Oliver Continuing Education Series. Understanding Mutual Funds. Continuing Education Module

Transcription

1 Oliver Continuing Education Series Understanding Mutual Funds Continuing Education Module

2 Copyright 2004 Oliver Publishing Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without the prior written permission of Oliver Publishing. First Printing, April 2004 ISBN Published by: Oliver Publishing 151 Bloor Street West, Suite 800 Toronto, Canada M5S 1S4 Tel: (416) Fax :(416) Toll Free info@oliverslearning.com Printed and bound in Canada

3 TABLE OF CONTENTS An Overview of Mutual Funds 1 The Service Bundle Offered by Mutual Funds 3 The Structure of a Mutual Fund 7 Why Mutual Funds are Different 10 Types of Mutual Funds and Their Investment Objectives 12 Selecting a Mutual Fund 29 Performance Indicators 34 Buying-In and Cashing Out 38 Investment Products That Compete with Mutual Funds 49 The Regulation of Mutual Funds 55 Mutual Funds and Taxes 61

4 AN OVERVIEW OF MUTUAL FUNDS A mutual fund is an open-ended investment fund. This means that units are continuously sold from the fund and redeemed upon demand (i.e. the fund buys them back). This positions an investment in mutual funds as being very liquid. The money that an individual invests in a mutual fund is pooled with the money of other investors who have similar objectives and it is used by the professionals who manage the fund to purchase a variety of investments for the fund's portfolio. This portfolio may change in either its composition (if a equity fund, the companies held) or weighting (number of shares of the companies) without the knowledge of individual investors. However, information on the holdings of a fund can be acquired at any time. Thus, an individual investor acquires a portfolio and achieves diversification of his or her investment. Access to a portfolio and professional management of the portfolio is a major benefit for most individuals; in general, they would likely not have the capital or the investment knowledge to purchase such a portfolio of securities on their own. In addition, a portfolio of securities represents a significant reduction in risk compared to investing in one or a small number of securities. The type of investments held by the fund depend on the fund s investment objectives. For instance, a high tech fund acquires shares of companies in the high tech sector. Some mutual funds concentrate their investments in one geographic area; others specialize in companies of a certain size or securities of one industry or related industries, while other funds do not have any restrictions. 1

5 The mutual fund s capital is invested in either equity or debt securities. Equity securities are either common or preferred shares. Debt securities are classified as either short-term debt (e.g. cash, treasury bills, or other money market instruments) or long-term debt (e.g. long-term government or corporate bonds). The fund is the legal owner of the securities, not the individual investor. Mutual funds can be structured as trusts or corporations. Mutual funds that are structured as trusts issue units of the fund to the individual investors, those that are corporations issue shares. The majority of mutual funds are trusts. Unitholders may or may not have voting rights in the fund, but most do; if so, they will have the right to vote on material issues such as changes to the fund s investment objectives or a change in the primary advisor or auditor. Currently, in many mutual fund families (mutual funds offered by the same mutual fund company), there are funds that offer multiple series of units. Each series has the same investment objective and is generally afforded the same rights as all other series. However, these series may have different management fee structures. Since units of mutual funds are bought from and sold to the funds themselves (rather than on an exchange), the capital of the funds is constantly changing. Because funds are continuously selling new units to the public, they are said to be in a state of "continuous primary distribution". The unitholders of the fund have the continuing right to withdraw their investment by submitting their units to the fund, itself; this right is called "the right of redemption". The fund pledges to purchase these units at any time at the Net Asset Value (NAV) at the time of the redemption. 2

6 THE SERVICE BUNDLE OFFERED BY MUTUAL FUNDS When an investor buys a unit of a mutual fund, he or she is actually buying a bundle of services that are also provided by the fund, the cost of which is reflected in the management fees that are charged by the fund. These services are also benefits of owing mutual funds. The services that are provided include: Professional portfolio management - The investments that are held in each mutual fund portfolio are selected and managed by investment professionals known as "portfolio managers". - Portfolio managers research companies in which they invest, and their expertise is highly valued. - The success of a mutual fund is based partly on the skill of the fund's portfolio manager. A diversified portfolio - Diversification is the spreading of the investment capital among many different industries, companies and types of securities so as to reduce the risk of losses that can result from an investment in any one (or a few) securities (i.e. the concept of reducing risk by not having "all eggs in one basket"). 3

7 - Since mutual funds hold a portfolio of securities, when an individual invests in a mutual fund, he or she is automatically receiving the benefit of diversification due to the portfolio of securities that is held by the fund. The ability to purchase units in the diversified portfolio with a relatively low investment cost - Mutual funds provide easy access to a variety of investments at a lower cost than might otherwise be available. By choosing a mutual fund, the individual is able to invest in a portfolio of stocks without paying fees for each individual transaction. Pooling funds enables investors to share these costs with other investors. - Also, mutual fund investment can be made in a lump sum or with regular contributions in some cases, as low as $25 per contribution. Having the benefit of a diversified portfolio without paying high per share commissions - Investing in a mutual fund provides the investor with the benefit of owning a proportionate share of a diversified portfolio without having to invest the capital that is necessary to purchase the securities outright and pay the respective brokerage commissions. Automatic record-keeping for the investor (e.g. quarterly statements summarizing all transactions) - The fund keeps the necessary records with respect to the securities held in the investment portfolio, informs investors about the status 4

