Module 7: Leveraging Managed Funds to Achieve Investment Objectives Flashcards
Identify the various types of managed funds operated by financial intermediaries in Canada.
Managed funds operated by financial intermediaries in Canada include:
(a) Mutual funds
(b) Commingled funds operated by institutional fund managers and insurance companies
(c) Exchange-traded funds (EFTs)
(d) Real estate investment trusts (REITs) and limited partnerships (RELPs)
(e) Hedge funds
(f) Private equity funds.
Identify functions provided by financial intermediaries who offer managed funds for their investors.
Pooling of assets is the key idea behind managed funds thus providing a mechanism for small investors to team up to obtain the benefits of large-scale investing. Functions performed by financial intermediaries to investors in managed funds include:
Recordkeeping and administration
Diversification and divisibility
Access to professional management
Lower transaction costs
Explain how investors participate in managed funds such as mutual funds, pooled funds, and pooled segregated funds.
Financial intermediaries that operate mutual funds, pooled funds, and pooled segregated funds pool assets of investors must be able divide claims to those assets among the investors. The mechanism used to do this for mutual funds is the net asset value (NAV), while for pooled funds and pooled segregated funds it is the “unit price.” In each case the approach is similar; investors are buying a proportion of the overall fund, represented by a number of “shares”, at a price.
For a mutual fund, the NAV expresses the value of each share. The formula for calculating NAV of a mutual fund is:
𝑁𝐴𝑉=𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠−𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠/𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
For a pooled fund or pooled segregated fund, the unit price expresses the value of each share. The formula for the unit price for those types of funds:
𝑈𝑛𝑖𝑡 𝑝𝑟𝑖𝑐𝑒=𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠−𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠/𝑈𝑛𝑖𝑡𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Describe the various asset classes available to investors who purchase commingled funds and mutual funds available to investors.
Commingled funds and mutual funds each have a specified investment policy— identified in the in the fund’s investment policy statement for pooled funds and pooled segregated funds or identified in the fund’s prospectus for mutual funds. In broad terms, that investment policy will specify the type of investments that the fund can purchase. The main types of funds that are available in Canada include:
(a) Money market funds investing in money market securities such as T-bills, commercial paper and certificates of deposit .
(b) Equity funds investing primarily in stock but possibly also holding fixed income or other types of securities and a small percentage of total fund assets in market securities to provide liquidity
(c) Some equity funds, called sector funds, concentrate on a particular industry, such as energy, precious metals, financial services, technology or telecommunications. Other funds specialize in securities of particular countries or regions (e.g., global, international, emerging markets, etc.).
(d) Fixed income funds, including bond funds. Within the fixed income sector there is considerable room for specialization. For example, various funds concentrate on government bonds, corporate bonds or mortgages. Other funds specialize by maturity of the securities, ranging from short-term to long-term, or by the credit risk of the issuer, ranging from very safe to high-yield or “junk” bonds.
(e) Balanced funds hold both equities and fixed income securities. In the context of Canadian retirement plans, “Balanced funds” is commonly used to mean funds that hold equities and fixed-income securities in relatively stable proportions, traditionally around 60% equity and 40% fixed income. “Life-cycle” funds referred to in the Text are commonly known as “Target Risk” funds, while “target-date funds” referred to in the Text are commonly known as “Target Retirement Date” funds.
Contrast “open-end” mutual funds and “closed-end” mutual funds and describe how they are sold.
There are two types of mutual funds—closed-end and open-end. For both types of funds, the fund’s board of directors hires a management company to manage the portfolio for an annual fee. In many cases the same company sponsors and manages the fund (e.g., RBC sponsors many mutual funds and is responsible for managing them).
Mutual funds are marketed to the public in two ways:
(a) Directly by the fund underwriter, through the fund’s offices, by telephone or increasingly through the internet, or
(b) Indirectly through brokers on behalf of the underwriter.
“Open-end” mutual funds do not trade on organized exchanges. Investors purchase shares from and redeem (sell) shares through the investment company at NAV; therefore, the price of shares of open-end funds cannot fall below NAV. Both purchases and redemptions may involve a sales charge (a “load”) paid to the seller.
