Unit 6: Non-insurance Investment Products

Transcription

1 Unit 6: Non-insurance Investment Products Welcome to Non-insurance Investment Products. In this unit, you will learn about the non-insurance investment products available and the financial institutions that offer them. As an insurance agent, you need to be familiar with these products so you can advise your clients about how insurance and insurance products can complement and enhance their existing financial situation. Note: While you need to have an understanding of the content in this unit, you must remember that being licensed as a life agent does NOT qualify you to sell non-insurance products. You must be registered with a provincial or territorial securities regulator to sell mutual funds, stocks, bonds, and other financial securities. Moreover you should be aware that without such registration you are prohibited from advising a client on a specific security. This unit takes about 4 hours to complete, and it consists of the following lessons: Guaranteed and Fixed Income Investments Equities Mutual Funds Evaluating Investments Calculating Investment Returns To start with the first lesson, click Guaranteed and Fixed Income Investments on the table of contents. Lesson 1: Guaranteed and Fixed Income Investments Welcome to Guaranteed and Fixed Income Investments. In this lesson, you will learn about various types of financial institutions and the types of investment products they make available. You will also learn about the benefits and limitations of guaranteed and fixed income investment products, particularly guaranteed investment certificates (GICs), index-linked GICs, Canada Savings Bonds (CSBs), Treasury bills (T-bills), and government and corporate bonds. This lesson takes about 50 minutes to complete. At the end of this lesson, you will be able to: list the major types of financial institutions list the types of investment products available from insurance companies and other financial institutions define the term guaranteed, in the context of guaranteed and fixed income investments, including guarantee of investment capital and guarantee of income define guaranteed investment certificates (GICs), identify the institutions that issue them, and describe their benefits and limitations define index-linked GICs, identify the institutions that issue them, and describe their benefits and limitations define the major types of fixed income investments, including bonds, debentures, Canada Savings Bonds, and Treasury bills describe the features, benefits and sources of Treasury bills, Canada Savings Bonds, federal government bonds, provincial government bonds, municipal government bonds, and corporate bonds Financial Institutions Individuals, organizations, businesses, and governments are either savers or borrowers. Financial markets channel money from those with surplus money to those with a shortage of money, and they facilitate the timing of purchases through lending and borrowing. Financial markets also provide a means by which our governments can implement monetary policies IFSE Institute 1

2 Unit 6: Non-insurance Investment Products Our financial institutions are critical to the flow of money between savers and borrowers, and to the operation of our financial markets. Canada's financial institutions include: the Bank of Canada chartered banks near banks (including credit unions and caisses populaires, trust companies, and finance companies) investment dealers and mutual fund companies life insurance companies property and casualty insurance companies However, sometimes the line between these financial institutions begins to blur, as we have chartered banks owning trust companies, or having a subsidiary brokerage arm. We discuss each of these in the following pages. Bank of Canada The Bank of Canada is Canada's central bank and is owned by the federal government. It is also the bank used by Canada's chartered banks. The Bank of Canada issues and distributes currency to these financial institutions. It also manages Canada's international currency and gold reserves. The government uses the Bank of Canada to implement its monetary policy, to control the value of the Canadian dollar and interest rates. The Bank of Canada does this primarily by buying and selling treasury bills (T-bills), and by changing the interest rate that it charges the chartered banks. Chartered Banks Chartered banks are publicly owned financial corporations. These banks have two primary functions: to accept deposits from the public (for deposit into savings accounts, term deposits and guaranteed investment certificates) to provide loans to the individuals and businesses They are registered under and regulated by the Bank Act, and they are monitored on an ongoing basis by the Office of the Superintendent of Financial Institutions (OSFI). The Bank Act divides chartered banks into Schedule I banks and Schedule II banks. Schedule I banks are the well-known big Canadian banks, including Royal Bank of Canada, Bank of Montreal, Toronto-Dominion Bank, Scotia Bank, National Bank, and Canadian Imperial Bank of Commerce. The Bank Act requires that the shares of Schedule I banks be widely held (no more than 10% by any one shareholder) and Canadian owned (no more than 25% may be owned by foreigners). Schedule II banks are usually wholly-owned subsidiaries of foreign banks, such as HSBC Bank Canada. The Bank Act places a number of restrictions on Schedule II banks, such as the number of branches that can be open in Canada. Near Banks Near banks provide many of the same services and products as chartered banks, including accepting deposits and offering loans, but they operate under a mix of provincial and federal laws. They cannot use the word "bank" in their names. Near banks include: trust companies credit unions and caisses populaires mortgage loan companies provincial savings offices IFSE Institute

3 Trust companies Trust companies accept deposits and make loans, but unlike banks, they are also allowed to offer executor and trustee services. They may be registered and regulated either federally or provincially. Many of the largest trust companies have been purchased by chartered banks during the last two decades. Credit unions and caisses populaires Credit unions (called caisses populaires in French-speaking jurisdictions) are financial institutions that are owned by their members. They provide traditional deposit and loan services to their members. Mortgage loan companies Mortgage loan companies take deposits from their members and then make mortgage loans that are secured by real estate. They are federally regulated, and many of them are affiliated with chartered banks or trust companies. Provincial savings offices Alberta is the only province that has its own provincial financial institution, the Alberta Treasury Branch (ATB). The ATB provides the same products and services as a chartered bank, but it is regulated by the Alberta government. Investment Fund Dealers and Mutual Funds Investment dealers Investment dealers provide securities underwriting services to corporate and government clients, helping them structure and issue new shares or bonds. They also sell investments to the public, and through margin accounts, they provide a way for investors to leverage their capital. Today most large brokerage firms are owned by chartered banks, and several large foreign firms have set up Canadian subsidiaries. Investment dealers are governed by provincial securities regulators, and by the Investment Industry Regulatory Organization of Canada (IIROC), a national self-regulatory organization (SRO). Mutual fund dealers A mutual fund dealer is defined as a dealer that is only permitted to trade in securities of: mutual funds, and investment funds that are labour-sponsored investment fund corporations or laboursponsored venture capital corporations under provincial legislation In Québec, a mutual fund dealer may not trade in labour-sponsored funds. In British Columbia, a mutual fund dealer may also trade in securities of scholarship plans, educational plans or educational trusts. In addition to registration with the securities commissions, mutual fund dealers are required, except in Québec, to be members of the Mutual Fund Dealers Association (MFDA). In Québec, mutual fund dealers are under the direct supervision of the AMF, the local securities regulator IFSE Institute 3

4 Unit 6: Non-insurance Investment Products Mutual fund companies Mutual funds are essentially large pools of money that have been contributed by individual investors and that are managed by a professional money manager. Mutual funds can be organized as either trusts or corporations. They can be structured to accept regular deposits during the accumulation phase, and to make regular payouts during the distribution phase. We will discuss mutual funds in more detail later in this unit. Insurance Companies Life insurance companies Life insurance companies in Canada now represent some of the country's largest financial institutions, holding large amounts of individual, group, and pension fund savings. The insurance companies in turn reinvest these savings in long-term bonds or mortgages that help finance major capital projects, such as railways, utilities, or commercial and residential real estate. The long-term nature of these investments help secure the liabilities associated with paying out death benefits well into the future. The regulation of life insurance companies was discussed in Unit 1 of this course. Property and casualty insurance companies Property and casualty (P&C) insurance companies provide much needed insurance coverage for our homes, cars, businesses and personal liabilities. However, the relatively short-term nature of these insurance contracts (usually one year) means that these insurance companies do not need to accumulate the large pools of capital generated by life insurance companies. So, P&C insurance companies are not as significant in terms of being a financial intermediary as the other financial institutions we have discussed in this unit. Exercise: Financial Institutions What is a Guaranteed Investment? A guaranteed investment offers the investor a guaranteed return of investment capital and/or a guaranteed level of investment income. Capital guarantee A capital guarantee assures the client that at some particular date in the future, the minimum amount that he or she will receive is the principal amount he or she invested. For most investments, the guarantee is only valid on or after the maturity date, and the return of principal is not guaranteed prior to that time. Claude bought a 5-year $10,000, 5% compound GIC from his bank. This investment has a capital guarantee, so Claude can be sure that as long as he waits until the end of the 5-year term, he will receive his $10,000 back. However, if he tries to cash it in earlier, there will likely be a penalty. A few investments, such as Canada Savings Bonds, provide a full capital guarantee for redemptions at any time. Income guarantee Investments that offer a guaranteed income or rate of return give the client the security of knowing exactly how much cash flow will be generated by that investment, and what the total return will be when the investment matures. Because the income stream is defined over the life of the investment, these investments are sometimes called fixed income investments IFSE Institute

