Chapter 18 Mutual Funds: Types and Features RQ Flashcards
Ridwan received a T5 for a mutual fund that he owned. On the T5, it stated that he earned $300 in Canadian dividends and $1,000 in capital gains. How could Ridwan have earned capital gains, when he did not sell his shares in the mutual fund?
A. Capital gains were made on the sale of securities during the year by the fund manager within the fund itself.
B. Capital gains due to an increase in the value of the fund are taxed annually, so they must be reported on an annual basis.
C. The fund company can choose how to categorize the annual distribution in order to provide tax benefits for the shareholders.
D. Capital gains can only be earned when shares of the fund are sold so the mutual fund must have been bought by another fund company.
A. Capital gains were made on the sale of securities during the year by the fund manager within the fund itself.
The fund manager buys and sells securities throughout the year for the mutual fund. If a security is sold for more than it was bought, a capital gain results. It is this capital gain that is passed on to the mutual fund holder. Unfortunately, capital losses that arise when selling a security for less than it was bought cannot be passed on to the mutual fund holder. The losses are held in the fund and may, however, be used to offset capital gains in subsequent years.
Why do some advisors caution investors against buying a mutual fund just prior to year-end?
A. Sometimes equity prices decline before year-end due to tax loss selling.
B. The investor might not receive the appropriate year-end distribution.
C. A large year-end distribution could trigger an unexpected tax payment.
D. Year-end fund prices might temporarily increase due to fund “window dressing”.
C. A large year-end distribution could trigger an unexpected tax payment.
If a large distribution is made by a mutual fund at year end, the investor who purchased late in the year will have a tax liability even if he did not earn the income over the year. For example, if an investor purchases a fund for $50/unit on December 12th and the fund makes a distribution of $7/unit on December 30th, it appears that the investor is not affected. He now has additional units with a NAVPS of $43. However, the $7 distribution will be taxed at the appropriate rate and the after-tax value of the investment will decline. Eventually, the tax paid will be recaptured when the ACB is calculated at the disposition of the shares but the investor has had his tax payment accelerated.
Identify the correct statements concerning withdrawal plans.
High constant dollar withdrawals may encroach upon the principal.
Ratio withdrawal plans are suitable for using the proceeds to pay a mortgage.
Life withdrawal plans do not always result in constant dollar payouts.
Under fixed period withdrawal plan, the yearly amount withdrawn remains unchanged.
A. 1 and 4.
B. 2 and 3.
C. 1 and 3.
D. 2 and 4.
C. 1 and 3.
To help investors who have a lump sum of money available, but who require cash flows over a number of periods, many funds offer one or more systematic withdrawal plans. In simple terms, a lump sum is invested in a fund with the intent of gradually withdrawing all or part of the capital invested plus dividends over a period of time. Withdrawals may be arranged monthly, quarterly or at other predetermined intervals. The following briefly outlines the four basic systematic withdrawal plans:
- Ratio Withdrawal Plan: Here the plan holder receives an annual income from the fund by redeeming a specified percentage of his holding of fund shares each year. The percentage chosen for redemption usually falls between 4% and 10% a year depending on the amount of takeout the plan holder requires. Obviously, the higher the percentage, the more rapid the rate of depletion of the investor’s original investment. Because amounts received by the investor may vary, they are not usually suitable for meeting fixed commitments.
- Fixed Dollar Withdrawal Plan: This plan is similar except that the plan holder chooses a specified dollar amount to be withdrawn on a monthly or quarterly basis.
- Fixed Period Withdrawal Plan: Here a specified amount is withdrawn over a determined period of time with the intent that all capital will be exhausted when the plan ends. Amounts withdrawn can be adjusted to compensate for the investment experience of the fund, while still attempting to reduce the holding to zero at the plan’s end.
- Life Expectancy Adjusted Withdrawal Plan: This type of plan is a variation of a Fixed Period Withdrawal Plan. Payments to the plan holder are designed to deplete the entire investment by the end of the plan, while providing as high an income as possible during the plan holder’s expected lifetime. However, to accomplish this, the amount withdrawn on each date is based on periods of time which are continually readjusted to the changing life expectancy of the plan holder taken from mortality tables. Thus, the amounts withdrawn vary in relation to the amount of capital remaining in the plan and the plan holder’s revised life expectancy.
Sara’s client, Jonah, feels he has an expected life span of 85 years. He began a Life Expectancy Adjusted Withdrawal Plan at age 70. Now at age 75, his expected life span was re-estimated as 88 years. How would this re-estimate affect future withdrawals from his mutual fund?