8 of their investments, sends the necessary tax documents to investors, and will automatically re-invest interest or dividends owing to each investor in additional shares or units of the fund (for compounding). The ability to transfer units from one fund to another under the same management umbrella, without additional costs - Most funds allow investors to switch from one fund to another fund in the same family of funds (e.g. Trimark family of mutual funds), without a charge. The availability of special purchase and redemption plans - Other special services include automatic investment plans for making regular purchases of shares or units of a fund directly from the investor's bank account, and automatic withdrawal plans for the investor who wishes to systematically receive income from the fund through the regular redemptions. Highly liquid - As most mutual funds are valued daily, an investment in a mutual fund is considered to be highly liquid. Units in the fund may be readily sold and converted into cash by the investor. 5

9 Access to markets - Mutual funds enable an investor to invest in global markets. With as little as $500 as an initial lump sum purchase, an investor can participate (via a mutual fund investment) in almost any asset class from around the world. Investment flexibility - Because of the virtually unlimited choice of mutual funds that are available, an investor has vast investment flexibility. 6

10 THE STRUCTURE OF A MUTUAL FUND The structure of a mutual fund includes: - the investment company - the investment portfolio manager - the custodian/transfer agent - the fund - the fund distributor The Investment Company The investment company: - manages all of the activities of the mutual funds under its management umbrella (e.g. Invesco Trimark, Investor's Group, Mackenzie Financial, Toronto Dominion Securities Inc.) - receives the management fees from each of the mutual funds that it manages - hires the investment portfolio managers - sells and the redeems units of the fund according to investor requests The Investment Portfolio Manager Working for the investment company, this person is responsible for managing the portfolio. Mutual funds employ professional investment managers, experienced in selecting securities and managing a diversified portfolio. This is a full-time job requiring specialized investment knowledge and skills. This professional manager provides day-to-day supervision of the fund's investment portfolio and observes guidelines specified in the fund's prospectus. 7

11 The manager must have an ability to judge the cash needs of the fund and be able to productively invest and manage the assets of the fund; this ability has a direct bearing on the success of the fund. Fund managers usually receive a management fee for providing these management services. The Custodian/Transfer Agent Canadian securities regulations require that the assets of a mutual fund must be held in trust on behalf of the unitholders of the fund by a Canadian financial institution (e.g. bank or trust company) which serves as "trustee". The trustee is: - responsible for the disbursement and the receipt of funds as well as the safekeeping of all securities in the portfolio - responsible for maintaining records of the ownership of the mutual fund shares or units Custodians collect portfolio income and arrange for dividend disbursements, interest disbursements, portfolio purchases, and share redemptions. The Fund Each mutual fund has a Board of Directors (for a corporation) or a Board of Trustees (for a trust). Board members are nominated by the investment company and must be approved by the unitholders or shareholders. 8

12 Unitholders (or shareholders) have one vote per unit and must approve any fee structure or changes in the fund's investment objectives. The Fund Distributor The fund distributor is the "sales force" for the mutual fund. Regardless of how or where the sales occur, the individual selling funds must be appropriately qualified and licensed. There are five ways in which mutual funds may be distributed: - Direct distribution: The investment company employs its own sales staff; however, these sales people do not generally meet with the clients. - Sales force distribution: Some mutual funds have their own sales force that solicit orders directly from customers. - Self-contained distribution: Banks and trust companies use their own staff to sell mutual funds. - Broker/investment dealer distribution: Most stockbrokers sell mutual funds as well as other types of securities. - Broker-managed fund distribution: Some stockbrokers both manage mutual funds as well as distribute them. 9

13 WHY MUTUAL FUNDS ARE DIFFERENT Consumers have shifted from investing in term deposits and GICs to mutual funds, especially as part of their RRSP investment strategy. More than 60% of consumers buy mutual funds offered through banks and trust companies. The reasons for the significant increase in mutual fund investment include: - consumers are more knowledgeable about investment alternatives - more consumers are saving for retirement than in the past - an investment in mutual funds offers more potential for growth than the low interest rates offered on alternative investments Investing in mutual funds may be riskier than an investment in a traditional deposit product because: - an investment in a mutual funds is not insured - unlike GICs or term deposits, a return on investment for many mutual funds is not guaranteed A risky investment is one that has the potential to change in value with changing market conditions. A risky investment is not necessarily a bad investment. Whether a particular investment is good or bad has more to do with "the fit" between the investment and the customer. 10