5 Claude's 5-year $10,000, 5% compound GIC also has an income guarantee, so Claude can be sure that he will receive interest income of 5% compounded annually. As a result, Claude knows that at the end of five years, when his GIC matures, he will receive exactly $12, If Claude had invested his $10,000 in corporate shares, he could not be certain of how much he would receive in dividends each year, or how much those shares would be worth at the end of five years. Investments that provide a capital guarantee and/or an income guarantee if held until maturity include: guaranteed investment certificates (GICs) term deposits Canada Savings Bonds (CSBs) Treasury bills (T-bills) government and corporate bonds Quality of the Guarantee Capital and income guarantees are only as good as the creditworthiness of the issuer, so some guarantees are better than others. For example, Canada Savings Bonds and federal government T-bills are backed by the Government of Canada, which due to its taxation powers, is highly unlikely to default on its payments. So, investments offered by the Government of Canada provide the highest level of security. GICs are backed by the issuing financial institution, usually a chartered bank. While chartered banks also offer a high degree of security, their guarantees rank below those offered by the Government of Canada. Corporate bonds are backed by the issuing corporation, and while the corporation is legally required to make its interest payments, if the business is failing, it may have trouble meeting those obligations. Risk vs. return In general, the quality of the guarantee is directly related to the rate of return that an investment offers, because risk and return are linked. The greater the creditworthiness of the issuer, the lower the rate of return offered by the investment. Conversely, if an issuer has a lower credit rating, it will have to offer a higher rate of return to entice investors to accept the added risk. Non-guaranteed investments Investments that do not offer a capital or income guarantee are called non-guaranteed investments. With non-guaranteed investments, such as stocks, the client can not be sure that he or she will recover his or her principal investment, or that he or she will receive a specific rate of return over the life of that investment. From the client's standpoint, the trade off for this uncertainty is that, over the long-term, the nonguaranteed investment should provide a greater return than the guaranteed investment, to compensate the investor for the increased risk. Term Deposits and Guaranteed Investment Certificates (GICs) A term deposit is an interest-bearing loan from the investor to a financial institution for a specified term at a specified annual interest rate. Term deposits with a duration of less than one year are usually called short-term deposits. Term deposits that mature in one to five years are generally called guaranteed investment certificates (GICs) IFSE Institute 5

6 Unit 6: Non-insurance Investment Products Term deposits and GICs have the following characteristics: they have very low risk and the return of principal is guaranteed the term can be as short as 30 days they offer better returns than bank savings accounts the returns are low compared to equity investments because they have minimal risk they typically must be held to maturity, otherwise an early penalty charge will apply, so they have low liquidity the income consists of interest term deposits do not trade in the secondary market, and they do not fluctuate in value Risk and Tax Considerations Guaranteed protection Term deposits with banks or trust companies are guaranteed up to $100,000 per financial institution by the Canada Deposit and Insurance Corporation (CDIC). Term deposits with insurance companies are guaranteed up to $100,000 by Assuris, as discussed in Unit 1. Tax considerations The investor must report GIC income on an accrual basis. This means that the investor must report the interest earned annually, even if he or she did not receive it in cash. Janet bought a $10,000, 5-year, 5% compound GIC. At the end of 5 years, she knows she is going to receive a lump-sum payment of $12,726.82, and the difference of $2, is interest income. However, under the accrual rules, she must report a portion of that interest income each year. The bank showed her a breakdown of how much interest is earned each year on this compound GIC: Year 1: $ Year 2: $ Year 3: $ Year 4: $ Year 5: $ So, Janet will have to report $500 at the end of Year 1, $525 at the end of Year 2, and so on. GICs and term deposits are eligible investments for RRSPs and RRIFs. At some financial institutions, you can buy a GIC directly to be held in an RRSP. Index-linked GICs Index-linked GICs are a special type of GIC, where the return is linked to the return on a stock market index. This lets the investor participate in any increase in the value of the stock market without putting his or her capital at risk, because the return of capital is guaranteed. This means that the worst that can happen is that the investor gets his or her money back but doesn't earn any return. Charlene wanted exposure to the stock market, but she was also very concerned about making sure that she did not lose her principal, because she needs it for a down payment on a house in 3 years. She chose a 3-year indexlinked GIC, because she is guaranteed to have at least the amount that she invests today (she can't lose money), and she has the potential for higher gains than a regular GIC without worrying about daily fluctuations in the stock market IFSE Institute

7 GICs can be linked to an individual stock market index, such as Standard & Poor's 500, or a group of stock market indices. Some GICs are linked to the performance of a group of mutual funds. The maximum return is typically capped, either annually or over the term. Some index-linked GICs also guarantee a minimum return, regardless of how the stock market performs. Index-linked GICs are issued for terms of 1 to 5 years. They typically lock in the positive performance at the end of each year. The following shows the return and maturing value of $10,000 invested in an indexed-linked GIC for a term of three years, where the GIC has a 10% annual performance cap. Year Return on Index-linked GIC Stock Index Return (%) GIC Annual Return (%) Value 1 9% 9% $10, % 0% $10, % 10% (capped) $11,990 Tax considerations The income earned on an index-linked GIC is interest income for tax purposes, NOT capital gains, even though the return is linked to the capital appreciation of the underlying index. Benefits and Limitations of Index-linked GICs Index-linked GICs are particularly appealing when the stock markets are booming, because they give investors the potential to earn returns higher than those offered on conventional GICs. Even better, it gives them that exposure to the stock market without putting their capital at risk. GIC investors are typically risk-adverse, so an index-linked GIC is a good product for someone looking for a safe "middle ground." They can be assured that their principal is safe, even if the index has negative returns, but they have the potential to earn higher returns compared to a traditional GIC. However, investors in index-linked GICs are trading a guaranteed return for the potential to earn a greater return that is not guaranteed. In periods when the stock market is in a decline, an indexlinked GIC may not earn any income for a given year, or even for its entire term. While the capital will be preserved, inflation over the term will reduce the purchasing power of that capital. Principal Protected Notes Principal protected notes (PPNs) are notes issued primarily by chartered banks. Their returns are tied to the performance of specific investments such as a basket of mutual funds, a specific hedge fund or stocks in a specific industry. Some are quite complex and may include leverage. A PPN guarantees that as long as it is held until maturity, its holders cannot receive less than their original investment, regardless of market conditions. Their principal is protected. A Canadian bank issues a note repayable in seven years' time. The note ranks equally with the bank's other deposit obligations. However, unlike traditional deposits, it does not carry a fixed rate of interest. Instead, at maturity, the investor will receive a return equal to a certain percentage (e.g., 50%) of the positive return, if any, of the S&P/TSX Composite Index over the term of the note. If the return of the index over the period is negative, the investor will receive the principal back without any return IFSE Institute 7

8 Unit 6: Non-insurance Investment Products This product has the characteristics of a PPN. Here, the underlying asset is the S&P/TSX Composite Index. The principal of a PPN is protected in the sense that the note is a direct, unconditional obligation of an issuer with a high credit quality. The principal is not protected in the sense that money has been set aside for the benefit of investors. Furthermore, unlike bank deposits, principal-protected notes do not enjoy the benefit of deposit insurance provided by the Canada Deposit Insurance Corporation (CDIC). Note: The principal protection applies only to the nominal value, and not the real or inflationadjusted value, of the principal. If the return on the PPN turns out to be lower than the rate of inflation over the term of the note, the purchasing power of investors' principal will be eroded. Tax considerations Income earned on principal protected notes is considered income for tax purposes although some are structured so that some monies returned are considered a return on capital, which is not taxable in the year it is received. If PPNs are sold prior to maturity, gains and losses are treated as capital gains or capital losses for tax purposes. Exercise: Guaranteed Investments Adjusting for Inflation and Income Taxes Term deposits and GICs provide investors with capital and income guarantees. This is particularly important for retirees who rely on their savings to provide a guaranteed income. However, the returns offered by GICs are currently very low. After inflation and income taxes, the purchasing power of the investor's savings may actually decrease over time. After-tax rate of return Interest income must be fully included in income (unless it is earned within a registered plan like an RRSP), so it is taxed at the investor's marginal tax rate (MTR). The after-tax rate of return (RATR) is calculated as: Doris has $10,000 invested in a GIC that provides a return of 4.5%. Doris has a marginal tax rate of 30%. Her after-tax return is 3.15%, calculated as IFSE Institute

