Chapter 18: Mutual funds: types and features

Question 1

What are Two important factors to consider mutual funds?

Answer 1

the available methods of withdrawal and the tax implications

Question 2

How are Mutual funds distinguished?

Answer 2

By either their basic investment policy or by the kind of assets they hold

Question 3

What are the categories that The Canadian Investment Funds Standards Committee (CIFSC) groups Canadian-domiciled mutual funds into? (based on the types of assets under management)

Answer 3

• Money market funds
• Fixed-income funds
• Balanced funds
• Equity funds
• Commodity funds
• Specialty funds
• Target-date funds
• Alternative Funds

Question 4

What are money market funds?

Answer 4

• Invest in the securities that trade in the money market like cash, cash-equivalent securities, and short-term debt securities of an approved credit rating.
• Investments might include Treasury bills, bankers’ acceptances, high-quality corporate paper, and short-term bonds. Funds in this category include Canadian and U.S. funds.
• They must maintain a minimum weighting of 95% of their total net assets in cash or cash-equivalent securities
• They have a constant share/unit value, often $10. To keep their net asset value per share (NAVPS) constant, the net income of the fund is calculated daily and credited to unitholders. The earned interest is paid out as cash or reinvested in additional shares on a monthly (or sometimes quarterly) basis.
• Distributions received from a money market fund are taxable as interest income when they are held outside of a registered plan. Investors must add the interest to their income and pay tax on that portion at their marginal rate.

Question 5

What is the advantage of money market funds?

Answer 5

• Money market funds add liquidity to a portfolio. They also provide a small stream of income and relative safety of principal. They are considered the least risky type of mutual fund.

Question 6

What is the main risk of money market fund?

Answer 6

The main risk to these funds is interest rate risk. Fund managers try to maintain a stable NAVPS, but rapid increases in interest rates can reduce the value of the shares.

Question 7

What are fixed income funds?

Answer 7

• Are designed to provide a steady stream of income and safety of principal, rather than capital appreciation.
• This category includes the following fund types:
  • Canadian short-term fixed income
  • Canadian long-term fixed income
  • Canadian inflation-protected fixed income
  • Global fixed income
  • High-yield fixed income
• High-yield fixed-income funds invest in fixed-income securities with a non-investment-grade credit rating.
  Otherwise, all mutual funds in the fixed-income category invest primarily in high-quality government and
  corporate debt securities. Their degree of volatility is related to the degree of interest rate fluctuation. However, fund managers attempt to change the duration of the portfolio and the mix of low- and high-coupon bonds to compensate for changes in interest rates.

Question 8

How much of their non-cash assets must Fix-income fund invest in fixed-income securities?

Answer 8

Funds in this category must invest at least 95% of their non-cash assets in fixed-income securities.

Question 9

What is the main risk of fix income funds?

Answer 9

Interest rate volatility is the main risk associated with this type of fund. Funds that invest in corporate bonds are
also exposed to default risk.
The primary source of returns from bond funds is interest income. The investor may also receive a capital gain if the fund sells some of its bonds at a profit

Question 10

What are balanced funds?

Answer 10

• Invest in both stocks and bonds to provide a balanced mix of income and capital growth. Some managers add value by shifting investment proportions in anticipation of market conditions. Otherwise, if diversification is the goal, investors can achieve the same effect by putting their money into more than one fund.
• The main objective is to provide a balanced portfolio of safety, income, and capital appreciation. Fixed-income securities provide stability and income, and a broadly diversified group of common stock holdings provide diversification, dividend income, and growth potential.
  The balance between defensive and aggressive security holdings is rarely split evenly. Rather, managers of balanced funds adjust the percentage of each part of the total portfolio in accordance with current market conditions and future expectations. In most cases, the prospectus specifies the fund’s minimum and maximum weighting for each asset class.

Question 11

What are the different type of balanced funds?