14 For a customer who is ready to take the risk, a risky investment can be a good investment and a bad investment for the customer who is not. Because many mutual funds are considered to be somewhat more risky than financial products that have traditionally been offered through banks and trust companies, the role of the financial advisor has changed: - in order to respond to customer demand, the financial advisor must take a more active role in the sale of the mutual funds - he or she must know the features and benefits of the mutual funds that are being offered - the advisor must also know the customer well enough to be able to judge whether or not the investment would likely be "a good fit" for the customer 11

15 TYPES OF MUTUAL FUNDS AND THEIR INVESTMENT OBJECTIVES Money Market Funds These consist of very short-term debt securities (e.g. T-bills and commercial paper), and are considered to be the lowest risk of all mutual funds. Money Market Funds: Investment Objectives The objective of these funds is to earn stable returns through investing in - short-term money market securities including government T-bills - short-term government securities other than T-bills - high quality corporate securities including Commercial Paper and Banker's Acceptance Money Market funds are limited to securities with maturities less than 365 days and with the average maturity of the fund no longer than 90 days. Because of their short-term maturities, Money Market funds have a low sensitivity to changes in market interest rates, however a change in interest rates will correspond with some increase or decease in the interest income paid by the fund. This can be a disadvantage to an investor if interest rates are expected to decline since the portfolio manager is not able to lengthen the average maturity of the portfolio to more than 90 days so as to generate a better return for the fund. 12

16 Money Market funds are considered to have low volatility and therefore, are very low risk, including a small amount of default risk. However, there are two important differences between Money Market funds and traditional Money Market securities: - investments in Money Market funds are not insured - yield may fluctuate with changes in short-term interest rates Safety of principal and liquidity are the two major investment objectives for investors considering an investment in a Money Market fund. The Returns on Money Market Funds Returns on Money Market funds have historically been stable. The average return tends to be somewhat lower than the average return on T-bills due to the management fees that are charged by the portfolio manager. Money Market funds distribute the interest earned on the portfolio to its investors on a monthly basis. These returns are taxed as interest income. Money Market funds assume that the net asset value per unit is constant at $10 and report the yield for the respective fund. The current yield and the effective yield are reported in the financial newspapers and are calculated as of the end of the previous business day and reported next day. - Current yield: calculated as the most recent seven-day average return for the fund, adjusted to an annual rate. Current yield is also calculated as the income divided by the purchase price or current market price. 13

17 - Effective yield: assumes that the yield generated for the last seven days will remain constant for one year into the future, and that the daily returns earned on the fund are reinvested in the fund. Therefore, daily compounding of returns at the current rate is assumed in the effective yield calculation. Effective yield will always be higher than the current yield for the same fund. Mortgage Funds Mortgage mutual funds are riskier than Money Market funds; they are more volatile and, have more default risk. The net asset value per unit of the fund is based on the value of the portfolio of mortgages assuming that the portfolio would be sold as of the day of the evaluation. This means that if mortgage rates are increasing, the net asset value of the portfolio will decline, and vice versa. Mortgage Funds: Investment Objectives The investment objective of Mortgage funds is to earn income from investing in a diversified portfolio of mortgages, while preserving capital. This means that Mortgage funds are considered to be a "fixed income" mutual fund (the same as a Bond fund and a Preferred Dividend fund). Because the net asset value of a Mortgage fund can change, there is an opportunity for an investor to earn capital gains on an investment in this type of fund. Unlike a Money Market fund, Mortgage funds can also generate capital gains. The type of mortgages that are typically held in a Mortgage fund can vary between funds, and therefore, the level of risk can vary as well. 14

18 Many Mortgage funds invest in mortgages that are insured under The National Housing Act (NHA). Some Mortgage funds restrict investment to residential first mortgages; other funds invest in commercial and industrial mortgages. Two types of risk associated with Mortgage funds are: - Default risk: is low for virtually all Mortgage funds because the portfolio of mortgages is highly diversified and most Mortgage funds invest in residential mortgages that are either NHA-insured or privately-insured against default. - Volatility: the volatility of Mortgage funds is directly related to the average term of the mortgage portfolio (e.g., 5 to 7 years). The longer the average term to maturity, the higher the fund's sensitivity to changes in mortgage rates and therefore, the higher the risk associated with volatility. Because Mortgage funds usually have an average term to maturity that is less than Bond funds, they are less volatile. The Returns on Mortgage Mutual Funds Because Mortgage funds are less risky than Bond funds, they tend to earn a lower return but a higher return than Money Market funds. The return on Mortgage funds are made up of two components: - interest: distributed quarterly and often monthly - capital gains: distributed annually. Reading the Tables for Mortgage Mutual Funds in the Financial Press "VAL" means the computed net asset value per unit as of the last valuation date. 15

