INVESTMENTS:
Analysis and Management
Second Canadian Edition
W. Sean Cleary
Charles P. Jones
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.
Indirect Investing
• Alternative to direct investment in or
ownership of securities
• 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
Shareholders also pay expenses
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 marketable securities

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Acts as conduit for distribution of dividends,
interest, and realized gains
Offers the benefits of diversification
Offers professional management
Fund Types
• Unit Investment Trust: an unmanaged, fixedincome security portfolio put together by a
sponsor and handled by an independent
trustee


Passive investments designed to be bought
and held with capital preservation as a major
objective
Currently represent a very small part of total
investment company assets
Fund Types
• Closed-end investment fund: No additional
shares sold after initial public offering


Share prices determined and traded in a
secondary market
Price may not equal Net Asset Value of the
shares
•
Net Asset Value (NAV): Total market value of
the security portfolio divided by total shares
Fund Types
• Open-end investment fund: Shares continue
to be sold to the public at NAV after initial sale
that capitalizes the company

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Shares may be sold back (“redeemed”) to the
company at NAV
Capitalization constantly changes
Popularly called mutual funds
Types of Mutual Funds
1. Money Market Funds


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Objectives of income and liquidity
Investments include short-term money market
instruments
Attractive to investors seeking low risk and high liquidity
2. (a) Mortgage Funds


Investment terms may be  5 years
Riskier than money market (more interest rate risk), but
less risky than bond funds (shorter maturities)
(b) Bond Funds


Objectives of income and safety
Subject to capital gains/losses due to interest rate risk
Types of Mutual Funds (cont’d)
3. (a) Balanced Funds
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
Objectives of safety, income and capital appreciation
Min./max. rules apply for percentage invested in each
asset class.
(b) Asset Allocation Funds

Similar objectives as balanced funds, but typically not
restricted by asset class percentage rules
4. Equity/Common Stock Funds


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Objective of capital gains
Bulk of assets are in equity, but other assets held for
liquidity, income and diversification purposes
May vary greatly in degree of risk and growth objectives
Types of Mutual Funds (cont’d)
5. 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)
6. Specialty Funds


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Objective of superior capital gains (through
minimal diversification)
Tend to focus on one industry, market, or segment
International/Global Funds, for example, invest in
foreign securities (and carry the risk of foreign
exchange exposure)
Types of Mutual Funds (cont’d)
7. (a) Real Estate Funds

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Invest in income-generating properties for longterm growth and capital gains
Portfolio valuation is based on infrequent external
appraisal
Less liquid than other funds – investors may need
to give advance notice when selling
(b) Ethical Funds


Relatively new type of fund
Investments are guided by moral criteria (e.g., not
investing in tobacco-related firms)
Types of Mutual Funds (cont’d)
8. Index Funds


Objective is to mirror the performance of a market
index (e.g., S&P/TSX 60)
Generally lower management fees than other
funds.
9. Dividend Funds

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Objective of tax reduction through favourable
treatment of dividend
Inappropriate for RRSPs or RRIFs
Price changes are driven by interest rates and
market trends
Types of Mutual Funds (cont’d)
• 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:


Value funds, which invest in undervalued
stocks as determined by fundamental financial
analysis
Growth funds, which invest in stocks of firms
expected to show future rapid earnings growth
Equity Funds
• Closed-End Funds

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NAV > market price, selling at a discount
NAV < market price, selling at a premium
If the value of the portfolio remains unchanged,
an investor can gain or lose if the discount
narrows or widens over time
Trade at premiums and discounts across time,
and variance is great
Exchange-Traded Funds (ETFs)
• Units of these trusts hold shares of firms in
market indices in proportion to their weights in
the index
• Differences from traditional mutual funds:
 Traded throughout the day on exchanges
 Lower management fees (e.g., 0.08% to 0.25%
versus 2.5% average for active equity funds
versus 0.75% average for Index funds)
 Lower portfolio turnover – reduces capital gains
income and taxes payable
 Permit short-selling
 May be purchased on margin
Canadian-Based ETFs
•
I-60s

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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

Represent units in the Dow Jones Canada Index
Participation Fund, which hold stocks that mimic
those of the Dow 40 Index; MER is 0.08%
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
There are now a growing number of small-cap,
mid-cap, industry-based, style-based, and bond
ETFs available
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

Provide death benefits
 Must guarantee 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)
 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
Other Funds
• Labour Sponsored Venture Capital Corporations
(LSVCCs)
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No 10% maximum ownership restriction
Restrictions on transferability and redemption
Valuation may not be based exclusively on market
prices
Tax advantages – federal & provincial tax credits
offered
Performance
• Reported on a regular basis (usually daily) in
the popular press
• Measured over a given time period as a
percentage of initial investment


Total returns include reinvested dividends and
capital gains
Average annual return reflects the mean
compound growth rate of investment over a
given time period
Performance
• Investors relate the performance to some
benchmark to judge relative performance
• An important issue is expenses: funds with
low MERs provide better returns in the long
run
• Mutual fund ratings: best known rating system
is provided by Morningstar
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 assets
•
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 account may provide access
“Supermarket” managers earn fee
• On-line investment services

Internet used to provide mutual fund
information and to make transactions
Copyright
Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights
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