Chapter 5: Mutual funds

Question 1

L01. The different types of mutual funds.

Answer 1

*Investment Company: Business that specializes in pooling funds from individual investors and investing them.
*2 Fundamental types of investment companies: Open-End vs Closed-End. The difference between the 2 is how shares are bought and sold.
->Open-End Fund: An investment company that stands ready to buy and sell shares at any time. The number of shares outstanding fluctuates through time.
->Closed-End Fund: An investment company with a fixed number of shares that are bought and sold only in the open stock market.
The key difference between Open-End and Closed-End is that with a Closed-End fund, the fund itself does not buy or sell shares. Shares in the Closed-End Fund are listed on stock exchanges just like ordinary shares of stock, where their shares are bought and sold in the same way. Open-End Funds are more popular among individual investors that Closed-End Funds.
*Net Asset Value (NAV): The value of assets less liabilities held by a mutual fund, divided by the number of shares outstanding. The NAV of a mutual fund will change essentially everyday because the value of the assets held by the fund fluctuates. The one exemption concerns money market mutual funds.
An open-end fund will redeem/buy back shares at any time, the price received for the shares you sell is the NAV. In contrast, the shares of closed-end funds are bought and sold in the stock market their share prices at any time may or not be equal to their NAV.

5.5 Short-Term Funds:
Mutual funds are divided into short-term funds and long-term funds. Short-term funds are knob as money market mutual funds. Long-term funds essentially include everything that is not a money market fund.
*Money Market Mutual Fund (MMMF): A mutual fund specializing in money market instruments (short-term debt obligations issued by government and corporations). All money market funds are open-end funds. Most money market funds invest in high-quality, low risk instruments with maturities less than 90 days. As a result, they have relatively little risk. However, some buy riskier assets or have longer maturities than others, so they do not all carry the same risk.
*Money Market Fund Accounting:
*Money Market Deposit Accounts:

5. 6 Long-Term Funds:
   * Stock Funds: Consider 9 separate general types and some subtypes.
   - >Capital Appreciation versus Income: the first 4 types of stock fund trade off capital appreciation and dividend income: 1. Capital Appreciation, 2. Growth, 3. Growth and Income, 4. Equity income.
   - >Company Size-Based funds: 1. Small company, 2. Mid-cap, 3. Large company.
   - >International Funds: 1. Global, 2. International.
   - >Sector Funds:.
   - >Other fund types and issues: 1. Index funds, 2. Social conscience funds, 3. Tax-managed funds.
   - >Short-term & Intermediate-term funds: these 2 fund types focus on bonds in a specific maturity range. Short-term maturities are generally considered to be less than 5 years. Intermediate-term would be less than 10 years. The credit quality of the issues can vary from fund to fund. One fund could hold risky intermediate-term bonds, while another might hold only the government issues with similar maturities.
   - >General Funds: Funds in this category simply don’t specialize in any particular way.
   - >High-Yield Funds: Funds specialize in low-credit quality issues. Such issues have higher yields because of their greater risks. As a result, high-yield bond funds can be quite volatile.
   - >Mortgage Funds: Funds specialize in mortgage backed securities.
   - >World Funds: Funds that invest world wide. Some specialize in only government issues; others buy a variety of non-domestic issues.
   - >Stock and bond funds: Variety of funds, the only common feature is that these funds don’t invest exclusively in either stocks or bonds (so they are called “blended” or “hybrid” funds).
   - >Balanced funds: These maintain a fixed split between stocks and bonds. They emphasize safe, high-quality investments. Such funds provide a “one-stop” shopping for fund investors (particularly small investors because they diversify into both stocks and funds).
   - >2 Asset Allocation Funds:
6. Extended version of a balanced fund, that holds relatively fixed proportional investment in stocks, bonds, money market instruments, and perhaps real state or other investment class.
7. Flexible Portfolio Fund,the fund manager may hold up to 100% in stock, bonds, or money market instruments, depending on his/her views about performance of these investments. These funds try to time the market, guessing which type of investment will do well (or poorly).
   - >Convertible Funds: Bonds that can be swapped for a fixed number of shares of stock at the option of the bondholder.
   - >Income Funds: Emphasizes generating dividend on a coupon income on its investments, so it would hold a variety of dividend-payment common and preferred stocks and bonds of various maturities.
   - >Target Date Funds (life cycle funds): The asset allocation chosen by target date funds is based on the anticipated retirement date of the investor.

Question 2

L02. How mutual funds operate.

Answer 2

• Advantages of Mutual Funds:
  1. Diversification: Diversification helps reducing but does not eliminate risk.
  2. Professional Management: The mutual fund manager makes the decision of when to add or remove securities from the mutual fund.
  3. Minimum Initial Investment.
• Drawbacks of Mutual Funds:
  1. Risk: The value of mutual funds could fall to be less than the initial investment, no government/agency guarantees the value of a mutual fund. There is a cost to diversification, while it reduces risk, spreading investments over many securities limits chances for large returns if one security increases dramatically in value.
  2. Cost: Mutual funds entails fees and expenses that do not usually accrue when purchasing individual securities directly.

