Chapter 3
Investments
Funds
Learning Objectives
• Distinguish between direct and indirect
investing.
• Define open-end and closed-end investment
funds.
• State the major types of mutual funds and
give their features.
• Define exchange-traded funds (ETFs).
Learning Objectives
• Explain the transactions behind indirect
investments.
• Understand how the performance of investment
funds is measured.
• Discuss the opportunities for investing indirectly
internationally.
Investment Choices
• Three investing choices:
1- Hold the liabilities of traditional intermediaries,
such as banks & insurance companies (e.g.
savings accounts, GICs, and so forth)
2- Hold securities directly by purchasing stocks and
bonds through brokers and other intermediaries
3- Hold securities indirectly through investment
companies, pension funds, & mutual funds
Indirect Investing
• Refers to buying and selling the shares of
intermediaries that hold a portfolio of securities
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Shares are ownership interest in the underlying
portfolio
Shareholders are entitled to portfolio income (e.g.
dividends, interest, & capital gains generated)
Shareholders also pay expenses (e.g. fund
expenses and management fees)
Total Net Assets
1993 to 2003
450
400
$Billion
350
300
250
200
150
100
50
0
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Investment Fund
• Financial company or trust fund that sells
shares to the public and uses the proceeds
to invest in a portfolio of securities such as
money market instruments, stocks, & bonds
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Acts as an intermediary for distribution of
dividends, interest, and realized gains
Offers the benefits of diversification
Offers professional management
Investment Fund Investors
• Investment funds are ideal for investors:
1- With small amounts of capital to invest who
cannot properly diversify it on their own
2- Who do not have adequate time to manage their
own investments
3- Who do not wish to manage their own portfolio
Types of Investment Funds
1- Unit Investment Trust: an unmanaged, fixedincome security portfolio put together by a
sponsor and handled by an independent
trustee
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Redeemable trust certificates representing
claims against the assets of the trust are sold
to investors
The assets are almost always kept unchanged
and the trust ceases to exist when the bonds
mature
Types of Investment Funds (cont.)
1- Unit Investment Trust (cont.):
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Passive investments designed to be bought and
held with capital preservation as a major objective
Currently represent a very small part of total
investment company assets
Types of Investment Funds (cont.)
2- Closed-end investment fund: An investment fund
with a fixed capitalization whose shares trade on
exchanges and over-the-counter (OTC) markets
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No additional shares sold after initial public offering
Share prices determined and traded in a secondary
market, i.e., on exchanges like any other stock
Price may not equal Net Asset Value of the shares
•
Net Asset Value (NAV): Total market value of the
security portfolio divided by total shares
Types of Investment Funds (cont.)
3- Open-end investment fund: An investment fund
whose capitalization constantly changes as new
shares or trust units are sold and outstanding units
are redeemed
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Popularly called mutual funds
Account for a large majority of aggregate funds
invested in Canada (from 294 with $20.4 billion in
assets in 1988 to 1,887 with $439 billion in 2003)
Are formed either by creating a mutual fund
company and selling shares in it, or by creating a
mutual fund trust and selling “units” in it.
Types of Investment Funds (cont.)
3- Open-end investment fund (cont.):
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Mutual funds can be purchased directly from a fund
company (e.g. mail or telephone) or indirectly from a
sales agent (e.g. securities firms and banks)
Maybe affiliated with an underwriter, who usually has
an exclusive right to distribute shares to investors
Mutual funds are the most popular form of
investment funds for the average investor because
of their small minimum investment requirements
(usually $1,000 and larger funds need as little as
$200)
Mutual Fund Examples
• As of March 2004, RBC Asset Management Inc., a
subsidiary of the Royal Bank of Canada, was the
largest mutual fund company in Canada with assets
of over $44.1 billion.
• Investors Group was the second largest company
with total assets exceeding $42.6 billion.
Calculating Net Asset Value
• Using the numbers from RBC Asset Management Inc.’s
2003 annual report for the RBC Canadian Equity Fund, the
year-end NAV is calculated as follows:
Total Assets
$3,354,161
Total Liabilities
8,752
Net Assets
$3,345,409
Units outstanding
193,959
NAV = $3,345,409 / 193,959 = $17.24/unit
Types of Mutual Funds
• The board of directors (or trustees) of an
investment fund must specify the objective that
the fund will pursue in its investment policy
• The companies try to follow a consistent
investment policy, according to their specifies
objectives
• This will have a great deal of influence on the
investor’s purchase decision
Types of Mutual Funds (cont.)