In contrast, “closed-end” funds do not redeem or issue shares. Shares of closed-end funds are traded on organized exchanges and can be purchased through brokers just like other common stock. Their prices can differ from NAV. Three key figures provided on exchange listings of closed-end fund information include:
(a) The fund’s most recent NAV
(b) The closing share price
(c) The premium or discount, which is the percentage difference between these two figures, which is
(𝑃𝑟𝑖𝑐𝑒−𝑁𝐴𝑉)/𝑁𝐴𝑉
TO ADD: 2.2, 2.4
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Explain how the rate of return on an investment in a mutual fund is determined.
The rate of return on an investment in a mutual fund is the increase or decrease in NAV over the period the investment is held, plus income distributions such as dividends or distributions of capital gains, expressed as a fraction of NAV at the beginning of an investment period. Front-end loads are not reflected in the rate of return but since the fund’s expenses are periodically deducted from the portfolio, they are considered in the rate of return. The investor’s rate of return thus equals the gross return on the investment portfolio minus the management expense ratio.
The formula for calculating the rate of return on a fund is:
𝑅=𝑁𝐴𝑉1−𝑁𝐴𝑉0+𝐼𝑛𝑐𝑜𝑚𝑒+𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠/𝑁𝐴𝑉0
Where:
R = Rate of return
NAV0 = Net asset value at beginning of period
NAV1 = Net asset value at end of period
Explain how returns on investments made by mutual funds are taxed.
Returns on these investments are taxable in the hands of the investors and not paid by the fund itself, provided the income is distributed to investors. A fund’s capital gains, interest and dividends are passed through to investors as though they earned the income directly.
However, to the extent that mutual funds are held by registered plans, investment returns are not taxable until payments are made from the registered plan.
Outline the fees associated with investing in mutual funds.
Management fees and operating expenses, including trailing commissions when they are allowed: Usually expressed as a percentage of total assets under management that ranges from less than 1% to over 3%. Expenses are periodically deducted from the assets of the fund. Shareholders do not receive an explicit bill for these; they are periodically deducted from the assets of the fund.
Front-end load: A front-end load is a commission or sales charge paid when shares are purchased and used primarily to pay the brokers who sell the funds. Loads effectively reduce the amount of money invested. For example, each $1,000 paid for a fund with a 6% load results in a sales charge of $60 and a fund investment of only $940. With this 6% load, you need cumulative returns of 6.4% of your net investment (60 ÷ 940 = .064) to break even.
Many funds offer “series” that represent ownership in the same portfolio of securities but with different management expense ratios (MERs). For example, Series A shares might have one or more sales charge options, while Series D shares sold through discount brokerages on a “no advice” basis have no trailing commissions. Series F shares are used in fee-based accounts where a single fee is paid to the broker based on all the assets in the account. Most fund companies also have series targeted at high-net-worth individuals or institutions. with a lower MER and higher minimum investment.
Identify how potential mutual fund investors can obtain information about available funds.
Canadian securities regulations require the production of a simplified prospectus and annual information form document for each series of a mutual fund. These are to be provided to an investor at the point of sale.
The fund’s investment objectives and strategies are presented, as are discussions of investment risks. The fund’s investment adviser and its portfolio manager are also described.
Fund managers are also required to create a summary document called Fund Facts, to be prepared in plain language and contain such information as the fund’s investment objectives, main holdings, risk profile, MER and trading expense ratio. These documents are typically available on the mutual fund companies’ websites.
Mutual fund NAVs and investment return information are publicly available through mutual fund company websites and other information sources. The information published is net of fees (i.e., after fees are considered). Morningstar Canada and the Globe and Mail funds are two major providers of fund and return information for Canadian mutual funds.
Outline the key characteristics of “commingled funds.”
Commingled funds are partnerships of investors that pool their funds. The management firm that organizes the partnership (for example, a bank, insurance company or institutional fund manager) manages the funds for a fee. Commingled funds are similar in form to open-end mutual funds. Instead of shares, the fund offers units, which are bought and sold at net asset value. A management firm may offer an array of different commingled funds—for example, a money market fund, a bond fund and a common stock fund. Other financial intermediaries that operate commingled funds in Canada are institutional fund managers who sell their services to institutional investors such as pension funds, endowments and very high-net-worth individuals.
Describe how Canadian pension and other retirement plans utilize commingled funds as investments for their plan assets.