5.3 Mutual Fund Operations:
*Mutual Fund Organization and Creation:
A mutual fund is simply a corporation. A mutual fund is owned by shareholders. Shareholders elect a board of directors (responsible for hiring a manager to oversee the fund’s operations).
Most mutual funds are created by banks or investment advisory firms (business that specialize in managing mutual funds). Investment advisory firms are also called mutual fund companies (such firms have additional operations such as discount brokerages and other financial services).
An investment advisory firm will can create new funds from time to time. Through time, this process leads to a family of funds managed by the same advisory firm. Each fund in the family will have its own fund manager, but the advisory firm will generally handle the record keeping, marketing and research of the fund’s investment decisions.

*Taxation of Investment Companies:
As long as an investment company meets the rules set by Canada Revenue Agency, the investment company is treated as a “flow-through entity” for tax purposes (This is important because a mutual fund does not pay taxes on its investment income). Instead, the fund passes through all realized investment income to fund shareholders, who pay taxes (the fund funnels gains/losses to fund owners).

*The Fund Prospectus and Annual Report:
By law mutual funds are required to produce a document called a “prospectus” which must be supplied to any investors wishing to purchase shares. Mutual funds must also provide an annual report to their shareholders. The annual report and prospectus which are sometimes combined contain financial statement and specific information concerning the fund’s expenses, gains and losses, holdings objectives, and management.

5.4 Mutual Fund Costs and Fees:
Mutual Fund’s expenses are paid by the shareholders.
*4 Types of Expenses and Fees in Mutual Funds:
1. Sales charges or “loads”: Fee charged when sales are purchased called Front-end loads. Funds that charge these are called “load funds”. Funds that have no such charges are called “no-load funds”. When you purchase shares in a load fund, you pay a price in excess of the net asset value (offering price). The difference between the offering price and NAV is called the “load” (shares in no-load fund are sold at NAV). Some funds have “backed-end” loads which are charges levied on redemptions. These loads are often called “deferred sales charges” (DSC) which usually declines through time.
2. Special Fees: charged for certain funds and under certain conditions. These fees include:
a. Annual RRSP, RRIF, or RESP trustee fee.
b. Account set-up fee.
c. Short-term trading fee.
d. Processing fees.
3. Management Fees: Fees are usually based first on the size of the fund; furthermore, there is often an incentive provision that increases the fee if the fund outperforms some benchmark.
4. Trading Costs: Mutual funds that do a lot of trading will have high trading costs (brokerage expenses). In the prospectus funds are required to report turnover ( a measure of how much trading a fund does, calculated as the lesser of total purchases or sales during a year divided by the average daily assets). A higher turnover indicates more frequent trading and higher trading costs. A fund with turnover of 1 has sold off its entire portfolio and replaced it once a year. Increased trading adds to amount of commissions paid and has related costs. Increased trading will result in gains (or losses) recognized in the fund. As these gains occur, capital gains will be passed to the investors which will increase the taxes for them.
Some managers purposefully choose higher cost broker (in house or third party) who fulfills the trades because the higher cost might provide added research or other materials that the fund manager considers beneficial. The added commission is called soft dollars.
*Expense reporting: Mutual funds are required to report expenses in a standardized way in the prospectus.
*Why pay loads and fees?:
1. You might want fund run by a particular manager.
2. You want a specialized type of fund.

Question 3

L03. How to find information about how mutual funds have performed.

Answer 3

5.7 Mutual Fund Performance

Question 4

L04. The workings of Exchange-Traded Funds (ETFs) and hedge funds.

Answer 4

*Hedge fund: An unregistered investment company not accessible by the general public and significantly less regulated than a mutual fund. Most hedge funds undertake aggressive risk enhancing strategies.
Hedge funds are not subject to the same disclosure requirement as mutual funds. Further, hedge funds are not required to maintain any particular degree of diversification or liquidity. Unlike mutual funds, hedge funds do not redeem shares on demand; instead, designate particular liquidation dates (possibly once per quarter). Investing in hedge funds is not suited for all investors, to prevent unsophisticated investors from getting involved hedge funds accept only qualified investors (investor need to be rich); also, hedge funds do not sell securities to the public, and limit number of investors in any particular fund to no more than 50-100 institutions or individuals.

• Hedge fund styles:
  1. Market neutral
  2. Arbitrage
  3. Distressed securities
  4. Macro
  5. Short selling
  6. Market timing

Question 5

L05. The workings of Registered Retirement Plans

Answer 5

Investors can open an RRSP account and contribute throughout the year. All contributions are tax deductible; thus, investors can use their contribution to these plans to reduce their income taxes. As long as their savings stay in the plan, investors do not pay tax. Once they withdraw the money they do pay tax.
RRSP funds can be invested in stocks, bonds, and mutual funds. Investors can only make a limited amount of contribution to the RRSP every year, there is also a deadline to make contributions for an RRSP to be eligible.

Question 6

L06. The workings of Income Trusts.

Answer 6

Income trusts are created as asset-holding entities by companies. A trust creates units and offers these units to the public in exchange or money. Trusts can use money collected from unit holders to pay debt and to purchase back the publicly traded shares of the original companies.