1- Money Market Funds (MMFs)
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Objective is a high level of income and liquidity
Investments include short-term money market
instruments (e.g., treasury bills & commercial paper)
Attractive to investors seeking low risk and high
liquidity
The average maturity of money market portfolios
ranges from 1 to 3 months
Investors in MMFs earn and are credited with
interest daily
Types of Mutual Funds (cont.)
1- Money Market Funds (cont.)
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MMFs are not insured
Created in 1974 when interest rates were at record
high levels
By March 31, 2004, Canadian MMFs had total
assets equal to $51.3 billion accounting for 11.1% of
all Canadian mutual fund assets.
Types of Mutual Funds (cont.)
2- Mortgage Funds
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Investment terms may be  5 years
Riskier than money market funds (more interest
rate risk due to longer maturities), but less risky
than bond funds (shorter maturities)
3- Bond Funds
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Objectives of income and safety
Subject to capital gains/losses due to interest rate
risk
Types of Mutual Funds (cont.)
4- Balanced Funds (e.g. AGF Canadian Balanced
Fund)
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Objective is to provide a mixture of safety, income
and capital appreciation
Min./max. rules apply for percentage invested in
each asset class.
Example: In Feb. 27, 2004, the portfolio of AGF
Canadian Balanced Fund was composed of 56.7%
equities, 29.1% bonds, and 14.2% cash and shortterm securities.
Types of Mutual Funds (cont.)
5- Asset Allocation Funds
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Similar objectives as balanced funds, but typically
not restricted to holding specified minimum
percentages in any class of investment
6- Equity/Common Stock Funds
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Objective of capital gains
Bulk of assets are in common shares, but other
assets are held for liquidity, income and
diversification purposes
May vary greatly in degree of risk and growth
objectives
Types of Mutual Funds (cont.)
7- Growth Funds
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Tend to invest in small-cap stocks, i.e. small companies
with growth potential
Riskier than equity funds (small firms pay no dividends
and have a higher risk of default)
8- Specialty Funds
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Objective of superior capital gains (through minimal
diversification)
Tend to focus on companies in one industry, one
segment of the capital market, or in one geographic
location
International/Global Funds, for example, invest in
foreign securities (and carry the risk of foreign exchange
exposure)
Types of Mutual Funds (cont.)
9- Real Estate Funds
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Invest in income-generating properties for long-term
growth and capital gains
Portfolio valuation is based on infrequent (monthly or
quarterly) external appraisal
Less liquid than other funds – investors may need to
give advance notice when selling
10- Ethical Funds
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Relatively new type of fund
Investments are guided by moral criteria (e.g., not
investing in tobacco-related firms)
Types of Mutual Funds (cont.)
11- Index Funds
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Objective is to mirror the performance of a market index
(e.g., S&P/TSX Composite Index)
Generally lower management fees than actively
managed funds.
12- Dividend Funds (e.g. Altamira Dividend Fund)
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Objective of tax reduction through favourable treatment
of dividend for companies
Inappropriate for RRSPs where the credit cannot be
applied
Price changes are driven by interest rates and market
trends
Types of Mutual Funds (cont.)
12- Dividend Funds (cont.)
Example
- The objective of the Altamira Dividend Fund is to achieve
the maximum level of dividend income as is consistent with
the prudent levels of capital preservation and liquidity
- The fund invests primarily in common and preferred stocks
that pay dividends
- The fund invests mainly in Canadian companies so that
investors can benefit from the favourable tax treatment of
dividends
- As of Feb. 27, 2004, the fund had 41% in financial services,
13% in utilities, and 14% in bonds.
Types of Mutual Funds (cont.)
• Each type of fund has different risk-return
characteristics. In general, they can be ranked from
lowest risk/return to highest risk/return as follows:
1. Money market
2. Mortgage
3. Bond
4. Balanced
5. Dividend
6. Equity
7. Real estate
8. Specialty
Mutual Fund Categories
• Money market mutual funds invest in a
portfolio of money market securities
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Treasury bills
Commercial paper
Short-term government bonds
Low risk
Not insured by the federal government
Mutual Fund Categories
• Equity, bond, and income funds invest in
portfolios of securities consistent with the
objectives of the particular fund
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Objectives set by the fund’s board
Disclosure of objectives to investors through
a prospectus
Equity Funds
• Most mutual fund assets are in equity funds rather
than bond or income funds
• Most equity funds are either:
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Value funds: which invest in cheap (undervalued)
stocks as determined by fundamental financial
analysis items, such as, earnings and dividend yield
Growth funds: which invest in stocks of firms
expected to show future rapid earnings growth even
if current earnings are poor or non-existent
Equity Funds (cont.)