9 Inflation-adjusted rate of return Inflation can significantly erode the purchasing power of investment income. The inflation-adjusted rate of return (R inf ) is calculated as: The inflation-adjusted rate of return is sometimes called the real rate of return. Continuing with Doris and her 4.5% GIC, if inflation is 2.5%, her inflation-adjusted rate of return (before considering taxes) is 1.95%, calculated as: After-tax, Inflation-adjusted Rate of Return If you want to consider the impact of income taxes and inflation simultaneously, you should use the after-tax rate of return for the investment return. The real, after-tax rate of return (R inf/atr ) is calculated as: Now let's consider the effect of both income taxes and inflation on Doris's GIC. We found that her after-tax rate of return on her 4.5% GIC was 3.15%. So, her real, after-tax rate of return is only 0.63%, calculated as So, while the GIC gives Doris a guaranteed income, the true value of that income after inflation and taxes is quite small. Exercise: After-tax, After-inflation Rates of Return 2010 IFSE Institute 9

10 Unit 6: Non-insurance Investment Products Treasury Bills Treasury bills (T-bills) are short-term debts that are primarily issued by the federal government, and sometimes by provincial governments. T-bills have the lowest default risk of all fixed income investments, because they are backed by the taxation powers of the government. However, because they carry such low risk, they also offer the lowest returns of all fixed income investments. The exception is in periods of high inflation when yields on Treasury bills tend to be higher than yields on medium and long-term government bonds. T-bills do not make periodic interest payments. Instead, they are sold at a discount and mature at face value. The Bank of Canada holds T-bill auctions every two weeks, issuing T-bills with terms of 91, 182, or 364 days (i.e., three, six, or twelve months). These T-bills are purchased by major financial institutions, including chartered banks and investment dealers. These institutions then sell them to the investing public. T-bills trade in the secondary market after issue, so an investor can buy T-bills with different terms remaining until maturity. There is a steady market for T-bills, so they are very liquid. Tax considerations If the investor holds a T-bill until maturity, the difference between the purchase price and the face value is interest income for tax purposes. Hector bought a 90-day $100,000 T-bill for $99,100. So, he paid $99,100 for the T-bill and he will get $100,000 back in 90 days. The difference of $900 is interest income. If the investor sells a T-bill prior to maturity, he or she could realize a capital gain or capital loss, depending on market interest rates. This is discussed more in the next section on bonds and debentures. So, T-bills are only very low risk if the investor holds them to maturity. Bonds and Debentures Bonds and debentures are debts that are issued by corporations or governments. By buying a bond, the investor is lending money to the issuer. In return, the investor usually receives semi-annual interest payments (called coupons) over the term of the bond, plus a return of capital at maturity. Bonds are secured by the assets of the issuer (i.e., they have collateral behind them). Debentures are unsecured promises to pay interest and to return capital upon maturity. Debentures rank behind bonds in terms of their claims on the assets of the company. If the company goes bankrupt, bondholders will receive their principal back before debenture holders. So, in general, debentures are riskier than bonds and the issuer must pay higher interest than on bonds to attract investors. Bond Risk and Return The risk that a bond issuer will default on its regular interest payments or the return of capital upon maturity is directly related to the creditworthiness of the issuer. Government bonds (which are really debentures) are backed by the taxation powers of that government. The federal government has the strongest taxation power, so Government of Canada bonds are slightly less risky than provincial bonds. Similarly, provincial bonds are generally less risky than municipal bonds. In general, corporate bonds are riskier than municipal bonds IFSE Institute

11 Exercise: Treasury Bills and Bonds Basic Bond Terminology Bonds are issued with a face amount, coupon and maturity. Click on the green boxes to get an explanation and/or example of each term. Face value (face amount, par value, principal amount) The face value is the amount that the bondholder will receive when the bond matures. It is sometimes called the face amount, par value, or principal amount. Face values vary with the issuer, but they are usually multiples of a round number, such as $1,000, $5,000 or $100,000. Coupon rate The coupon rate is the nominal annual interest rate (NOM%) that the issuer pays to the bondholder. It is expressed as an annual percentage of the face amount, although most bonds split this into two equal semi-annual payments. Each individual payment is called a coupon. This is a historical reference to the fact that, in the past, bond certificates had coupons attached to them that the bondholder had to physically detach and present to the issuer in order to receive an interest payment. Bonnie bought an 8.5%, semi-annual $10,000 bond. She will receive two equal coupons (i.e., interest payments) of $425, calculated as [face amount (NOM% 2)] or [$10,000 (8.5% 2)]. This will give her an effective annual return of 8.68%. We will explain how to calculate the effective annual return later in this unit. Maturity, term to maturity Most bonds have a specified maturity date, which is the date the issuer must pay the face amount to the bondholder. The term to maturity is the length of time between the current date and the maturity date IFSE Institute 11

12 Unit 6: Non-insurance Investment Products Bonds are initially issued with a term to maturity that is a multiple of 1 year (e.g., 1 year, 10 years, 15 years, etc.) After issue, bonds can trade in the secondary market, and their term to maturity will depend on the subsequent date of purchase, because the maturity date is fixed. ABC Ltd. issued a series of $10,000 bonds on December 1, 2003 with a maturity date of December 1, When first issued, these bonds had a term to maturity of 7 years. Angelo bought one of these bonds in the secondary market on June 1, At the time of his purchase, the bond had a term to maturity of 3.5 years. Trading prices Although bonds are usually issued for par value (i.e., for their face value), they seldom trade at par value in the secondary market. Bonds that are bought or sold at their face value are said to trade at par. In the secondary market, bonds usually trade in units of par value, where par value is arbitrarily set at 100. Any difference between the market price and the face amount is then related to this base of 100. If a $1,000 bond is trading at par, this means it will sell for $1,000, and it is said to be priced at 100. If that same bond is priced at 96, the investor must pay $960 for the bond, calculated as [(price par of 100) face value] or [(96 100) $1,000]. If the bond trades at 105, the investor must pay $1,050 for the $1,000 bond, calculated as [( ) $1,000]. Long-term bonds Long-term bonds have terms to maturity of more than 10 years. In the early 1900s, companies often issued bonds with terms to maturity of 50 years or more. While most new bonds have a term of maturity of 20 years or less, a few companies have started to offer bonds with very long terms. However, investors are wary of these long-term investments, because there are significant risks associated with such a long term. In 1993, Walt Disney and Coca Cola were the first companies to issue 100-year bonds. Several other companies have since followed suit, including Bell South Communications, which issued century bonds in Discount or Premium Bonds that are bought or sold for less than their face value are said to trade at a discount. Bonds that are bought or sold for more than their face value are said to trade at a premium. Trish paid $11,599 to buy a $10,000, 9% bond that matures in 3 years. She paid a premium of $1,599, calculated as ($11,599 - $10,000), because the price of the bond was greater than its face value. Paul paid $9,839 to buy a $10,000 bond with a coupon rate of 4.2% that matures in 5 years. He bought the bond at a discount of $161, calculated as ($10,000 - $9,839), because the price of the bond was less than its face value. In summary, bonds result in a stream of regular interest payments, called coupons, plus a repayment of the face amount at maturity. The final interest payment is usually paid at the same time as the principal repayment, as illustrated by the following example IFSE Institute