Answer 11

• Canadian equity balanced
• Canadian neutral balanced
• Canadian fixed income balanced
• Global equity balanced
• Global neutral balanced
• Global fixed income balanced
• Tactical balanced

Question 12

What are the maximum and minimum of holding fixed-income asset and equities of balanced funds?

Answer 12

According to the CIFSC, balanced funds can hold a range of 5% to 90% in equities and 10% to 95% in fixed-income securities

Question 13

What are the risks of balanced funds?

Answer 13

Investors in balanced funds are subject to market and interest rate risk in varying degrees, depending on the split between fixed-income and equity securities. They may receive a combination of interest, dividends, and capital gains, and are taxed accordingly

Question 14

How many subcategories there are in equity funds?

Answer 14

24

Question 15

What are the equity fund types?

Answer 15

• Canadian, U.S., and global equity
• Canadian dividend
• Canadian and U.S. small- and mid-cap equity
• International, European, and emerging markets equity
• Asia Pacific equity
• Greater China equity
• Health care, precious metal, natural resources, and real estate equity

Question 16

What are the maximum and minimum of equities the equity funds must hold?

Answer 16

• Funds in the equity category must invest a minimum of 90% of their non-cash assets in equity securities
• Invests primarily in the common shares of publicly traded companies. They may purchase short-term notes or other fixed-income securities from time to time in limited amounts for liquidity and, occasionally, income. The bulk of assets, however, are in common shares in the pursuit of capital gains. Because common share prices are typically more volatile than other types of securities, prices of equity funds tend to fluctuate widely. These funds are therefore considered riskier than other fund types.

Question 17

What is the main objective of equity funds?

Answer 17

• Is long-term capital growth.

Question 18

What are the characteristics of equity funds?

Answer 18

• Equity funds range greatly in degree of risk and growth potential. All equity funds are subject to market risk, and investments in markets outside of Canada are subject to foreign exchange rate risk.
• Some equity funds are broadly diversified holdings of blue-chip, income-yielding common shares. This type is
  classified at the conservative end of the equity fund scale. Other equity funds adopt a slightly more aggressive investment stance. For example, they may invest in emerging growth companies with the objective of above-average growth of capital.
• Still other equity funds are more speculative; they aggressively seek capital gains at the sacrifice of safety and income. These funds invest in certain sectors of the market, such as precious metals, health care, and biotechnology, or in certain geographical locations, such as China, Latin America, and Japan.
• The tax implications are the same as for any fund that holds equity securities. Distributions are in the form of capital gains and dividends and are taxed accordingly.

Question 19

What is small-cap and mid-cap equity funds?

Answer 19

• Some Canadian equity funds limit investments to companies with capitalization below those of the hundred largest Canadian companies. These funds are considered to be small- to mid-cap Canadian equity funds.
• Smaller companies are considered to have a higher potential for growth than large, well-established ones. These funds, therefore, offer opportunities that theoretically differ from general Canadian equity funds. Because these young companies tend to reinvest profits into expansion, they do not usually pay dividends.
  Along with the potential for greater gains comes more volatility than is typically experienced with equity funds that invest in mature blue-chip equities. Distributions in this type of fund are usually in the form of capital gains

Question 20

What is dividend funds?

Answer 20

Canadian dividend funds provide tax-advantaged income with some possibility of capital appreciation. Dividend
funds invest in preferred shares as well as high-quality common shares, with a history of consistently paying
dividends. The income from these funds is in the form of dividends, which have the tax advantage of receiving the
dividend tax credit. There may be capital gains as well.
The price changes that lead to capital gains or losses on dividend funds are driven by changes in interest rates and general market trends. They are thus subject to both interest rate risk and market risk. Price changes in the preferred share component of these funds are driven by interest rate changes. General upward or downward movements in the stock market most heavily affect the common share component. As discussed earlier in this course, preferred shareholders rank ahead of common shareholders, but below bondholders, in the event of bankruptcy or insolvency.
-> dividend funds are considered riskier than bond funds, but less risky than equity funds.

