Chapter 13 - Investing in Mutual Funds

Question 1

Pooled Investment Funds

Answer 1

Pooled investment fund: an investment vehicle that pools together money from many investors and invests in a variety of securities.

Question 2

Equity mutual funds

Answer 2

Equity mutual funds: funds that sell units, or shares, to individuals and use this money to invest in stocks.

Question 3

Bond mutual funds

Answer 3

Bond mutual funds: funds that sell units, or shares, to individuals and use this money to invest in bonds

Question 4

Balanced mutual funds

Answer 4

Balanced mutual funds: funds that sell units, or shares, to individuals and use this money to invest in a combination of stocks and bonds.

Question 5

Money market mutual funds (MMFs)

Answer 5

Money market mutual funds (MMFs): funds that sell units, or shares, to individuals and use this money to invest in cash and investments that can be converted to cash quickly

Mutual funds employ portfolio managers.
Minimum initial investment is usually between $500 and $5000.

Question 6

Advantages of Investing in Mutual Funds

Answer 6

-Portfolio diversification
-Lower transactions costs
-Marketability: the ease with which an investor can convert an investment into cash
-Professional management
-Record keeping
-Modest initial investment
-Exchange privileges Within a mutual fund corporation
- Reinvestment of dividends and capital gains
- Convenience

Question 7

Disadvantages of Investing in Mutual Funds

Answer 7

-Management fees
-Load charges
-Lack of control over the investments
-Poor investment selection
-Unexpected tax liability-Portfolio manager decides to sell an investment within a mutual fund, the sale may result in a capital gain.
-Low liquidity
Liquidity: the ease with which the investor can convert the investment into cash without a loss of capital.

Question 8

Net asset value (NAV) and NAVPS

Answer 8

Net asset value (NAV): the market value of the securities that a mutual fund has purchased minus any liabilities and fees owed.
NAV = Market value of all assets purchased – all liabilities
NAV is commonly reported on a per share basis.

Net asset value per share (NAVPS): calculated by dividing the NAV by the number of shares in the fund.

Interest or dividends earned by the fund are added to the market value of the assets.

Fund expenses and any dividends distributed to the fund’s shareholder’s are deducted.

As the value of the mutual fund’s portfolio increases, so does the fund’s NAVPS.
Assume NAV = $5M, Number shares outstanding = 500K
NAVPS = $5M/500K = $10

Question 9

Open-end mutual funds

Answer 9

Open-end mutual funds: funds that sell shares directly to investors and will redeem those shares whenever investors wish to “cash in”.

Funds are managed by investment companies that are commonly subsidiaries of a larger financial conglomerate.

Fund managers typically maintain a small portion of the fund’s portfolio in the form of cash or liquid securities so that they have sufficient liquidity when redemptions exceed new share purchases.

Question 10

Closed-end funds

Answer 10

Closed-end funds: funds that issue shares to investors but do not redeem those shares; instead, the fund’s shares are traded on a stock exchange.

Traded on a stock exchange
Capital in a closed-end fund is fixed
Tend to be fully invested

Question 11

No-load mutual funds

Answer 11

No-load mutual funds: sell directly to investors and do not charge a fee.

Question 12

Front-end load mutual funds

Answer 12

Front-end load mutual funds: charge a fee at time of purchase, which is paid to stockbrokers or other financial service advisers who execute transactions for investors.

Question 13

Back-end load mutual funds

Answer 13

Back-end load mutual funds: charge a fee if shares are redeemed within a set period of time.
- Declining redemption schedule possible.

Question 14

Management Expense Ratio (MER)

Answer 14

Management expense ratio (MER): the annual expenses incurred by a fund on a percentage basis, calculated as annual expenses of the fund divided by the net asset value of the fund; the result is then divided by the number of units outstanding.

The higher the MER, the lower the return for a given level of portfolio performance.

On average, mutual funds have a MER of about 2.5%.

Question 15

Reported Components of MER

Answer 15

• Management expenses
• Investment research, portfolio management, marketing costs, and profit.
• Dealer/adviser compensation
  Includes trailing commission - the ongoing fee paid to the mutual fund representative to provide ongoing services and advice to investors.
• Administrative costs
  Transaction processing, client reporting, audit and legal fees.
• GST/HST

Question 16

Mutual Fund Series

Answer 16

Many mutual fund companies offer the same mutual fund but under a different series label (e.g. Series A, Series D, Series F, Series I).

Series label indicates:
Type of account and investor for which the mutual fund can be purchased, and
Type of compensation arrangement for the planner selling that mutual fund.

No standard lettering system

Question 17

Types of Mutual Funds

Answer 17

Equity mutual funds:
Growth funds, Small Cap funds, Mid-Size Cap funds, Dividend funds, Balanced Growth and Income funds, Sector funds, Index funds, International Equity funds, Ethical funds, Asset Allocation funds, Target date funds, Portfolio funds

Bond mutual funds:
Canadian bond funds, Global bond funds

Question 18

Exchange-traded funds

Answer 18

Exchange-traded funds: designed to track other assets such as a particular stock index (like index funds), a particular bond index, a commodity, or a basket of assets.
-Traded on a stock exchange.
-Share price changes throughout the day.
-New shares are continuously created and redemption of existing shares take place throughout the trading day.

Question 19

Advantages and Disadvantages of ETFs

Answer 19

Advantages:
Lower expense ratios
More tax efficient
Do not make capital gain distributions
Buy or sell them at anytime throughout the day
Use limit orders, stop-buy orders, buy on margin
No minimum initial investment

Disadvantages:
-Can be illiquid
-Have to pay a broker’s commission

Question 20

Return from investing in a mutual fund

Answer 20

Return from investing in a mutual fund
1. Interest income distributions
2. Dividend distributions
3. Capital gains distributions

Interest income, dividends, and capital gains must be distributed in the year that they are earned.

Investors are normally given the opportunity to choose whether to receive these distributions in the form of a cash payment or as additional shares.

Question 21

Risk from investing in an equity mutual fund
Market risk

Answer 21

Market risk: the susceptibility of a mutual fund’s performance to general stock market conditions

Question 22

Risk From Investing In Hedge Funds

Answer 22

Hedge funds: limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions.

Investor must be classified as either an accredited investor or a sophisticated investor to invest in a hedge fund.

Not regulated by a securities commission.

May invest in a wide variety of investments.

May engage in short selling and/or buying stocks on margin.

Question 23

Risk from investing in a bond mutual fund

Answer 23

Performance depends on movement in interest rates.

Interest rate risk: risk that occurs because of changes in the interest rate, affects funds that invest in debt securities and other income-orientated investments.

• Longer-term bonds are the most sensitive.
• Bond funds with a high degree of default risk tend to offer a higher potential return.
• Bond funds can have high and/or low levels of either interest rate risk and default risk.

Question 24

Deciding among Mutual Funds

Answer 24

Consider:
- Your investment objectives
- Your risk tolerance
- Fund characteristics you want

Search for mutual funds that exhibit those desired characteristics.

Question 25

Segregated Funds

Answer 25

• Easy to mistake a segregated fund for a mutual fund.
• Insurance products regulated through the insurance legislation of the province in which they are sold.
• Principal Protection
  –Offer a guarantee on your deposits when the contract matures.
  –Usually matures 10 years after the date of purchase.
  –Deposit guarantee will be 75–100 % of deposits.