13 Shafik bought a 3-year, 7.5%, $5,000 bond, priced at 94.5, paying interest semi-annually. He paid $4,725, calculated as (( ) x $5,000). If he holds the bond until maturity, he will receive the following stream of payments: Exercise: Basic Bond Terminology Bond Prices Bonds are typically issued at face value and redeemed for the same amount upon maturity. However, if an investor wants to sell a bond between issue and maturity, the price will be affected by the current interest rates being offered on new bonds with the same level of risk and with the same remaining term to maturity. The relationship between bond prices and market interest rates is inverse, which means that if the prevailing interest rate increases, bond values will drop; if market interest rates decrease, bond values will rise. In fact, this inverse relationship applies to all fixed income investments that can trade between issue and maturity, including T- bills, bonds, and mortgages. Taxation of Bonds If an investor buys a bond at par and redeems it at maturity, he or she will only have to report annual interest income for tax purposes. However, if the investor sells the bond between the time it is issued and the maturity date, and its value has fluctuated in response to changing market interest rates, the investor may realize a capital gain or loss. Two years ago, Claire bought a new 10-year, 8% semi-annual, $1,000 bond. If Claire holds this bond until it matures, she will receive a total of $80 each year, in two equal instalments of $40 each, for 10 years, and at the end of 10 years she will receive her $1,000 back. However, Claire has decided to sell the bond now, when it still has 8 years left to maturity. Let's look at the potential scenarios. Scenario 1: interest rates stay the same If, when Claire wants to sell her bond, the coupon rate on new 8-year bonds is 8%, then the value of Claire's bond will not have changed. She would be able to sell it for $1,000. Her only return from the bond would be the interest of $80 that she received each year that she owned the bond. Scenario 2: interest rates increase Now suppose that new 8-year bonds offer a 10% interest rate. This means that a new $1,000 bond would pay $100 in annual interest. Because investors can obtain $100 a year on new bonds and Claire's bond only pays $80 a year, she will have to lower the price of her bond to attract investors. In fact, using the time value of money calculations you will learn about later in this course, we can determine that she would likely only be able to get $892 for her bond IFSE Institute 13

14 Unit 6: Non-insurance Investment Products Like scenario 1, Claire would have reported interest income of $80 per year for the two years that she held her bond. However, she could also claim a capital loss of $108 on the sale of the bond, calculated as ($892 - $1000). Scenario 3: interest rates decrease Now suppose that new 8-year bonds offer a 6% interest rate. This means that a new $1,000 bond would pay only $60 in annual interest. Because Claire's bond offers $80 a year and new bonds would only offer $60 a year, Claire will be able to charge a premium for her bond. In fact, using the time value of money calculations you will learn about later in this course, we can determine that she would likely be able to sell her bond for $1,126. Like scenario 1, Claire would have reported interest income of $80 per year for the two years that she held her bond. However, she would also have to report a capital gain of $126 on the sale of the bond, calculated as ($1, ). Exercise: Bond Prices and Taxation Canada Savings Bonds Canada Savings Bonds (CSBs) are savings instruments that are issued by the federal government. CSBs have a 10-year term to maturity although interest rates may be set for a shorter period to start, with new rates announced after the initial period. Unlike Government of Canada coupon bonds, CSBs do not trade in the secondary bond market. CSBs have the following characteristics: They are always worth their face value (plus any accrued interest if held for at least three months from the date of issue). They are very liquid and, depending on the type, can be redeemed at any time, or on the anniversary date and in the 30 day period following, but typically the investor can only buy them at specified times. They have very low risk, so the yield is also quite low compared to other investments, but higher than most savings accounts. The payments are interest income for tax purposes. Because they are always worth their face value, they can never result in a capital gain or loss. Click here to learn more about CSBs. Types of Canada Savings Bonds There are four types of CSBs: The regular interest or R series Canada Savings Bond can be redeemed any time during the year. It has a 10-year term to maturity although interest rates are often announced for a shorter period. The Canada Premium Bond (CSP) which has a higher rate of interest at time of issue than the regular CSB. The CSP bonds can be redeemed only on the anniversary date of issue and in the 30 days following so they are less liquid. The Canada RSP is either a CSB or CSP that is designated as a no-fee retirement savings plan (RSP) at the time of purchase. Interest grows untaxed in the plan and contributions are taxdeferred IFSE Institute

15 The Canada retirement income fund (RIF) is either a CSB or CSP that is designated as a nofee RIF at the time of purchase. Interest grows untaxed in the plan and contributions are taxdeferred. Buying and Redeeming CSBs Buying CSBs Investors can buy CSBs: directly from the government, either online or by phone at most banks, credit unions, caisses populaires, trust companies, investment dealers and discount brokerage companies through a payroll deduction program, if their employer sponsors a program Regular interest CSBs are sold in denominations of $300, $500, $1,000, $5,000, and $10,000. Compound interest CSBs are sold in denominations of $100, $300, $500, $1,000, and $5,000, or for as little as $2 per week through a payroll deduction program. Both regular and compound CSBs are eligible investments for self-directed RRSPs and other selfdirected registered plans. Investors can buy compound interest CSBs directly within a Canada RSP, which is a basic single purpose RRSP with no fees, with a minimum investment of $500. The maximum amount of principal that a person may own per series and per type of registration of CSBs is $500,000. Redeeming CSBs The owner of a CSB can cash it at any financial institution in Canada on any business day. However, CSBs only pay interest to the end of the prior month. To earn interest for a month, the investor must have held the CSB for the entire month. In addition, if the investor redeems the CSB before 90 days from the date of issue, he or she will not receive any interest. Exercise: CSB Facts Lesson 2: Equities Welcome to Equities. In this lesson, you will learn about the various types of equity investments, such as stocks and derivatives. This lesson takes about 30 minutes to complete. At the end of this lesson, you will be able to: define the major types of equity-based investments trading in the capital markets, including stocks, investments based on stock market indices, and derivatives such as options, futures contracts, rights and warrants What are Equities? Equities give investors an ownership interest in the issuing companies. This entitles them to share in the growth of those companies, and/or to receive a share of companies' profits as dividends. An investor can get exposure to the equity markets by buying: common shares preferred shares mutual funds investments tied to stock market indices 2010 IFSE Institute 15

16 Unit 6: Non-insurance Investment Products options rights or warrants futures contracts We will briefly discuss all of these equity types, except for mutual funds, in this lesson. We will discuss mutual funds in more detail in the next lesson. Common Shares Common shares give the investor a direct ownership interest in the issuing corporation. Common shareholders get to share in the profits of that corporation, without assuming any legal responsibility for company operations. If the company prospers, the common shareholders will benefit from an increase in the share price, and they may also receive a share of profits as dividends. Share price is also affected by general stock market conditions and investor confidence in that particular stock. Limited liability One of the attractions of shares is that they give investors the potential to share in business successes, while limiting their risk exposure. While shareholders risk losing their entire investment if the company or stock markets perform poorly, they are not liable for the debts of the company beyond the extent of their investments. They are also not personally liable for any actions taken by the company while they are shareholders. Dividends and Retained Earnings A dividend is the portion of its after-tax profits that a corporation pays to its shareholders. The company's net income is first taxed at the corporate level, and then the corporation can pay the after-tax amount to the shareholders as dividend income, where it is taxed again. Unlike the interest payments on bonds issued by a corporation, a corporation does not have a legal obligation to pay dividends. A corporation's board of directors decides whether to pay some or all of its after-tax profits out as dividends. The board could decide that the company should retain some or all of those after-tax profits to pay for future expansions or to build up a reserve. These unpaid after-tax profits are called retained earnings. An increase in retained earnings tends to increase the value of the corporation's common shares, because the assets per outstanding share have increased. Given the fact that common share prices can vary dramatically, they should only be considered suitable investments for investors with a higher tolerance for risk. Taxation of dividends Dividend income received by an individual investor from a taxable Canadian corporation receives preferential tax treatment, because it is eligible for federal and provincial dividend tax credits. We will discuss this tax treatment in greater detail in Unit 9: Taxation. Preferred Shares Preferred shares also give the investor a direct ownership interest in the issuing corporation, but there are several important differences from common shares. Preferred shares are issued at a par or face value. They have a stated dividend rate (e.g., $0.25 per share, four times per year). While this is not an absolute legal obligation, the corporation tries very hard to maintain these payments IFSE Institute