Question 21

What is commodity funds?

Answer 21

Either invest in physical commodities or gain exposure to commodities through the use of derivatives. The exposure to commodities is primarily long and must not exceed 100% by way of leverage

Question 22

What kind of funds are considered as specialty funds?

Answer 22

The funds that do not fit easily into any of the broader categories defined above. They concentrate their assets into one main area, such as a specific industry or region.

Question 23

What are the different types of funds in Specialty funds?

Answer 23

1. Retail venture capital
2. Alternative strategies
3. Miscellaneous including:
   - Income and real property
   - Leveraged
   - Geographic
   - Sector

Question 24

What are the characteristics of specialty funds?

Answer 24

• Seek capital gains and are willing to forgo (kiem loi nhuan) broad market diversification in the hope of achieving above-average returns.
• Because of their narrower investment focus, these funds often carry substantial concentration risk.
• They offer some diversification when combined with other fund types in a portfolio. However, they are
  vulnerable to swings in the industry in which they specialize or, if they have a portfolio of foreign securities, in currency values. Many, but not all, specialty funds tend to be more speculative than most types of equity funds

Question 25

What are target-date funds (target-based funds or life-cycle funds)?

Answer 25

• Are structured on the assumption that risk tolerance declines as investors grow older.
• > Target-date funds have their own category under the CIFSC classification. Upon maturity, they are moved out of the target-date group and included in the appropriate fixed income or balanced fund category

Question 26

What are the characteristics of target-date funds (target-based funds or life-cycle funds)?

Answer 26

1. Target date is a date set by the investor to match a certain life goal. The date of retirement is a common target date
2. The glide path (Đường trượt) refers to changes in the fund’s asset allocation mix over time. The fund pursues a growth strategy in its early years by holding more risky assets. It then gradually moves towards less risky assets as the target date approaches. The fund manager adjusts the fund over time, without any action required from the fundholder.

Question 27

What are alternative funds?

Answer 27

Alternative Funds category employ alternative strategies such as short selling or other forms of leverage that the typical mutual fund is not permitted to use. Funds in this category may use speculative as well as hedging strategies. Funds that do not issue a simplified prospectus will not be ranked with the funds in this category

Question 28

What is index funds?

Answer 28

• An index fund sets out to match the performance of a broad market index, such as the S&P/TSX Composite
  Index (for an equity index fund) or the FTSE Canada Universe Bond Index (for a bond index fund). Index funds are not specifically listed in these categories; instead, they are categorized under the type of asset class they tend to replicate.
• The index fund manager invests in the securities that make up the model index, in the same proportion that these securities are weighted in the index
• the management fees associated with index funds are usually lower than those of other equity or bond
  funds
• The investment objective of an equity index fund is to provide long-term growth of capital. These funds are subject to market risk because the portfolio is tied to the performance of the market. With a bond index fund, the main risk is interest rate risk
• The distributions of an index fund depend on the type of index being matched. For example, the income of a fund
  matching a bond index will be primarily interest, with some capital gains. An index fund matching an equity index, on the other hand, may have dividend and capital gains distributions.

Question 29

What is the ranking of all kinds of funds on the x = risk and y = return model?

Answer 29

Money market funds < fixed income funds < balanced funds < equity funds < specialty funds

Question 30

what are the styles of fund managers?

Answer 30

1. Passive (involves some form of indexing to a market or a customized benchmark) -> lower management expense
2. Active (designed to outperform the market benchmarks)

Question 31

What are the two passive styles of passive fund managers?

Answer 31

1. Indexing

2. Closet indexing

Question 32

What is indexing style in styles of passive fund managers?

Answer 32

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 lowcost, long-term, buy-and-hold strategy, with no need to conduct individual securities analysis. Many index funds, particularly those that provide foreign exposure, rely on a combination of stock index futures and Canadian Treasury bills

• > Ad: simpler to understand, an advantage for taxable accounts.
• > Dis: return is less than market benchmark because of all fees and expense and distributions in the form of derivative-based income are taxable as income rather than as capital gains

Question 33

What is closet indexing style in styles of passive fund managers?