19 If there is no date given after the word mortgage, then the Mortgage fund is valued daily. "NRD" means: N for "no load"; R for "qualified as an investment in an RRSP or RRIF"; D for "distribution by the fund sponsor". If a small "x" is listed at month-end or quarter-end (e.g., "xmortgage") this means that the fund has just paid a dividend to unitholders and the unit value will show a substantial decline representing the transfer of the money from the portfolio to the unitholders, as either interest or dividends. Bond Funds Bond funds are generally considered to be less risky than Balanced funds and more risky than Mortgage funds. The risk characteristics of a Bond fund depend entirely on the make-up of its portfolio. Interest Rate Risk and the Concept of Duration Bond funds (and other fixed income funds) are affected by interest rate risk. As interest rates increase, the market price of bonds will fall, and vice versa. Therefore, the net asset value of Bond funds will fall as well. Bonds with a long term to maturity are more sensitive to changes in interest rates than those with a shorter term to maturity. This means that portfolios of bonds that have longer terms to maturity are more sensitive to changes in interest rates than portfolios of bonds that have shorter terms to maturity. Bonds that have lower coupon rates also tend to be more sensitive to interest rate changes than those with higher coupon rates. 16

20 The concept of "duration" helps an investor determine which bonds (or a portfolio of bonds) will be more sensitive to a change in interest rates, without having to examine all of the features of the respective bonds in the portfolio. Duration is very closely related to "term to maturity"; however, the duration is always less than the term to maturity except for zero coupon bonds for which the duration is equal to the term to maturity. Duration is sometimes referred to as a bond's "time weighted maturity". If portfolio managers expect interest rates to fall, they will increase the duration of a bond portfolio. This makes the portfolio more sensitive to the decrease in interest rates so that the portfolio will generate capital gains. Increasing the duration of a bond portfolio is done by selling bonds that have shorter durations and replacing them with bonds with longer durations. This means that the duration of the portfolio of a Bond fund is the weighted average of the duration of each of the individual bonds held in the portfolio. The Investment Objectives of Bond Funds The objective of Bond funds is: - to provide current income - to preserve capital - to have the potential to generate some capital gains Conservative Bond funds emphasize current income and preservation of capital; aggressive Bond funds emphasize capital gains. In order to provide potential for capital gains, the portfolio manager will invest in bonds with a longer duration when interest rates are expected to fall. 17

21 Although Bond funds are considered to be a stable investment, this is not always the case especially in a market with fluctuating interest rates. Also, a portfolio manager may choose to invest in a selection of bonds that vary from the perspective of risk; because one Bond fund is riskier than another does not mean that the realized returns of the riskier fund will be higher. Other Fixed Income Funds In addition to the Mortgage fund and Bond fund, two other fixed income funds are: Short-Term Bond Funds Preferred Dividend Funds The Investment Objectives of Short-Term Bond Funds A Short-Term Bond fund is part Money Market fund and part Bond fund. The investment objectives restrict the portfolio of a Short-Term Bond fund to maturities of less than five years. The investment objective of this type of fund is to preserve capital and at the same time generate better income than is likely from a Money Market fund. This type of fund offers very limited potential for capital gains. The Investment Objectives of Preferred Dividend Funds The objective of these funds is to earn dividend income and preserve capital. However, with these funds there is limited potential for capital gains. The portfolio of these funds is made up of preferred shares that have the highest quality ratings and the most stable dividends. 18

22 A Preferred Dividend fund need not only hold preferred shares in the portfolio; common shares of some firms also pay very regular dividends. However, when the shares of the fund are mainly common shares, the fund is referred to as a "Dividend Fund" rather than a "Preferred Dividend Fund". Two reasons why investors would invest in a Preferred Dividend fund rather than a Bond fund are: - dividends are paid by securities that have a higher risk profile than bonds and therefore, higher returns can be expected - dividend income from Canadian sources is taxed at a lower rate than interest income Balanced Funds Balanced mutual funds are also called Asset Allocation Funds. These funds are part Fixed Income fund, holding some debt securities in the portfolios, and part Equity fund with an equity component. The Investment Objectives of Balanced Mutual Funds The objective of these funds is to earn income and capital gains while at the same time preserving capital. 19

23 Portfolio managers shift the fixed income and equity portions in keeping with changes in market conditions. When interest rates have peaked, the managers want the balance to be tipped in favour of fixed income securities and when the stock market is ready to increase, they want to have the largest portion of the portfolio in stocks. If both the bond and stock markets are volatile, the managers will hold a large portion of the portfolio in money market securities. This means that Balanced fund managers attempt to time the market to get the best returns depending on market conditions, without being 100% invested in either fixed income or equity securities. The Return on Balanced Funds The performance of Balanced funds should be the average of the performance of Bond funds and Equity funds. When the bond market is outperforming the stock market, Balanced funds should earn the returns of Bond funds, and vice versa. Balanced funds are considered to be more risky than Bond funds but less risky than Equity funds. Equity Funds Equity funds represent the largest type of mutual fund. The primary objective of Equity funds is long-term capital gains (i.e. growth) and income from dividends. 20