17 Sandy bought 1,000 cumulative preferred shares from the XYZ Company. The preferred shares offer a fixed dividend of $0.25 per quarter. Every three months, Sandy will likely receive a dividend payment of $250, calculated as (1000 shares $0.25/share). Because preferred shares offer a fixed dividend payment, they mimic a fixed income investment, and their share price reacts like a bond to changing interest rates (i.e., if interest rates increase, preferred share prices tend to drop, and vice versa). Because of their dividends preferred shares tend to be less volatile than common shares. Prices of specific preferred shares will reflect investor expectations of whether a company will be able to maintain its preferred dividend payments. Preference as to dividends Most preferred shares are cumulative, which means that the corporation must pay all missed preferred dividend payments before it can make any dividend payments to common shareholders. So, preferred shareholders rank ahead of common shareholders in terms of their right to receive dividends. The XYZ Company missed its last quarterly preferred dividend payment. Before it can pay any dividends to its common shareholders, XYZ Company will have to pay Sandy a dividend of $0.50 per share, the dividend for the current period, plus the missed dividend. Preference as to assets Preferred shareholders also rank ahead of common shareholders in terms of their rights to corporate assets in the event of bankruptcy. If a corporation goes bankrupt, its assets are first used to pay off creditors and bondholders. Any remaining assets are divided between the shareholders. The preferred shareholders receive payment first, up to the par value of their shares. If any assets remain after the preferred shareholders are paid, those assets are divided between the common shareholders. Common vs. Preferred Shares The following table summarizes the difference between common and preferred shares. Common Shares Preferred Shares Issue price can vary depending on the issue most are issued at a stated par value Share price increases or decreases to reflect retained earnings and investor confidence less volatile than common share prices no guaranteed redemption value influenced by prevailing interest rates some may be redeemable at par value at specific dates; some may be convertible into common shares Dividends are paid at the discretion of the Board of Directors, depending on profits are not cumulative cannot be paid until all cumulative preferred dividends are paid usually stated as a fixed percentage of par value are usually cumulative, so they must be paid before any dividends are paid to common shareholders while the company is not legally required to pay preferred dividends, it will 2010 IFSE Institute 17

18 Unit 6: Non-insurance Investment Products Retained earnings Common Shares accrue to the benefit of common shareholders Preferred Shares usually make great efforts to do so do not accrue to the benefit of preferred shareholders Preference as to assets if the company is dissolved, common shareholders rank behind preferred shareholders in terms of their claim on company assets if the company is dissolved, preferred shareholders rank ahead of common shareholders in terms of their claim on company assets Exercise: Common and Preferred Shares Stock Market Indices A stock market index is essentially an imaginary portfolio that contains all of the stocks represented in a specific stock market, or a defined portion of that market. This portfolio is weighted to reflect the relative share capital of each company on the index. The value of an index reflects the value of the shares that make up the index, and the change in that value over time is an indicator of how the market, or market segment, is performing. For example, the S&P/TSX 60 is a stock market index that represents the 60 largest companies listed on the Toronto Stock Exchange (TSX), while the S&P/TSX Capped Financials Index represents the approximately two dozen financial companies on the TSX. Most investors can't afford to buy individual ownership interests in all of the companies contained in a stock market index, but they can acquire the same diversified exposure through either an index fund or exchange traded fund. Index funds An index fund is a mutual fund that has a portfolio that matches or tracks the composition of the underlying index. Mutual funds market their index funds directly to consumers, for a price that reflects the net asset value of its holdings. We will be discussing mutual funds in more detail in the next lesson. Exchange-traded Funds (ETFs) Exchange-traded funds (ETFs) are open-end investment funds whose units are traded on an exchange. ETFs can be bought and sold at any time that the exchange is open. They are purchased or sold through an investment dealer or broker. Their price is determined by demand and supply conditions and varies continuously during the day. In this way, ETFs differ from mutual funds, which can be bought or redeemed only at the end of the day. Most ETFs are designed to track a specific stock index or subindex, like the S&P/TSX 60 Index or S&P/TSX Capped Financial Index. Others track bond indices, a commodity index, or a commodity itself. Historically, the management fee, or trustee fee, has been substantially lower than for mutual funds. Newer ETFs in Canada also involve leverage and active management. Depending on the ETF, it may also pay dividends. They are also eligible for RRSPs and other registered plans. The ishares LargeCap 60 Index Fund is an ETF that trades on the TSX under the symbol XIU and replicates as closely as possible the performance of the S&P/TSX 60 Index. This index consists of stocks from 60 large corporations that represent the major sectors of the Canadian economy IFSE Institute

19 Similar to index mutual funds, investors receive a diversified portfolio of Canadian companies that fluctuates in value with general market trends. ETFs attempt to replicate an index as closely as they can. Often, they will underperform their benchmark. This difference is called a tracking error. This is represented by the gap between XIU and the S&P/TSX 60 Index in the graph above. ETFs are traded during the day The ability to trade at any time during the day is particularly valuable to traders (as opposed to investors) when the market is volatile. For example, the holders of an ETF who expect that the market will drop during the day can sell their units at any time before the market's close. If they are right, they will obtain a better price than the closing price. On the other hand, mutual fund investors will always receive the net asset value calculated on the basis of closing prices, no matter at what time during the day they submit their redemption request. Financial Derivatives Financial derivatives are investments whose values depend on (or are derived from) the value of their underlying assets. These underlying assets can be stocks, bonds, commodities, or other financial instruments. Almost all derivatives have a limited lifespan. At some point, the investor must recognize the value of the derivative by buying, selling, or exercising the derivative, or allowing it to expire. The most familiar derivatives are: options rights and warrants futures contracts We will discuss each of these derivatives. Options Options give an investor the right to buy or sell a specified amount of an underlying security at a set price (called the strike price or exercise price), for a set period. Most options trade on options exchanges, which are similar to stock exchanges. Each option usually represents 100 shares of the underlying stock. There are two parties involved in an option transaction: the buyer and the seller. The option buyer, also known as the holder, has the right to buy or sell the underlying security IFSE Institute 19

20 Unit 6: Non-insurance Investment Products The option seller, also known as the writer, has the corresponding obligation to sell or buy the underlying security if the buyer decides to exercise the option. There are options on many different securities, such as stocks, bonds, and stock market indices, but the most common options are stock options. Call vs. Put Options There are two kinds of options: Call options give the investor the right to buy a specified amount of the underlying security at a set price for a specified time period, and the option writer would have the obligation to sell the security at that price. An investor would buy a call option if he or she expected the underlying security to increase in price. Put options give the investor the right to sell a specified amount of the underlying security at a set price for a specified time period, and the option writer would be obliged to buy that security at that price. An investor would buy a put option if he or she already owned the underlying security, but expected the price of that security to decline or if he or she hoped to profit from a declining share price. If the option buyer does not exercise the option within the specified period, it will expire without value. Type of option contract The option buyer or holder has the right to The option writer or seller has the obligation to Call Buy the underlying security Sell the underlying security Put Sell the underlying security Buy the underlying security Andy bought a September 45 call option on Newport shares, at a cost of $1.00 per share. The call option gives Andy the right to buy 100 Newport shares at a price of $45 each from Jack at any time before the end of September. If Andy decides to exercise the option, Jack will be obligated to sell him the Newport shares for that price, even if their current value is well over $45. Rights and Warrants Rights and warrants are similar to call options, but they are written by the company that issues the underlying shares. Once they are issued by the company, rights and warrants can both trade in the secondary market, listed on a public stock exchange. Rights Some companies issue rights to current shareholders, giving them the right to buy additional shares directly from the company at a specified price, usually below the current market price. The company issues rights to encourage existing shareholders to invest more money in the company. Rights usually have a life span of a few weeks to a few months, after which they expire. Toro Inc. made a rights offering to all shareholders. According to the terms of the rights offering, existing investors receive one right for each existing common share, and they need three rights to buy one additional share. The exercise price is $8.25, and the rights offering expires on April 30. So, a shareholder with 1,000 existing shares will receive 1,000 rights. This will entitle the shareholder to buy 333 additional shares, calculated as (1,000 rights 3 rights per share), at the exercise price of $8.25 per share IFSE Institute