Answer 33

does not replicate the market exactly, but sticks fairly closely to the market weightings by industry
sector, by country or region, or by average market capitalization. Some active managers are closet indexers. Their style can be determined by how closely their returns, volatility, and average market capitalization correspond to the index as a whole

Question 34

What are the steps to redeem mutual fund units?

Answer 34

Step 1: The client contacts you and asks to sell or redeem fund units.
Step 2: You then place the trade request with the fund or the fund’s distributor.
Step 3: At the end of the valuation day, the fund calculates the net asset value, and the proceeds are sent to the investor.

Question 35

What is the value the investor will receive after redeem?

Answer 35

If there are no back-end load charges or deferred sales charges, the investor receives the NAVPS amount. Otherwise, the investor receives the NAVPS amount less the sales commission.

Question 36

How mutual funds generate taxable income?

Answer 36

in 2 ways:

• Through the distribution of interest income, dividends, and capital gains realized by the fund
• Through any capital gains realized when the investor sells the fund

Question 37

How is the tax record for annual distributions?

Answer 37

• When mutual funds are held outside a registered plan such as a registered retirement savings plan or a registered retirement income fund, the fund holder is sent either a T3 form (for unitholders) or a T5 form (for shareholders).
• Both tax forms report the types of income distributed that year: foreign income and Canadian interest, capital gains, and dividends, including dividends that have been reinvested. Each type of income is taxed at the fund holder’s personal rate in the year received

Question 38

How is the capital gain taxed for investors who redeemed the mutual fund share?

Answer 38

Only 50% of net capital gains is added to the investor’s income and taxed at their marginal rate. (Net capital gains is equal to total capital gains less total capital losses.)

Question 39

What is the problem of distribution of capital gains throughout the year of mutual funds to investors?

Answer 39

Can trigger unexpected taxed. If the distribution of capital gains is carried out only at year end, it can pose a problem for investors who purchase a fund close to the end of the year -> caution to buy mutual fund just before year end. They should first check with the fund sponsor to determine whether a capital gains distribution is
pending.

Question 40

When do they need to adjust the cost base?

Answer 40

• When investor chooses to reinvest income to additional, non-registered units -> price difference between the original purchase price and the sale price -> need to adjest the cost base of the investment so that investors don’t pay tax twice on the same ammount.
• Many investment funds provide this information on quarterly or annual statements

Question 41

What would many funds do with the dividend if there is no otherwise advised?

Answer 41

• They automatically reinvest distributions into new shares at the prevailing net asset value, without a sales charge on the shares purchased.
• Most funds also have provisions for shareholders to switch from cash dividends to dividend reinvestment, and vice versa.

Question 42

What is the reaction of the NAVPS to a distribution of funds?.

Answer 42

NAVPS will react similar to stock on the day it begins to trade exdividend. The NAVPS falls by an amount proportionate to the dividend. Because most investors receive their dividends in the form of more units rather than cash, the net result of the distribution is that the investor owns more units, but the units are each worth less

Question 43

What is right of redemption?

Answer 43

A mutual fund’s shareholders have a continual right to withdraw their investment in the fund simply by making
the request to the fund itself. In return, they receive the dollar amount of their net asset value.

Question 44

What is the hallmark (dau hieu) of mutual fund?

Answer 44

Right of redemption

Question 45

Why many funds offer one or more systematic withdrawal plans?

Answer 45

To meet the needs of investors (such as retired) who do not want to withdraw their entire investment at the same time. Withdrawals may be arranged monthly or quarterly, or at other predetermined intervals.

Question 46

What is the risk with systematic withdrawal plans that you need to explain to investors?