24 Fixed income securities may be purchased in limited quantities for diversification, income and liquidity. Depending on the weighting, the degree of risk and capital gains potential varies from one growth fund to another. The price or Net Asset Value Per Share (NAV) of growth funds fluctuates more widely due to the volatility (i.e. the market prices can change quickly and without warning) of common share prices. Equity mutual funds are allowed to invest in futures contracts and options on stock market indices so as to -e the market values of securities held in their portfolios. However, the futures or options positions may not have an underlying value of more than 10% of the total value of the mutual fund portfolio. Most mutual funds do not permit the fund's portfolio managers to take speculative positions in derivatives, but only to use derivatives as a hedge. In addition to the standard type of Equity mutual fund, there are also "Equity Growth funds and "Equity Index funds. Equity Growth funds that are heavily invested in blue-chip common stock with good income potential are the most conservative of the Growth Funds. Equity Index funds consist of an investment portfolio that parallels a stock market index. Speculative Funds usually seek short-term capital gains, thereby frequently sacrificing broad diversification. Typically, they are heavily invested in high-risk speculative common stocks. 21

25 This more aggressive approach focuses on Canadian and American securities that are more speculative and have the potential for above-average capital gains. Those funds that aggressively seek capital gains thereby sacrificing some safety and income include securities of smaller companies pioneering new developments of industrial, scientific, engineering, and technological changes. The Investment Objectives of Equity Mutual Funds The investment objective of this type of fund is to earn capital gains and for some Equity funds, to also earn some dividend income. Equity mutual funds are one of the riskiest type of mutual fund and suitable only for investors with long investment horizons. The major differences between the Equity mutual fund and the Preferred Dividend fund is that the Equity mutual fund has a much stronger focus on capital gains; also, Equity funds do not typically have an objective of preserving capital. Equity Growth Funds: Investment Objective The investment objective of an Equity Growth fund is capital gains. Growth funds tend to invest in smaller companies that provide the opportunity for substantial capital gains. The share prices of these smaller companies tend to be more volatile. Therefore Equity Growth funds tend to have volatility. 22

26 An aggressive Growth fund will invest exclusively in smaller, highly volatile companies. Sometimes these types of funds are called "Small Cap" funds. More conservative Equity Growth funds will seek out small, growth-oriented firms that are less risky. Equity Index Funds: Investment Objective The investment objective of these funds is capital gains. Since Equity Index funds invest in the stocks of companies that make-up the stock market index, many of the stocks in the portfolio will pay dividends; however, this is not typically an objective of the fund. Index funds are attractive to investors who do not believe that portfolio managers are able to earn better returns than the market as a whole. Because Index funds are simple to construct and manage, lower management fees are charged. Global Funds Global mutual funds can be Bond funds, Equity funds or any type of fund for which the portfolio is made up of securities that have been purchased from various foreign countries. An International fund is a fund that invests in other countries but does not invest in Canada. 23

27 The Investment Objectives of Global Funds The investment objective of a Global fund depends on the class of security held in the portfolio of the fund; the objective of a Global Equity fund is to earn capital gains and the objective of a Global Bond fund is to earn interest income with some capital gains. There are two reasons for investors to be attracted to Global funds: - Other countries may be at a different stage of the economic cycle and therefore, an investment in securities from that country may perform better than an investment in Canadian securities. - An investment in a Global fund can be used as a hedge against a decline in the value of the Canadian dollar. There are two types of risk associated with Global funds: - market risk of the country or countries in which the fund invests - foreign exchange risk However, portfolio managers can use a hedging strategy in the foreign exchange market so as to remove, reduce, or manage the foreign exchange risk associated with a Global fund. The prospectus of the fund will indicate the extent to which the Global fund hedges for foreign exchange risk. Another risk associated with Global funds is the issue of the liquidity and efficiency of the foreign stock markets in which the securities are bought and sold. 24

28 The Returns on Global Equity Funds Global Equity funds are the most common type of Global funds. They earn dividends and capital gains. However, since dividends from foreign companies are not eligible for the dividend tax credit, foreign source dividends are taxed at the same rate as interest income to the investor. Synthetic Global Index Funds These types of funds are RRSP eligible and allow investors to hold more foreign content than the rules permit because they are considered Canadian content investments. When a fund manger wants to replicate the S&P 500 Index, he or she could purchase each of the stocks making up the index according to their appropriate weightings. This fund would still be considered foreign content and subject to the tax deferral rules on the amount allowed. Synthetic Index funds get around this issue. For example, Synthetic Global Index funds consist of Canadian T-Bills and futures contracts on non-canadian stock market indexes. Fund managers can replicate the performance of an index by deciding on the combination of T-Bills and futures contracts needed. Fund managers will also purchase forward contracts on the Canadian dollar to hedge against changes in the value of the dollar. 25

