Download ch03 - U of L Class Index

Chapter 3
Investment 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).
Indirect Investing
 Refers to buying and selling the shares of
intermediaries that hold a portfolio of
securities
 Shares are ownership interest in the
underlying portfolio
 Shareholders are entitled to portfolio
income
 Shareholders also pay expenses
Investment Fund
 Financial company or trust fund that sells
shares to the public and uses the proceeds
to invest in marketable securities
 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,
fixed-income 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



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
 Objectives of income and liquidity
 Short-term money market instruments
 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
3. (a) Balanced Funds
 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
 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
Types of Mutual Funds
5. Growth Funds
 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
 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
7. (a) Real Estate Funds
 Invest in income-generating properties for
long-term 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
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
 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
 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
Mutual Fund Categories
 Money market mutual funds invest
in a portfolio of money market
securities





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


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
 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
 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
Canadian-Based ETFs
 TD S&P/TSX Index Fund
 The S&P/TSX Composite Index is the
underlying index; MER is 0.25%
 There are now a growing number of smallcap, mid-cap, industry-based, style-based,
and bond ETFs available
 There are now a growing number of smallcap, mid-cap, industry-based, style-based,
and bond ETFs available
Differences between ETFs and
Mutual Funds
 ETFs
 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
 Bought and sold at the end of the trading day when
the NAV is calculated
 Most are actively managed
 Trade at NAV
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)




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




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”



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