Answer 46

If the fund invests successfully, the increased worth of its shares helps offset the reduction of principal that been withdrawn. However, if the investment decreases in value, the investor’s entire investment may be
extinguished earlier than expected

Question 47

What is ratio withdrawal plan?

Answer 47

• The investor receives an annual income from the fund by redeeming a specified percentage of fund holdings each year. The percentage chosen for redemption usually falls between 4% and 10% per year, depending on investor requirements.
• Because the payout is a set percentage of the
  value of the fund, the amounts may vary each time

Question 48

What is fixed-dollar withdrawal plan?

Answer 48

• Similar to a ratio withdrawal plan except the investor chooses a specified dollar amount to be withdrawn on a monthly or quarterly basis. If the investor’s fixed withdrawals are greater than the growth of the fund, the withdrawals will encroach upon the principal.

Question 49

What is fixed-period withdrawal plan?

Answer 49

a specified amount is withdrawn over a pre-determined period with the intent that all capital will be exhausted when the plan ends.

Question 50

What is a life expectancy-adjusted withdrawal plan?

Answer 50

• Kind of a fixed-period withdrawal plan. Withdrawals are
  designed to deplete (lam can kiet) the entire investment by the end of the plan, while providing as high an income as possible during the investor’s expected lifetime. The amount withdrawn on each date is based on periods that are continually readjusted to the changing life expectancy of the plan holder.
• Readjustments are based on mortality tables. Therefore, the amounts withdrawn vary in relation to the amount of capital remaining in the plan and the plan holder’s revised life expectancy

Question 51

Is there any suspension of redemptions?

Answer 51

Yes. Securities commissions require all Canadian mutual funds to make payment on redemptions within a specified time; however, redemption suspensions are permitted in rare cases. Almost all funds reserve the right to suspend or defer a shareholder’s privilege to redeem shares, if necessary.

Question 52

What is “vty” stand for when reading quptation of a mutual fund?

Answer 52

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; funds with a Vty of 10 have the highest variability in returns.

Question 53

How different the performance of money market presented compare to mutual funds?

Answer 53

Because of the relatively fixed NAVPS that these funds maintain, financial sources generally do not report the NAVPS. Instead, they report each fund’s current and effective yield. The current yield reports the rate of return on the fund over the most recent seven-day period expressed as an annualized percentage. The effective yield is the rate of return that would result if the current yield were compounded over a year, thereby allowing comparison with other types of compounding investments

Question 54

How mutual fund performance is measured?

Answer 54

Performance is measured by calculating the return realized by a portfolio manager over a specified time interval called the evaluation period.

Question 55

What is the most frequently used method to measure mutual fund performance?

Answer 55

• Is to compare NAVPS at the beginning and at the end of the period.
• Usually, this method is based on several assumptions, including the assumption that all dividends are reinvested. The increase or decrease at the end of the period is then expressed as a percentage of the initial value

Question 56

How can you minimize the effect of investor contributions and withdrawals When measuring the return on a mutual fund?

Answer 56

using a time-weighted rate of return (TWRR), which measures the actual rate of return earned by the portfolio manager

Question 57

How to calcualte Time-weighted rate of return (TWRR)?

Answer 57

The TWRR is calculated by averaging the return for each sub-period in which a cash flow occurs to create a return for the reporting period. Therefore, unlike a total return, it does account for cash flows such as deposits, withdrawals, and reinvestments

Question 58

What are the Methods of calculating a time-weighted return?

Answer 58

1. Daily valuation method

2. Modified dietz method.

Question 59

What is daily valuation method?

Answer 59

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, mortgagebacked securities, and illiquid issues.

Question 60

What is modified dietz method?

Answer 60

This method reduces the extensive calculations of the daily valuation method by providing a good approximation. It assumes a constant rate of return through the period, eliminating the need to value the portfolio on the date of each cash flow. The Modified
Dietz method weights each cash flow by the length of time it is held in the portfolio

Question 61

What is standard performance data?