21 Warrants Warrants are like rights in that they give the holder the option to buy additional shares directly from the company at a specified price. However, a company attaches warrants to new bond or preferred share issues, to entice investors to buy the new bond or preferred share offering. Once an investor buys the bonds or preferred shares, he or she can detach the warrants and choose to exercise them, or to sell them in the secondary market. Warrants have a life span that can range from one to ten years with five to seven years being most common. Lucas Inc. issued 2 million preferred shares at $15 per share in February Each share included two warrants. Each warrant entitles the warrant holder to buy one additional common share from the company at a price of $18 per share, between March 1, 2010 and February 28, 2013, when the warrants expire. Futures Contracts If an investor buys an option, he or she has the right (but not the obligation) to buy or sell the underlying security, depending on whether it was a call option or a put option. If an investor buys a futures contract, he or she undertakes the obligation to buy or sell a set amount of the underlying product for delivery at a specified point in the future, at a specified price. Historically, futures contracts were created on agricultural commodities, such as wheat, cattle or soybeans, but now futures contracts can be found on a wide range of underlying products, such as metals, stock indices, and bonds. There are two main parties in the futures market, hedgers, and speculators: hedgers are trying to protect themselves from adverse changes in the value of the underlying goods speculators are trying to make a profit from those price movements Hedging Jim, a wheat farmer, will bring his crop to market in about five months, in September. Now, in April, wheat is selling in the open market for $5 per bushel. Jim does not know what the price of wheat will be in September, but he sells a futures contract on his wheat at $5 per bushel. In other words, Jim has contracted to sell his wheat for $5 per bushel in 5 months time. Scenario 1: In September, wheat is selling for $3 per bushel. Jim sells his wheat as per the futures contract for $5 per bushel, despite the fact that it is currently selling for $3 per bushel. Scenario 2: In September, wheat is selling for $8 per bushel. Jim will have to sell his wheat for $5 per bushel, as per his futures contract. In both cases, Jim sells his wheat for $5 per bushel. By hedging his position and protecting himself from a drop in price, he also forgoes the potential profit if the price of wheat increases. Speculating Jim could have sold his futures contract to a speculator. The speculator does not have any interest in acquiring wheat; he or she just wants to profit by selling the futures contract later. Scenario 1: If wheat is selling for $3 per bushel in September, the speculator will lose money because he or she has contracted to buy the wheat for $5 when it is only worth $3. The speculator would close out the futures contract by selling it for $3, losing $2 per bushel IFSE Institute 21

22 Unit 6: Non-insurance Investment Products Scenario 2: If wheat is selling for $8 per bushel in September, the speculator would be able to sell his or her contract for $8, realizing a profit of $3 because he or she had contracted to pay only $5 per bushel. Note: The speculator does not actually buy the wheat from Jim. He or she sells the contract to someone who wants to buy wheat. Exercise: Financial Derivatives Lesson 3: Mutual Funds Welcome to Mutual Funds. In this lesson, you will learn about the benefits and features of mutual funds, how they are regulated, how they are valued, and the various types of mutual funds available. This lesson takes about 50 minutes to complete. At the end of this lesson, you will be able to: define mutual funds describe how a mutual fund works discuss the benefits of investing in mutual funds define and calculate the Net Asset Value Per Share (NAVPS) describe mutual fund rules and regulations, including the rights of withdrawal and rescission discuss the three main categories of mutual funds: income funds, growth funds, and combined income and growth funds compare the risk and volatility of various types of funds, including money market funds, mortgage funds, bond funds, dividend funds, equity funds, international and global funds, specialty funds, real estate funds, balanced funds, asset allocation funds, and index funds What is a Mutual Fund? A mutual fund is a corporation or a trust that pools the money of many investors, and invests that money in a portfolio of investments. The portfolio can include stocks, bonds, term deposits, Treasury bills, real estate, etc., depending on the objectives of the fund. Closed-end mutual funds The earliest mutual funds were closed-end funds, and some funds today are still structured as closed-end funds. Closed-end funds issue a fixed number of shares when the fund is first established. The number of shares remains fixed unless the fund company decides to issue new shares. Because the number of shares remains constant, new investors can only buy shares from existing investors, usually on a stock exchange. The sales process normally does not involve the mutual fund company. The price of a closed-end mutual fund will be influenced by stock market movements and investor sentiment, so it may be more or less than the fund's net asset value per share (NAVPS). We will discuss the calculation of NAVPS later in this unit. Open-end mutual funds The majority of mutual funds sold today are open-end funds, where the investor deals directly with the mutual fund company, which continually issues and redeems shares or units in the fund. The number of outstanding shares will therefore fluctuate over time. Open-end funds are priced at their NAVPS IFSE Institute

23 Mutual fund corporations and trusts Mutual funds can be structured as either a corporation or a trust. A mutual fund that is structured as a corporation issues shares, while a fund that is structured as a trust issues units. From the investor's point of view, there is no significant difference or advantage of one form over the other. Exercise: Comparing Closed-end and Open-end Funds Benefits of Mutual Funds Mutual funds allow both small and large investors with similar investment objectives to take advantage of investment opportunities by pooling their money together. They also offer several other advantages to investors: professional management diversification flexibility liquidity investor protection administrative services and support Professional Management For a fee, trained professional managers make the investment decisions on behalf of the mutual fund investors. Fund managers must meet high standards of education and experience before they can be registered as a portfolio manager with provincial securities regulators. Portfolio managers have access to a greater amount of research and more sophisticated analytical tools than the average investor does. Even the smartest investors may not have the time needed to research and monitor their investment portfolios, and they can benefit from the professional management provided by mutual funds. Diversification Diversification means limiting investment risk by spreading investment dollars over a suitable number of different investments, thereby minimizing the risk that comes with having "all of your eggs in one basket". Most investors do not have enough money to invest in more than a few individual investments, so they would have difficulty diversifying their portfolio if they could only invest in individual securities. Mutual funds give small investors access to a larger variety of different investments, which might not be practical otherwise. Securities regulations prevent mutual funds from holding more than 10% of their assets in one company, and this encourages diversification within the mutual fund IFSE Institute 23

24 Unit 6: Non-insurance Investment Products Jim has $500 to invest and he decided to invest it all in one company, ABC Ltd. Because Jim has all of his money in ABC Ltd. shares, the change in the value of his stock portfolio will coincide precisely with the change in the value of ABC Ltd. shares. If ABC shares drop 50% in price because of poor management, for example, then the value of Jim's stock portfolio will drop by the same amount, so it will only be worth $250. However, if Jim had invested his $500 in a mutual fund where ABC Ltd. is only 10% of the mutual fund's holdings, only $50 of his original investment would be tied up in ABC stock. If ABC shares drop by 50%, the value of Jim's mutual fund will only drop by $25. As long as the other investments held by the mutual fund maintain their value, Jim's investment portfolio would still be worth $475. How Diversification Works Value of Jim s investment after the price drops IFSE Institute

25 Flexibility Suitability for a wide range of investors There are thousands of different mutual funds, each with its own investment objectives and style. Every investor should be able to find one or more mutual fund that suits his or her goals, whether that is income, capital appreciation, safety of capital, or a combination. Mutual funds allow investors with even small amounts of capital to participate in the stock market and create a diversified portfolio. Most fund companies accept initial investments of $500 to $1,000, after which they will allow regular purchases of $25 or even less. Transferability In most cases, investors can easily switch from one mutual fund to another within the same fund family. This allows them to change their portfolios in response to changing market conditions or their own changing objectives. Income choice Investors can find mutual funds that provide a certain type of income, depending on their needs. For example, mutual funds could specialize in producing interest income, dividend income, or capital gains. Liquidity With a few exceptions, such as real estate funds and labor sponsored investment funds, an investor can convert a mutual fund investment into cash quickly and easily. Investors can buy funds through many sources, including: banks, trust companies and credit unions investment dealers and brokerage firms mutual fund dealers mutual fund companies (if they are registered as dealers) independent financial planners and consultants To redeem units or shares (i.e., convert them back into cash), an investor must submit a redemption request directly to the fund management company or their distributor. The investor usually receives the funds from the sale within three business days. Note: Liquidity should not be confused with gaining or losing money in a mutual fund. For example, you might have purchased mutual fund units for $10 per unit. If the units later dropped in value to $7 per unit and you redeemed the units, you would receive only $7 per unit but you would receive it quickly. Investor Protection While mutual funds are not protected by the Canada Deposit Insurance Corporation (CDIC) the way bank deposits are, they are protected in other ways: under securities laws, a mutual fund management company cannot co-mingle (mix) investors' funds with the company's operating funds, or with any other assets that they manage the investors' funds are held by a custodian, which is a trust company or bank each mutual fund is audited by an independent auditor at least once a year The Investor Protection Corporation (IPC) protects investors from losses due to the bankruptcy of a mutual fund dealer that is a member of the Mutual Fund Dealers Association 2010 IFSE Institute 25