A. They would be unchanged as once the withdrawals have begun, the client can’t change them.
B. They would be lower than those with the original calculation.
C. They would be higher than those with the original calculation.
D. The client would have to start a new withdrawal plan based on the revised life span.
B. They would be lower than those with the original calculation.
Future withdrawals from the mutual fund would be lower to reflect the longer expected life span. This method attempts to ensure that the person will not deplete their funds during their life. The new higher life span results in a larger denominator and a lower annual payment as per the formula: Withdrawals = (Value of the Portfolio/ (Life Expectancy - Current Age)). At age 75, the withdrawal calculation before any adjustment would have been:
Value of portfolio / (85 - 75) = Value of portfolio / 10
But the life expectancy was adjusted to 88 years. The adjusted withdrawal amount now changes to:
Value of portfolio / (88 - 75) = Value of portfolio / 13
Since the adjustment forces the denominator to increase, the payment now becomes smaller than it would have been if the life expectancy had remained unchanged.
Sulee is considering investing in one of two funds, from the same fund family. One is a balanced fund, while the other is a fixed-income fund. Which fund would you tell her is likely to be riskier?
A. The fixed-income fund would be riskier than the balanced fund as balanced funds invest in only one asset class.
B. The risk would be about the same, as the two invest in the same types of securities.
C. The fixed-income fund would be less risky than the balanced fund as balanced funds also invest in equities which tend to be riskier.
D. You can’t compare the two because one has a goal of income and the other a goal of income and growth.
C. The fixed-income fund would be less risky than the balanced fund as balanced funds also invest in equities which tend to be riskier.
Unit values of bond funds are affected by shifts in interest rates (interest rate risk) in the same way that bond prices are affected by changes in interest rates. Balanced funds include both fixed-income and equity securities as part of their asset allocation. The equity portion adds greater volatility to balanced funds and this results in bond funds being considered less risky than balanced funds.
Yuri is planning to buy a house in the next two years and can’t afford to lose any of the capital he has saved to make a down payment on the house. If interest rates were to move up rapidly, which type of mutual fund would be the safest for him to invest in?
A. Money market funds.
B. Preferred share funds.
C. Bond funds.
D. Mortgage funds.
A. Money market funds.
The objective of money market funds is to achieve some income and liquidity through investment in short-term money market instruments such as treasury bills, commercial paper and short-term government bonds. These funds have almost no opportunity for price changes as most funds keep the net asset value at a set level of $10.
Select the correct statements about balanced funds.
Expected returns on balanced funds should be higher than the return on money market funds.
The balance between defensive and aggressive holdings is rarely 50-50.
The main objective is to provide a balanced mixture of safety and capital appreciation.
Balanced funds are equally balanced between bonds, preferreds and equity.
A. 1 and 2.
B. 1 and 3.
C. 2 and 4.
D. 3 and 4.
A. 1 and 2.
A balanced fund’s investment objectives are a mixture of safety, income and capital appreciation. These objectives are sought through a portfolio of fixed-income securities for stability and income, plus a broadly diversified group of common stock holdings for diversification, dividend income and growth potential. This means that the “expected” return should be higher than the return on money market instruments. The balance between defensive and aggressive security holdings is rarely 50:50; rather, managers of balanced funds adjust the percentage of each part of the total portfolio in accordance with current market conditions and future expectations.
Identify the statement that accurately reflects the characteristics of an indexing investment style.
A. Low-cost, short-term, buy-and-hold.
B. Low-cost, long-term, buy-and-hold.
C. High-cost, long-term, active trading.
D. High-cost, short-term, active trading.
B. Low-cost, long-term, buy-and-hold.
Indexing represents a passive style of investing that attempts to buy securities that constitute or closely replicate the performance of a market benchmark such as the S&P/TSX Composite Index or the S&P 500 Composite Index. The indexing style is a low-cost, long-term, buy-and-hold strategy. There is no need to conduct individual securities analysis.
What is the main disadvantage of using the daily valuation method of calculating a time-weighted return?
A. This method provides only an approximation of a return, not an accurate return.
B. The calculation is too complex for the average investor to understand.
C. The method does not take into account cash flows such as withdrawals and deposits during the time period which can cause the return to be under or over reported.
D. The securities in the portfolio need to be valued every day, which can be difficult for some funds with illiquid assets.
D. The securities in the portfolio need to be valued every day, which can be difficult for some funds with illiquid assets.
With this method, the incremental change in value from day to day is expressed as an index from which the return can be calculated. This method is beneficial for mutual funds, which generally calculate NAVPS daily. It greatly simplifies their return calculation at the end of the month. The main drawback is the need to value the portfolio every day. It can be difficult to price the daily market value of such assets as real estate, mortgage-backed securities, and illiquid issues.