• Closed-End Funds
NAV > market price, selling at a discount
 NAV < market price, selling at a premium
 On average, closed-end funds tend to sell at a
discount from their NAV.
 Reasons:
1- illiquidity
2- high expenses
3- poor performance
4- unrealized capital gains
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Equity Funds (cont.)
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Example: On May 25, 2004, shares of the Canadian
General closed-end fund closed trading on the TSX
at $12.75, which represented a discount of 26.8%
from its NAV per share of $17.42
Closed-end funds trade at premiums and discounts
across time, and the variance between funds is great
Example: over a recent 5 year period, closed-end
funds were trading at discounts averaging 11%,
while a US closed-end fund (the Thai Capital Fund)
was trading at a premium of roughly 55%.
Load vs. No-Load Funds
• Mutual funds can be subdivided into load funds
(those that charge a sales fee) and no-load funds
(those that do not)
• Load funds charge investors a sales fee for the
costs involved in selling the fund
• Investors either pay the fee initially when the fund
units are purchased (front-end sales charge), or in
the future when the sales are redeemed (back-end
charges)
• Offering or purchase price = (NAV)/(100%-sales
charge)
Example- Load vs. No-Load Funds
• What is the offering price for a fund that has a NAV
of $10 and a 5% upfront sales charge
• Offering price = $10/(1.0-0.05) = $10.53
• Notice that $0.53 is 5.3% of the NAV.
• Regulators require that the firms report sales
charges in their prospectus.
Load vs. No-Load Funds (cont.)
• In 2004, 70% of Canadian mutual funds charged
loads.
• Front-end sales charges – 4%
• Back-end (redemption) charges – 18%
• Option between front-end and back-end charges –
48%
• The remaining 30% of funds were no-loads that did
not charge direct selling charges.
• No-load funds charge administration fees and early
redemption fee (usually 2%)
Exchange-Traded Funds (ETFs)
• An ETF is an index fund holding a diversified
portfolio of securities, priced and traded on public
exchanges
• Most ETFs are passively managed fund
• Unlike mutual funds, investors don’t buy shares of
ETFs from investment companies directly, but
rather from other investors
• ETFs involve regular brokerage transactions and
fees.
• This makes the ETF resemble a closed-end fund
in many respects
Exchange-Traded Funds (ETFs)
• Units of these trusts hold shares of firms in
market indices in proportion to their weights in
the index
• Differences from traditional mutual funds:
 Traded throughout the day on exchanges
 Lower management fees (e.g., 0.08% to 0.25%
versus 2.5% average for active equity funds
versus 0.75% average for Index funds)
 Lower portfolio turnover – reduces capital gains
income and taxes payable
 Permit short-selling (Ch. 4)
 May be purchased on margin (Ch. 4)
Canadian-Based ETFs
•
I-60s (most widely traded Canadian ETFs)
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Represent units in the S&P/TSX 60 Index
Trade on the TSX (ticker: XIU).; units are valued
at 1/10th the value of the S&P/TSX 60 Index; for
example, if index is valued at 450, each unit is
valued at $45
Dividends are paid every quarter; MER is 0.17%
DJ40s
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Represent units in the Dow Jones Canada 40
Index Participation Fund, which hold stocks that
mimic those of the Dow 40 Index; MER is 0.08%
Canadian-Based ETFs
•
TD S&P/TSX Index Fund
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The S&P/TSX Composite Index is the underlying
index; MER is 0.25%
There are now a growing number of small-cap,
mid-cap, industry-based, style-based, and bond
ETFs available on the TSX
Differences between ETFs and Mutual
Funds
• ETFs
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Trade all day on exchanges, can be bought on margin, and can
be shorted
Currently passive in nature
Can be traded at discount or premiums.