26 Unit 6: Non-insurance Investment Products (MFDA); eligible members are covered up to a maximum of $1 million for any combination of mutual funds and cash balances in their general accounts and up to $1 million for any combination of their retirement accounts, such as RRSPs and RRIFs. the Canadian Investor Protection Fund (CIPF) protects investors from losses due to bankruptcy of a mutual fund seller that is a member of the Investment Industry Regulatory Organization of Canada (IIROC); eligible members are covered up to a maximum of $1 million for any combination of securities and cash balances in their general accounts and up to $1 million for any combination of their retirement accounts, such as RRSPs and RRIFs. some provinces also have contingency funds, which are pools of money that are set aside to protect investors from non-market-related losses, such as fraudulent activities by a fund company Administrative Services and Support Many mutual fund companies or dealers offer administrative services, such as: tax reporting pre-authorized chequing (PAC) deposit plans simplified statements automatic distribution reinvestment plans Exercise: Advantages of Mutual Funds Net Asset Value Per Share (NAVPS) The net asset value per share (NAVPS) is the price at which shares of an open-end mutual fund corporation are bought or sold on a given day, excluding front-end loads or commissions. For a mutual fund trust, it is called the net asset value per unit (NAVPU). The NAVPS is calculated using the following formula: Assets fund's investment portfolio cash near-cash investments (those that can be quickly converted to cash) accounts receivable from dealers Liabilities expenses incurred for the valuation period dividends payable to investors redemption amounts owed to investors Fund ABC has fund assets with a market value of $25,000,000, liabilities (debts) of $5,000,000, and 1,000,000 shares outstanding. NAVPS = ($25,000,000 - $5,000,000) 1,000,000 = $20 Management Fees A mutual fund pays a management fee to its management company for supervising the portfolio and administering its operations. When a mutual fund reports its rate of return to investors, it is the return after management fees have been deducted IFSE Institute

27 While the mutual fund pays these management fees, they are still of concern to investors because they reduce the fund's rate of return. For example, if a fund earns a 10% return before management fees, but pays a management fee of 1.5%, the investor is only going to see an 8.5% return. Click here to visit a very useful tool to help you compare management fees. Management expense ratio The management expense ratio (MER) provides a standardized measure of a mutual fund's management expenses, by relating them to the fund's average NAVPS. It allows investors to compare how much of each fund's assets are being used to pay for management services. The MER is calculated as: A mutual fund is required to report its MER for the last five years in its management report of fund performance. The MER includes the total expenses that the fund pays to its management company and other service providers, including interest charges, sales taxes, audit fees, legal fees, accounting fees, and the costs associated with maintaining investment records. It does not include brokerage fees that the fund pays when buying and selling securities for the fund's investment portfolio. Exercise: NAVPS and MER The Mutual Fund Prospectus A prospectus is a formal document that describes the mutual fund being offered. Among other things, it must describe: the fund's investment objectives all sales charges (front-end loads, redemption charges or deferred sales charges, trailer fees) and management fees the tax status of the fund, including RRSP eligibility the investment risks associated with the fund how to buy, sell, and exchange shares or units in the fund The issuer cannot sell a mutual fund before first having the fund's prospectus approved annually by the provincial securities commission. Investors purchasing a mutual fund must receive a copy of the simplified prospectus, a condensed version of the prospectus. The mutual fund prospectus is similar to the information folder of a segregated fund. We will compare mutual funds to segregated funds in Unit IFSE Institute 27

28 Unit 6: Non-insurance Investment Products Rights of Withdrawal and Rescission Securities legislation in some jurisdictions gives investors the right to withdraw from an agreement to buy mutual funds within two business days of receiving the simplified prospectus, or to cancel their purchase within 48 hours of receiving confirmation of their order. Securities legislation in some jurisdictions also allows investors to cancel an agreement to buy mutual funds and get their money back if they do not receive the simplified prospectus, or to make a claim for damages if the simplified prospectus or any of the documents incorporated by reference misrepresents any fact about the fund. The above rights must usually be exercised within certain time limits. Rules may differ from province to province. Make sure that you are familiar with the legislation in your jurisdiction. Three Main Types of Mutual Funds You need to appreciate the characteristics of the various mutual funds to determine which fund is appropriate for your client. There are three main types of mutual funds. Click each type to read its description. Income Funds Growth Funds Balanced Funds Income funds are designed to provide a steady flow of income to client, with a low to moderate level of risk. Growth funds try to achieve long-term growth by purchasing stocks or other assets that will increase in value over time, such as real estate. They tend to be riskier than balanced or income funds. Balanced funds use a combination of income and growth investments to provide a mix of capital appreciation and a regular income stream. Volatility, Risk, and Return Risk and return are directly related. If an investor wants the chance to earn a higher return, he or she must be prepared to assume more risk. In investment terms, risk can be expressed as price volatility. If you purchase two different investments, both at an initial price of $20, the one with the greatest fluctuation in price (volatility) will be the riskier investment. Within each of these categories, there are numerous subtypes. We will discuss the characteristics, including the risk profile, of each subtype. Many things can cause investment values to fluctuate, including: changing interest rates political uncertainty shifts in market expectations changes in technology changes in the credit rating of borrowers Because each mutual fund holds a portfolio of different investments, the mutual fund structure itself helps diversify and reduce the investor's risk. However, there are still substantial differences in the risks, and thus the potential returns offered by different mutual funds. The different fund types, and their risk and return characteristics, are discussed below IFSE Institute

29 Income Funds Income funds provide a regular stream of income to the investor. Income funds are considered the safest type of mutual fund, but they come with their own type of risk, depending on the kinds of investments they hold. Income funds include: money market funds mortgage funds bond funds dividend funds Money Market Funds Money market funds invest in short-term, highly liquid products, primarily T-Bills. These funds have the following characteristics: they have very low risk and but also provide a low return the investor receives regular interest income the investor will never have a capital gain or loss, because the NAVPS is always fixed, usually at $10 they are very close to cash and are sometimes used instead of a chequing account Money market funds are unique in that investors will never realize capital gains or losses. Investing in any other type of mutual fund could result in a capital gain or loss. Suitable uses Money market funds are suitable for investors who want some income but are unwilling to risk their capital. They are not typically good as long-term investments, but they can be a smart choice for short-term goals, such as saving for a vacation in the next year, or as a place to park money while deciding on a longer-term investment. Mortgage Funds Mortgage funds invest in government-guaranteed residential mortgages. These funds have the following characteristics: they have low to moderate risk, usually falling between money market funds and bond funds the investor mainly receives regular interest income, but may realize a capital gain if interest rates decrease, or a capital loss if interest rates rise A few funds are offered as mortgage and income funds. They hold mortgage backed securities or other bonds, in addition to or instead of, mortgages IFSE Institute 29

