments offered
  by Insurance companies.

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Segregated Funds

• Segregated Funds are an insurance product,
  combining a mutual fund-like investment with the
  protection of an insurance policy. As with mutual
  funds, an investor's money is pooled with the
  contributions of other investors to purchase a
  portfolio of securities. The value of the units
  purchased is based on the value of the underlying
  securities and will change in response to market
  conditions.
• Segregated funds are the investment portion of
  variable life insurance policies as such they
  usually guarantee return of principle if held for
  a given period of time and are also
  creditor-proof.

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Hedge Funds

• Take note of the differences between hedge funds
  and mutual funds
• That hedge funds are often organized as limited
  partnershipsand are structured such that they
  lay outside of normal regulatory boundaries (499
  limited partners, must have annual incomes of
  over 200,000 and net worth exceeding 1,000,000
  and must invest a sizeable amount of money)
  this classifies them as sophisticated investors
  who dont require regulatory over site.
• Over 7,000 hedge funds involve over 860 billion
  at year-end 2003.
• Of course, the LTCM debacle has affected the
  industry in many different ways.
• Hedge funds have become important to Canadian
  investors during times of poor stock market
  performance and when interest rates and inflation
  remain low.