DB pension plan sponsors that are not of sufficient size or that lack the resources to warrant managing plan investments internally may retain institutional fund managers to act as their investment manager(s). Sometimes, if the pension fund is large enough, the fund manager may establish a “separate fund” for that client, structuring it in accordance with the pension fund’s requirements.
Other (usually smaller) DB pension plan sponsors and sponsors of retirement plans that are capital accumulation plans (CAPs) may use pooled segregated funds for their plan investments.
Describe the types of commingled funds commonly used as investments for Canadian pension and other retirement plans.
In Canada, two types of commingled funds are widely used as investments for pension and other retirement plans. Managers of both of these types of commingled funds normally make available a range of funds in different asset classes (e.g., a fixed income fund, Canadian equity fund, etc.). The two types are:
(1) “Pooled funds” operated by institutional fund managers.
(2) “Pooled segregated funds” operated by insurance companies. Pooled segregated funds are very similar to pooled funds, but because they are regulated by insurance legislation, must be called segregated. This is to indicate that the funds’ assets are segregated from the insurers’ general funds and owned by the investors in the funds. Major Canadian insurers operate these funds through their internal investment management operations or wholly owned subsidiaries.
In addition to proprietary segregated funds, and in order to maximize their access to the CAP market, insurers also operate segregated funds that invest in mutual funds and pooled funds managed by institutional fund managers. In these latter cases, the segregated fund invests in the “underlying” mutual or institutional manager’s pooled fund.
Note that pooled segregated funds used by Canadian retirement plans do not attach any guarantee(s) for a minimum value that are available in pooled funds sold only to individual investors.
Describe the key features of the two types of commingled funds used by Canadian pension and retirement plans—pooled funds and pooled segregated funds.
The key features of pooled funds and pooled segregated funds are as follows:
(a) Investors buy “units” of the funds with the price of the units determined in a manner very similar to that used in determining the net asset value (NAV) for a mutual fund, as follows:
𝑈𝑛𝑖𝑡 𝑝𝑟𝑖𝑐𝑒=𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠−𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠𝑆ℎ𝑎𝑟𝑒𝑠 (𝑜𝑟 𝑢𝑛𝑖𝑡𝑠) 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
(b) These funds are almost always open-end funds; it is unusual for pooled funds to operate as closed-end funds.
(c) Different regulatory regimes apply. The regulatory regime differs between the types of funds. Institutional fund managers are regulated by the securities regulator for the particular jurisdiction. Pooled segregated funds are instead subject to legislation that applies to the insurance industry.
(d) Investor information required under the regulatory regimes include information summaries about each fund and an investment policy statement for each fund. Fund return information is included in the information summaries and some performance measurement companies. Net rate of return information for pooled segregated funds (for the use of CAP plan members) is available through the insurer’s secure websites for plan members. Information issued by insurers complies with both insurance industry requirements and the CAPSA Guideline No. 3, Guidelines for Capital Accumulation Plans (CAP Guidelines) that apply to those types of retirement plans.
(e) Pooled funds and pooled segregated funds operate as no-load funds; front-end loads are extremely unusual.
(f) Costs of investing in the funds are expressed as separate “investment management fees” and, in the case of pooled segregated funds, “operating fees.” No “management expense ratio, MER, is identified.
Describe the way that commingled funds deal with investment management fees and other investment expenses, and compare it to the method used by mutual funds.
Mutual fund expenses are expressed as the management expense ratio (MER) and front- end loads. Trailing commissions, when they are allowed, will be included in the MER. Back-end loads were prohibited by Canadian security regulators in all jurisdictions in 2022. Many funds offer series with different management expense ratios, including a series targeted at high-net-worth individuals or institutions that have a lower MER and a higher minimum investment.
Fees for pooled funds and pooled segregated funds are typically negotiated between the parties (fund manager or insurer, and plan sponsor) and ultimately determined based upon the specific circumstances of the retirement plan in question. Fees are contractual between the parties and disclosed within the legal documents established at the time the fund manager is retained.
For DB pension plans, fees associated with the management of pooled funds and pooled segregated funds are normally directly billed to the pension fund. For CAP plans, the various investment fees are charged to the fund prior to establishing the unit price and are therefore less visible (i.e., as with mutual funds, these expenses are regularly deducted from the assets of the fund). Investment fees within CAPs serve to reduce unit values and hence reduce returns to the investors (i.e., plan members).