29 Two risks associated with these funds are: - Counterparty risk: the risk that the other party selling the future contract will not honour his or her commitment when the contract is due. The risk is small for futures trading on an exchange because the exchange guarantees the contract. For Over-the-counter (OTC) traded contracts, the risk is greater. - Tracking risk: the risk that the synthetic portfolio will not track the index because the stock market and futures markets are different markets with different participants. This can cause deviations in the pricing between them. Clone Funds Synthetic index funds are "passive" investments and are purchased by investors who do not believe managers have the ability to consistently beat the market. "Active" management is when a manager attempts to beat a market index. Clone funds track the performance of an actively managed foreign fund. The managers purchase Canadian T-Bills and negotiate with Canadian financial institutions for the purchase of forward contracts on the underlying fund (i.e. the fund it is tracking). These funds are 100% RRSP-eligible. 26

30 They are not subject to tracking risk but are subject to counterparty risk. They will earn a little less than the underlying fund due to the cost of purchasing forward contracts. Specialized Funds A Specialized mutual fund restricts the investment objectives of the fund in some particular way (e.g., concentrating in a particular type of security or industry such as Precious Metal funds or Natural Resource funds). The risks associated with specialized funds are consistent with the risks associated with the securities held in the portfolios (e.g. Gold funds will rise and fall with the value of gold). Their risk factor arises from the lack of diversification within the portfolio. An investor who holds a specialized fund may be exposed to unnecessary risk. Real Estate Funds Investing in income-producing commercial real estate is designed to achieve long-term growth and re-investment of income. An investment in this type of fund is considered to be less liquid than most funds. Most Real Estate funds are valued quarterly but may be valued monthly. Some of the revenue in the fund is generated through rental income but the majority is generated through capital gains. 27

31 Ethical Funds Ethical mutual funds focus their investments on companies that fit "ethical principles" that are listed in the fund's prospectus. These funds seek to establish a socially responsible framework for their investments. Items such as industrial relations with staff, little or no income from tobacco corporations and compliance with environmental regulations are examples of some of these ethical principles. 28

32 SELECTING A MUTUAL FUND Investors should select mutual funds that are consistent with their investment objectives, financial situation, personal circumstances and risk tolerance. Asset allocation is the most important decision for an investor (i.e. how much of each class of asset should be held in the investor's portfolio). Asset allocation can be aggressive (e.g. a heavy weighting toward Equity mutual funds), or conservative, (e.g., a heavy weighting toward Money Market funds). The Steps in Selecting a Mutual Fund The steps for selecting mutual funds within each asset class are as follows: - identify those mutual funds with appropriate investment objectives - look for funds with the best long-term performance (e.g., the average annual rate of return for a reasonable period of time; three years is too short; 10 years is considered to be ideal) - look for funds that have consistently been good performers from year to year (e.g. as evidenced by their simple annual rates of return) - look for funds with similar performance, isolate those with lower volatility (from the published volatility rating for mutual funds) - obtain the prospectus of the selected funds and make sure that the objectives of the funds and investment policies are appropriate - examine fees and charges 29

33 - select the fund with the best long-term performance relative to the risk (volatility) Once the performance data has been gathered, the investor should focus on mutual funds that have similar investment objectives. It is a major error to compare the performance of funds that have different investment objectives. Reducing Risk Through Diversification in a Client s Portfolio Although one of the key benefits of investing in a mutual fund is the diversification of the fund s portfolio, an investor can further reduce risk by spreading his or her investments over mutual funds that represent different asset classes. Diversifying into mutual funds that cover a number of industries also reduces risk. Diversification, either within a mutual fund or a client s personal portfolio, does not entirely remove market risk (i.e. the risk of positive or negative movements within the entire market). The Risk/Return Trade-off for Mutual Funds Most investors are concerned with the amount of risk they have to assume for the potential return. Typically, an investor will either seek to maximize the return for a given level of risk, or minimize the risk for a given level of return. 30

34 As risk increases, so should the investor's potential return. Risk is basically nonexistent in money market instruments because they are very short term and most are guaranteed. The short-term return on T-Bills is considered to be "a base return" from which other investments are compared (sometimes called "the risk free rate"). In order to be competitive, other investments must often pay this "risk free rate of return" plus an additional return to compensate for any additional risk (known as a "risk premium"). The risk/return trade-off can influence investors to be either buyers or sellers of mutual funds; most investors have a level of risk that they are willing to accept for a level of expected return. The risk and return of specific mutual funds depends on the securities held in the fund's portfolio. HIGHER Specialty Funds Real Estate Funds RETURN Equity Funds Dividend Funds Bond Funds Balanced Funds LOWER Mortgage Funds Money Market Funds LOWER RISK HIGHER 31