Offer an important advantage over funds with regard to flexibility
on taxes
• Mutual Funds
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Bought and sold at the end of the trading day when the NAV is
calculated
Most are actively managed
Trade at NAV
Mutual fund mangers may have to sell shares to pay those who
want to leave the fund, thereby generating capital gains
Other Funds
• Segregated funds
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Offered by insurance companies as alternatives to mutual
funds
 Provide death benefits
 Guarantee that, regardless of how poorly the fund is
performing, investors are entitled to at least a minimum
percentage of their total contributions to the fund
 A minimum percentage (75% is required, 100% is usually
offered) of investor’s payments will be returned at fund
maturity (or at death of owner)
 The guarantee is only good for a certain period of time. If
investors sell their funds before this date they may
receive less than the guaranteed percentage
Other Funds
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Structured to prevent fund assets from being seized by
creditors if investor declares bankruptcy
Upon owner’s death, assets may be transferred to
beneficiaries without being subject to probate fees
These funds have grown in popularity in recent years,
with assets growing from $20 billion in 1991 to $89 billion
in 2002
Segregated funds tend to have higher load fees
Other Funds
• Labour Sponsored Venture Capital Corporations
(LSVCCs)
 Are sponsored by labor organizations with a
specific mandate of investing in small and mediumsize businesses
 Main objectives is to create and protect jobs,
promote economic growth and diversification,
increase the supply of venture capital, &
encourage greater participation in share ownership
 Eligible investments for LSVCCs is restricted to
taxable Canadian businesses that are active in
Canada
Other Funds
• Labour Sponsored Venture Capital Corporations
(LSVCCs)
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Tax advantages – federal tax credit of 15% & provincial
tax credit in the 15-20% range
While there is no maximum amount an investor may
invest in an LSVCC, the total tax credit cannot exceed
$1,500 in any year
Most LSVCCs are RRSP eligible, which implies the
potential of a double tax advantage
Investors must be aware of the highly speculative and
illiquid nature of LSVCCs since the portfolios are
generally not well diversified and are composed of
venture capital investments in small and medium size
firms with no established track record
Other Funds
• Labour Sponsored Venture Capital Corporations
(LSVCCs)
Unlike mutual funds, LSVCCs:
 Are not restricted to 10% ownership in given companies
(they may exceed 20%)
 Have restrictions on transferability and redemption
 Valuation may not be based exclusively on market prices,
but rather, may require valuation by independent qualified
persons
Performance
• Reported on a regular basis (usually daily) in the
popular press (e.g. The Globe and Mail, National
Post, Business Week, and Forbes)
• Measured over a given time period as a percentage
of initial investment
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Total return for a mutual fund includes reinvested
dividends and/or capital gains
Total return includes all the ways investors make
money from financial assets
Total return is stated as a percentage and can cover
any time period- one day, one month, one year, or
several years
Performance
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A cumulative total return measures the actual
performance over a stated period of time, such
as, the past three, five, or ten years
Average annual total return reflects the mean
compound growth rate of investment over a given
time period
Average annual total return allows investors to
make direct comparisons among funds so as to
their performance. However, the risk of the funds
being compared should be equivalent and the
funds should have the same general objectives
Performance
• Investors relate the performance to some benchmark to
judge relative performance with a comparable
investment alternative
• An important issue is expenses: funds with low MERs
provide better returns in the long run (since
management expenses reduce investors’ returns)
• Mutual fund ratings: best known rating system is
provided by Morningstar
• Globefund is a major provider of information and ratings
for Canadian mutual funds
• Although past fund performance provides useful
information for investors, strong past performance is no
guarantee of strong future performance
International Investing Through
Investment Funds
• The mutual fund industry has become a global
industry
• Open-end funds (mutual funds) around the world
have grown rapidly, with worldwide assets of
approximately $11.6 trillion US by mid-2002
• Canadian investors can invest internationally by
buying and selling international funds
International Funds
• Some mutual funds specialize in international
securities
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Canadian investors can participate in
emerging market economies
International diversification
International funds or global funds emphasize
international stocks
Single-country funds concentrate on the
securities of a single country
•
Actively or passively managed
New Directions in Funds
• Mutual fund “supermarkets”
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Various mutual fund families can be
purchased through a single source
Brokerage firms may provide access
“Supermarket” managers earn fee which is
paid by the funds participating in the
supermarket (0.25% to 0.4% of assets per
year)
• On-line investment services
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Internet used to provide mutual fund
information and to make transactions