Answer 61

• specify the minimum return measures that mutual fund companies must include, and how they are to be calculated,.
• These measures ensure that mutual fund returns are comparable across different funds and fund companies. When they are presented in sales communications, they must be printed as prominently as any other performance data that the mutual fund company provides

Question 62

What include in standard perfromance data of mutual funds except money market fund?

Answer 62

standard performance data include compounded annual return periods of one, three, five, and 10 years, as well as the total period since inception of the fund. For money market funds, the standard performance data include the current yield and the effective yield

Question 63

What should you do as a mutual fund advisor?

Answer 63

you should look at periods of three to five years or more, as well as individual years. Nevertheless, it is reasonable to ask questions if the fund is falling well short of the average in its category.
Always keep in mind, however, that past performance is not indicative of future performance

Question 64

What are the general standards of comparison between different mutual funds?

Answer 64

the return on a fund’s benchmark index and the average

return on the fund’s peer group of funds

Question 65

What is the benchmark comparison?

Answer 65

All mutual funds have a benchmark index against which their return can be measured. Examples include the
S&P/TSX Composite Index for broad-based Canadian equity funds and the FTSE Canada Universe Bond Index
for bond funds

Question 66

Where can we find mutual fund benchmark?

Answer 66

Morningstar Canada has developed a series of mutual fund benchmarks that summarize average rates of return for Canadian bond, Canadian equity, U.S. equity, global bond, and international equity funds. These indexes, which are available on the firm’s website, provide a benchmark that investors can use to measure the relative performance of various funds

Question 67

What is peer group comparisons?

Answer 67

A peer group is made up of mutual funds with a similar investment mandate. To measure the performance of a fund, its return is compared to the average return of the peer group. Therefore, if a fund posted a one-year return of 12% while the average return of its peer group over the same period was 9%, we can say that the fund outperformed its peer group over the evaluation period

Question 68

What are issues that complicate mutual fund performance?

Answer 68

• the name or class of fund does not accurately reflect the actual asset base of the fund -> can impair attempts to create a portfolio.
• 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.
• the volatility of a fund’s returns. The measures of volatility attempt to quantify the extent to which returns will fluctuate. From an investor’s standpoint, a fund that exhibits significant volatility in returns is riskier than those with less volatility

Question 69

What should you avoid when comparing performance of mutual funds?

Answer 69

• avoid comparing the performance of two funds that are
  dissimilar or comparing funds that have differing investment objectives or degrees of risk acceptance
• 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. The beta, available on most fund performance software, measures the extent to which a fund is more or less volatile than the underlying market in which it invests. The greater the variation in the fund’s returns, the riskier it tends to be. Particular attention should be paid to periods during which a fund has lost money

Question 70

What are measures are used to quantify mutual fund volatility?

Answer 70

• The standard deviation of the fund’s returns, which, if high, might indicate future volatility
• Beta, which relates the change in the price of a security to the change of the market as a whole
• The number of calendar years it has lost money
• The fund’s best and worst 12-month periods
• The fund’s worst annual, quarterly, or monthly losses
- calculate best-case and worst-case scenarios

Question 71

What are the pitfalls (cạm bẫy) to avoid in judsing mutual fund performance?

Answer 71

• Past performance is not indicative of future performance.
• Historical performance may be especially irrelevant when there has been a change in portfolio manager. Some observers argue that the performance of a fund is a direct reflection of the skill of the portfolio manager.
• Although average returns for a peer group of funds are useful measures, they can reflect survivorship bias. This
term describes a tendency for poorly performing funds to be discontinued or merged. Therefore, average returns of surviving funds may be artificially high because they do not fully reflect past performance of the entire spectrum of funds.
• Mutual fund performance evaluations should consider both the type of fund and its investment objectives. Bond
funds cannot be compared with equity funds, nor should you compare equity funds with different investment
objectives.
• Finally, beware of selective reporting of performance periods, especially when there are no comparable numbers for the performance of a market benchmark or a peer group of competing funds.