35 The value of most mutual funds changes daily in response to changes in the value of the securities in which they invest. This means that an investor can lose money through investing in a mutual fund and, the greater the potential for return, the greater the risk of losing money. Risk is defined as the volatility of the return that can be earned by an investor. The risk to a mutual fund can be the result of the interplay of a number of risk factors. Market risk means that the value of a security held in a mutual fund portfolio is subject to the risks that affect the entire market. Growth funds have market risk. Most mutual funds, except money market/t-bill funds have some amount of market risk. Fixed income funds have interest rate risk; this means that the value of the fund is dependent on interest rates (i.e. as interest rates rise, the value of these funds can be expected to fall, and vice versa). Balanced funds also have interest rate risk (because of the fixed income securities held in the portfolio), and they also have market risk (because of the stocks held). Exchange rate risk applies to US and other international funds. The risk is that the value of the Canadian dollar $ will fluctuate vis-a-vis the value of the currency in which the foreign securities held in the funds are denominated. 32

36 All risks with the exception of business risk, default risk and exchange risk can be reduced or eliminated through diversification; these risks are called non-systematic or diversifiable risks. All risks beyond the control of the fund manager are called systematic or nondiversifiable risks. 33

37 PERFORMANCE INDICATORS Volatility Ratings Volatility is the tendency of a fund to vary often or widely in price. Volatility ratings are based on the most recent three years of data for each fund. The volatility rating provides the same comparative data as comparing the simple rates of return for the past three years. If funds that are being compared have the same long-term compounded rate of return, the fund with the lower volatility should be chosen. The "reward to risk ratio" is the return earned by a fund over a period of time, divided by the standard deviation. Reward to risk ratio = fund's return fund's standard deviation. The "Sharpe measure" (of risk to reward ratio) = fund's return - T-bill rate fund's standard deviation The reward to risk ratio and the Sharpe measure provide an indication of how successful the fund has been in term of volatility. Simple Rates of Return A simple rate of return is a return earned by the fund over a one-year period. 34

38 Comparing the simple rate of return between comparative funds is a very useful way of determining the consistency of the return; the fund with less variation from year to year is a more consistent performer. The formula for calculating a one year simple rate of return is: ending value beginning value + any distributions received x 100 = % beginning value For example: a fund had a value of $8.50 at the beginning of the year and a value of $9.25 at year-end. The fund also paid out a $.10 distribution per unit. The simple rate of return for the year would be: x 100 = 10% 8.50 The consistency of performance is very important; even though Equity funds are bought for the long term, if liquidity is needed, the fund with the most consistent performance is less likely to be sold at a loss. Compound Rates of Return Published compound rates of return for comparative funds should be reviewed over the period of time that the fund has been in existence. The compound rate of return is based on the reinvestment of all dividends (dividends distributed by the fund as well as capital gain dividends), and is calculated after all management fees and expenses have been paid by the fund. It does not include the individual sales charges that an investor may have to pay. 35

39 A fund with a ten-year performance has been through at least one complete market cycle and perhaps two. If an Equity fund does not have performance data for a three-year period, it is very hard to determine how the fund might perform over the longer term. The Size of the Mutual Fund One theory holds that, as mutual funds grow beyond a certain size, the economies of scale that have been beneficial to the fund begin to decrease. Very large mutual funds tend to be at a disadvantage compared to smaller funds because they cannot shift their large portfolios as rapidly because sales of their securities can have an impact on the overall market price. The Hazards of Switching from Fund to Fund Rarely is one fund a top performer every year; however, if the long-term performance of the fund is disappointing or the investment objectives of the fund or the investor have changed, then fund switching may appropriate. In most cases, fund switching should be actively discouraged; it can be expensive to the investor because of the switching fees or sales charges that may be charged for switching (i.e. either buying or selling) plus there is no assurance that another fund will perform as well as the original one in an up-coming year. Switching funds in a non-registered account may also trigger capital gains, which are taxable in the year of the switch. 36

40 Unnecessary switching should be discouraged because mutual funds are not vehicles for catching short-term market swings; each is geared for long-term investment and therefore, can best be evaluated over the longer term. The portfolio approach is aimed at building a portfolio to achieve long-term objectives. If the investor has shorter-term goals, investments other than mutual funds should be selected to achieve these goals. 37

41 BUYING-IN AND CASHING OUT Acquisition and Withdrawal Plans Two types of acquisition plans are: voluntary and contractual. Voluntary (or Pre-Authorized Investment) Plans A voluntary acquisition plan is the most popular type. It allows investors to specify the amount and the timing of the regular investments that they are willing to make. The plan may be cancelled at any time: sometimes a small termination fee may apply. Investments may be made monthly, quarterly, semi-annually or annually. Contractual Plans Few investors choose a contractual plan. This plan commits an investor commits to purchase a certain dollar value of units over an extended period of time. Contractual plans are usually used for mutual funds that charge acquisition fees so that an investor may commit him or herself to investments in the mutual fund, thereby reducing the sales commissions that would normally have to be paid. 38