An investor purchases units of XYZ Fund in her non-registered account on December 20, 20XX at $30 NAVPU. On December 30, XYZ Fund pays a capital gain of $6 per unit and the NAVPU falls to $24. Calculate the investor’s taxes payable per unit if her marginal tax rate is 40%.
A. $0.00.
B. $1.20.
C. $2.40.
D. $3.00.
B. $1.20.
When mutual funds distribute capital gains to unitholders, the gains are taxed as ordinary capital gains at the investor’s marginal tax rate. In this example, the tax is ($6 x 50%) x 40% = $1.20.
An investor purchases 500 units of a no-load fund for $10,000. In Year 1, he receives $200 in dividends, in Year 2, $150 in dividends, and in Year 3, $400 in dividends. All dividends are re-invested in new shares of the Fund. In Year 3, he sells all of his units for $20,000. Calculate his taxable capital gain.
A. $4,625.
B. $5,000.
C. $9,250.
D. $10,000.
A. $4,625.
When dividends or other income are reinvested in new fund units, the amounts reinvested increase the adjusted cost base of the investment. In this example, the $750 in reinvested dividends increased the adjusted cost base by $750, resulting in a $9,250 gain on disposition, with a taxable amount of $9,250 x 50% = $4,625.
Based on the volatility (Vty) rating of the funds listed, select the fund that is most suitable for an elderly retiree on a fixed pension?
A. ABC Balanced Fund, Vty 1.0.
B. DEF Balanced Fund, Vty 5.5.
C. GHI Balanced Fund, Vty 8.0.
D. JKL Balanced Fund, Vty 10.0.
A. ABC Balanced Fund, Vty 1.0.
Vty is a measure of fund volatility (i.e., the variability in returns over the previous three-year period compared with other funds in this asset class). The scale is from 1 to 10. Funds with a Vty of 1 have the lowest variability in returns and funds with a Vty of 10 have the highest variability in returns. In this instance, the ABC Balanced Fund has the lowest volatility of the group, while the other funds are evidencing a high degree of volatility, making them inappropriate for an elderly individual with apparent low ability to tolerate risk.
What type of mutual fund will tend to have the lowest capital gains due to portfolio turnover?
A. Dividend funds.
B. Index funds.
C. Equity funds.
D. Balanced funds.
B. Index funds.
As index funds simply buy the same stocks as the chosen index, they generally have low portfolio turnover, which is an advantage for taxable accounts.
An investor holds $20,000 of a mutual fund and enrolls in a ratio withdrawal plan with an annual withdrawal of 20% per year at the beginning of each year. Assume that the first withdrawal takes place at the beginning of Year 1, and that the fund grows by 6% per year. Calculate the amount that would be withdrawn in Year 2.
A. $3,392.
B. $4,000.
C. $4,240.
D. $4,494.
A. $3,392.
With a ratio withdrawal plan, the investor receives an annual income from the fund by redeeming a specified percentage of fund holdings each year. Since the payout is a set percentage of the value of the fund, the amounts will vary each time. In this example, the withdrawals take place at the beginning of the year. Thus, the first withdrawal will be (20,000 x 20%) = $4,000, leaving $16,000 for investment. At the end of the year, the investment is worth $960 more due to the 6% return on investment. $16,960 x 20% for the Year 2 withdrawal amount would result in a withdrawal of $3,392.
Identify the issues that can complicate mutual fund comparisons.
The name of the fund does not always accurately reflect the actual asset base of the fund.
There is no attempt to consider the relative risk of funds of the same type.
The comparison does not always consider the volatility of the fund’s returns.
The comparison does not take the fund’s performance relative to the stock market cycle.
A. 1, 2 and 4.
B. 2, 3 and 4.
C. 2 and 4.
D. 1, 2, 3 and 4.
D. 1, 2, 3 and 4. One complicating factor occurs when the name or class of fund does not accurately reflect the actual asset base of the fund. Investors should be aware, for example, that funds classified as Canadian equity funds may at times have significant portions of their assets invested in equities other than Canadian stocks.
Another factor that complicates comparisons between funds is that there is often no attempt to consider the relative risk of funds of the same type. One equity fund may be conservatively managed, whereas another is willing to invest in much riskier stocks in an attempt to achieve higher returns.
Any assessment of fund performance should consider the volatility of a fund’s returns. Any assessment of fund performance should consider the volatility of a fund’s returns. The measures of volatility attempt to quantify the extent to which returns will fluctuate.
When dealing with mutual funds as an advisor, you should be aware of a fund’s performance relative to the stock market cycle. Some funds will outperform others in rising markets, but do worse than average in declining markets.