30 Unit 6: Non-insurance Investment Products Suitable uses Mortgage funds are suitable for clients who want to protect their capital, need a steady stream of income, and do not have an immediate need for the invested funds. Bond Funds Bond funds invest in a portfolio of bonds and debentures. Some bond funds specialize in one type of bonds (e.g., long-term government bonds), while others hold a combination of bonds. These funds have the following characteristics: they have low to moderate risk, but are usually riskier than mortgage funds because the term to maturity of the bonds is usually longer the investor mainly receives regular interest income, but may realize a capital gain if interest rates decrease, or a capital loss if interest rates rise Suitable uses Bond funds are suitable for investors who want to protect their capital, but also need a steady stream of income. However, some specialty bond funds invest in lower quality bonds and would be riskier than other bond funds. Dividend Funds Dividend funds invest primarily in preferred shares but also some common stock of dividend-paying corporations. They are designed to provide a regular flow of dividend income to the investor. These funds have the following characteristics: they have moderate risk, and tend to be riskier than bond and mortgage funds because: share prices fluctuate with market conditions and investor sentiment, and the issuer has no legal obligation to pay dividends (unlike the interest payments on a bond) the investor mainly receives tax-preferred dividend income, but may realize a capital gain if interest rates decrease, or a capital loss if interest rates rise Suitable uses Dividend funds are suitable for investors with a moderate risk profile who would like a steady stream of tax-preferred income, but who would also like the potential to earn some capital gains through growth of the investments. Investors should be able to tolerate some decline in the value of the funds. Exercise: Income Funds Growth Funds Growth funds provide long-term growth. These funds tend to be the riskiest category, because investments within the fund are stocks or other equity-based investments. Growth funds include: equity funds international and global funds specialty funds real estate funds index funds IFSE Institute

31 Equity Funds Equity funds invest primarily in the common shares of corporations. There are many types of equity funds, ranging from funds that invest in the shares of other mutual funds, to highly specialized funds that focus on a specific economic sector, geographic region, or companies of a certain size. Equity funds are riskier than income funds, because stock prices can be quite volatile. The more specialized or targeted the equity fund, the greater the risk. However, they also have the potential to produce greater returns. The equity fund investor mainly realizes capital gains or losses because of movement in the fund's NAVPS. However, the fund may also distribute dividend income that it receives from its portfolio of investments. Suitable uses Equity funds are suitable for the moderate to high-risk investor who is looking for capital growth the longer term. The investor should be prepared to see his or her investment decline in value over the short term. International and Global Funds International funds invest in the securities issued by foreign companies. Global funds invest in both domestic and foreign companies. International and global mutual funds can have moderate to high risk, depending on the location of the investment, the type of securities they hold, and the volatility of the currency exchange rate. The international or global fund investor mainly realizes capital gains or losses because of movement in the fund's NAVPS, coupled with currency fluctuations. However, the fund may also distribute dividend income that it receives from its portfolio of investments. Dividend income from non- Canadian corporations is fully taxable as foreign source income; it is not eligible for the dividend tax credit. Suitable uses International and global funds are suitable for investors who are looking for international diversification and who have a higher risk tolerance. Specialty Funds (Sector Funds) Specialty funds invest in the stocks or bonds of companies in a particular geographic area (e.g., Latin America) or industrial sector (e.g., biotechnology). This narrow focus reduces diversification, which increases risk. If the particular geographical area or industrial sector does poorly, then the fund will also do poorly. Suitable uses Specialty funds are suitable for investors who have a high tolerance for risk and a long investment horizon. Real Estate Funds Real estate funds invest directly in commercial and industrial properties, as well as the shares of real estate management or development companies IFSE Institute 31

32 Unit 6: Non-insurance Investment Products Investors in real estate funds may receive rental income generated by the properties, as well as capital gains or losses when those properties are sold. There may be certain tax deductions that make these funds more tax effective for some investors. They have a high risk due to the volatile nature of the real estate market. They are also less liquid than most other mutual funds, because the properties held by the fund are usually only appraised monthly or quarterly. Suitable uses Real estate funds are suitable for investors who have a high tolerance for risk, a long investment horizon, and who are looking for possible tax advantages. Index Funds Index funds invest in all of the stocks that make up a specific stock index, such as the TSX 60. They are designed to provide returns that mimic the returns earned by the index. A stock market index is used to measure and report changes in the value of a specified group of stocks, and it is designed to be a market indicator. The value of the index is calculated as the weighted average of the market prices of the stocks included in that index. Index funds are passive funds because the manager does no research when managing the fund. As a result, index funds have very low management fees. The index fund investor mainly realizes capital gains or losses because of movement in the fund's NAVPS. However, the fund may also distribute dividend income that it receives from its portfolio of investments. Index funds have moderate to high risk, depending on the nature of the underlying index. Suitable uses Index funds are suitable for investors with moderate to high risk tolerance, and who are not expecting a steady stream of income. Investors should have a relatively long time horizon because market indices can fluctuate over the short term, despite the general upwards trend over the long term. Exercise: Growth Funds Combined Income and Growth Funds Funds that provide a combination of income and growth hold a mix of fixed income and equity investments. These funds are considered moderate risk because they provide the investor with a level of stability along with the potential for capital growth. The following funds would fit into this category: balanced funds asset allocation funds Balanced Funds Balanced funds invest in a combination of fixed income and growth investments, including T-bills, bonds, debentures, mortgages, and common and preferred shares. The managers of most balanced funds are required to maintain the asset allocations within specified limits, according to the objectives set out in the fund's prospectus. For example, one balanced fund might be required to hold no less than 30%, but no more than 60%, of its portfolio in equities IFSE Institute

33 Balanced funds offer moderate risk, between that of income and growth funds. They are suitable for the investor who wants the safety and income offered by fixed income investments but also the potential to earn capital gains through equity investments. The balanced fund investor may receive a combination of interest, dividends, and capital gains. Returns are generally higher than bond funds but lower than pure equity funds. Suitable uses Balanced funds are suitable for investors with a moderate risk profile, and for investors who want the potential to earn both income and capital gains. Asset Allocation Funds Unlike other combined funds, asset allocation funds generally do not have any restrictions on the asset mix of the portfolio. Managers of asset allocation funds have a lot of freedom to vary the asset mix in response to changing market conditions. For example, if they expect a decline in bond values, a manager might decide to weight the portfolio more heavily in equities. A balanced fund manager might take the same approach, but would be restricted by the minimum and maximum limits set for that fund. Target date funds Target date funds (also known as life-cycle funds) are a kind of asset allocation fund that focuses on a specific future date, like retirement, and changes the asset mix throughout the life of the fund. As time goes on and the investor approaches retirement, the fund manager adjusts the asset allocation away from equities and towards fixed income, thereby reducing risk exposure. Suitable uses Asset allocation funds are suitable for investors with a moderate to high tolerance for risk, and investors who want the potential to earn both income and capital gains. Exercise: Types of Mutual Funds Comparing Risks While the risk of each mutual fund will vary, this chart provides an indication of the typical riskreward characteristics of most mutual fund types. If you would like to print out this chart, click on the Job Aid icon. It will help you with this lesson, as well as on the job IFSE Institute 33

34 Unit 6: Non-insurance Investment Products Exercise: Comparing Risks Lesson 4: Evaluating Investments and Calculating Investment Returns Welcome to Evaluating Investments and Calculating Investment Returns. In this lesson, you will learn about the different factors to consider when choosing an investment, the power of compounding, factors that affect investment returns, and common measures of investment returns. This lesson takes about 40 minutes to complete. At the end of this lesson, you will be able to: list the general factors to be considered when evaluating investments define the Know Your Client Rule define the risks associated with investing, including market risk, business risk, interest rate risk, liquidity risk, currency risk, and inflation risk rank investment types based on their risk/reward characteristics explain the power of compounding returns over time define the various measurements of investment returns: net versus gross returns, after-tax returns, current yield, and yield to maturity describe the effects of inflation on investments Know Your Client Rule Know Your Client Rule If you are going to be providing investment advice to your clients, or selling investments to them, securities regulators require you to follow the Know Your Client (KYC) Rule. The KYC Rule says you must gather enough information about your client and his or her financial situation to form a valid basis for your recommendations. To satisfy the KYC Rule, you should obtain the following information about your client at a minimum: age annual income and net worth occupation risk tolerance investment objectives investment knowledge and experience You should update this information in all future dealings with your client. Securities regulators require you to keep fully aware of each client's changing needs so that you can tailor your services and recommendations to suit them. As a rule, the more information you can obtain about your clients' financial circumstances and investment needs, the better you will be able to serve those clients. Click this link to open a list of additional questions that you can ask your clients IFSE Institute