42 Contractual plans tend to charge the acquisition fees over the first year of the plan; these fees are limited to a maximum of 12% of the total investment in the plan. National Policy 39 allows investors to withdraw from a contractual plan within sixty days after having entered into the contract and to receive a reimbursement of all sales charges as well as any purchases made during that period. If the investor withdraws from a contractual plan after sixty days but within one year after the plan goes into effect, the investor will be able to get back any sales charges in excess of 30% of the total sales charges paid, plus the net asset value of the investment, as at the next valuation date. Contractual plans allow investors these options: - partial withdrawal privileges - investors are allowed to redeem a percent (e.g., 90%) of the plan and then later repurchase that amount without having to repay the acquisition fee - investors are allowed to temporarily suspend payments - they are allowed an accelerated or reduced payment schedule - some plans sell the investor life insurance, so that in the event of death, plan payments will still be made Dollar Cost Averaging By investing regular dollar amounts over a period of time, the average cost of the investment over the long run tends to be lower. This is the essence of dollar cost averaging. 39

43 The benefits of dollar cost averaging include: - removes the need for investors to accurately time the market - tends to lower the average cost of the investment over the long run - allows the investor to invest on a regular basis and thereby not miss out on positive market swings - forces the investor to make the investment rather than waiting until the time when the funds may not be available Systematic Withdrawal Plans A systematic withdrawal plan allows a shareholder to withdraw all or part of the capital that he or she put into the fund, plus dividends or interest that was re-invested over a period of time. The purpose of this type of plan is to: - provide the shareholder with the opportunity to earn a higher return on the funds invested than if he or she invested the money in an interest-bearing security, and - provide the shareholder with access to the money when such access becomes necessary. In order for an investor to set up a systematic withdrawal plan, there often is a requirement for the investor to have a minimum amount invested in the fund. Withdrawal arrangements vary from monthly, quarterly, semi-annually and annually. There may be an administration charge for setting up the plan and there may also be a fee for each withdrawal. 40

44 The five types of systematic withdrawal plans are: 1. Fixed (or Constant) Dollar Withdrawal: investors have the option of receiving a fixed amount of money through the redemption of units of a mutual fund, on a regular basis. The investor decides exactly how much money is to be paid out. If the payout is larger than the combination of income and capital gains earned by the fund, part of the payout will reduce the investor's initial capital. Fixed dollar withdrawal plans are most suitable for investors who look to their mutual funds investment for most of their income. 2. Ratio Withdrawal: the investor receives a fixed percentage of the fund value on a regular basis. The ratio is always based on the current portfolio value. These plans are most suitable for investors looking to supplement income from other sources; this plan will not result in a constant dollar amount being paid out each time a payment is made. 3. Fixed-Period Withdrawal: the investor receives payouts over a fixed period and then the mutual fund is completely paid out. This plan is most suitable for those who are saving for something that requires funding over a known period of time. 4. Life Withdrawal: the period selected is the expected remaining life span of the individual. 5. Annuities: are offered through an insurance company. The insurance company makes regular payments to the individual over a guaranteed term. Most annuity payments are fixed, however, there is one type that is variable. 41

45 Calculating the Purchase and Redemption Price of Mutual Fund Units Units are purchased and redeemed at the Net Asset Value Per Share (NAV) of the fund, less any sales charges that are applicable. The Net Asset Value Per Share is also called the Liquidation or Break-up Value of the fund. The NAV is calculated as: the total assets in the fund (the market value of the portfolio of the fund) less total liabilities (owed by the fund) divided by the total number of shares or units of the fund that are outstanding. The NAV used for either the purchase or redemption is the next NAV calculation that immediately follows the request. Calculating the NAV is known as the "forward pricing policy". For equity-based mutual funds, the actual calculation is done daily when the Toronto Stock Exchange closes at 4:00 pm Eastern time. If the NAV of a particular fund is valued less frequently, it is usually redeemed at the next valuation date after the request is received. Typically, the NAV is calculated daily, weekly, and monthly, except for some Real Estate funds that are calculated quarterly or annually. Provincial law requires that the NAV be calculated at least once a week, unless the shareholders approve that it be calculated less frequently. The calculation of the market value of the fund's portfolio is based on the closing sale price of the securities in the portfolio on the day that the calculation is being made, if the securities traded that day. 42

46 Mutual Fund Sales Charges There are sales charges to buy into mutual funds that are either incurred on purchase (acquisition or front-end load) or on redemption (back-end load). Acquisition Fees (Front-End Load) The front-end load is a sales charge based on the dollar value invested in the mutual fund and is payable at the time the units in the fund are acquired. The amount of the charge is usually negotiable depending on the size of the investment. Acquisition fees or front-end load fees are charged by many mutual funds but not those funds that are available through the banks or trust companies. The charge compensates the investment advisor for the advice he or she provides. If the sales charge is levied when the shares or units are purchased, an additional sales charge is normally not levied for the redemption of the units. Front-end sales charges range between 0% to 9%, but can be a high as 12%. Usually the charge can be negotiated with the investment advisor. National Policy 39 requires that all front-end load fees must be stated both as a percentage of the total amount paid by the investor, including the front-end load fee, and as a percentage of the net amount paid, excluding the front-end load fee. 43