Week 3 - Mutual Funds and ETFs

Question 1

What is a mutual fund?

Answer 1

• financial intermediary that collects funds from individual investors and invest those funds in a potentially wide range of securities or other assets
• pooling assets is the key idea behind investment companies. Each investors has a claim to the portfolio established by the investment company in proportion to the amount invested
• mutual funds stand to redeem their shares at their NAV

Question 2

What key functions to investment companies perform?

Answer 2

1. record keeping and administration
2. diversification and divisibility
3. professional management
4. lower transaction costs

Question 3

What is NAV?

Answer 3

the value of each share is called the net asset value
NAV = (Market Value of Assets Minus Liabilities)/Shares Outstanding
- NAV doesn’t reflect expenses i.e., rent/wage etc.

Question 4

Open-end vs. Closed-End Mutual Funds

Answer 4

• open-end funds stand ready to redeem or issue shares at their NAV. When investors in open-end funds wish to cash out their shares, they sell them back to the fund at NAV
• closed-end funds do not redeem or issue shares. Investors in closed-end funds who wish to cash out must sell their shares to other investors. Shares of closed-end funds are traded on exchanges and can be purchased through brokers.
• -> often trade at a discount relative to their assets

Question 5

Why do closed-end funds trade at a premium/discount to NAV?

Answer 5

When this situation occurs and the fund is trading above this price, it is said to be trading at a premium; conversely, when the fund is trading below this price, it is said to be trading at a discount.

Possible reasons for why the discrepancy:

1. market forces
2. management: Sometimes, if the manager is highly regarded, a premium will be paid by investors wishing to hold the fund.
3. expectation: Portfolios expected to perform well in the near future will demand a premium to NAV, while those with assets expected to perform poorly may sell at a discount.

• the price of open-end funds CANNOT fall below NAV, because these funds stand ready to redeem shares at NAV

Question 6

More on open-end funds…

Answer 6

• Open end funds are always open to new investments…able to issue new shares as new investors become interested
• Freely issue new shares
• Priced at NAV
• typically must purchase directly from an investment company (Fidelity)
• since you must purchase from an investment firm, that means the firm must hold enough cash to meet redemption demand, thus they hold a % of the fund in cash, which is missing out on potential investment returns

Question 7

Close-end funds…

Answer 7

• Raises all its capital through an IPO when created
• Limited number of shares, can only buy shares of closed-end funds on exchanges (not from investment firm)
• the investment firm is not responsible for repurchasing your shares when you want to sell…when you ant to cash in have to sell on exchange
• closed-end funds don’t need to keep cash on hand…100% of money invested rather than a portion sitting in cash
• in theory, this means closed-end funds are capable of producing higher returns
• Since shares purchased on exchange, entirely avail not effects of market supply/demand
• Shares of a closed-end trade at a premium/discount to NAV due to the market forces
• possibility of purchasing the fund at a discount to NAV is a big benefit to closed-end funds
• don’t have to keep cash on hand, much more creative and unconventional - able to make investments that open-end wouldn’t have access too
• can’t raise more capital to acquire new investments - closed-end have to rely on performance to continue growing the portfolio…have to be that much more responsible/risky

Question 8

Summary of differences between open-end vs. closed-end

Answer 8

OPEN-END FUNDS:
1. always accepting capital
2, traded directly with firms
3. must keep cash on hand
4. not 100% invested
5. slightly lower returns
6. priced at/near NAV

CLOSED-END FUNDS:

1. capital raised at IPO
2. just trade on exchanges
3. no liquidity obligations
4. often 100% invested
5. more investment options
6. pay premium or discount

Question 9

Why do people buy mutual funds?

Answer 9

• a low cost way to diversify
• get a known exposure to different asset classes
• expert decisions based on superior information
• investing in a fund is a way to outperform a benchmark
• called active portfolio management

Question 10

What is a fixed income fund?

Answer 10

invests primarily in fixed income

Question 11

What is a balance fund?

Answer 11

keep relatively stable proportions of funds invested in each asset class

Question 12

What is asset allocation fund?

Answer 12

like balance funds but more aggressive asset allocation bets

Question 13

Front-end Load

Answer 13

a commission or sales charged the you purchase shares

Question 14

What are the cost of investing in mutual funds?

Answer 14

• Management fees and operating expenses: these costs are incurred by the mutual fund in operating the portfolio and include administrative expenses, marketing expenses, taxes, and advisory fees paid to the investment manager. Usually expressed as a % of AUM - the management expense ratio (MER). Doesn’t include sales load or brokerage commissions
• Front-end Load: a commission or sales charge paid when shares are purchased.
• Back-end Load: a fee incurred when you sell your shares
• Trailing Commissions: most mutual funds pay trailing commissions to the broker who sold the fund. Many funds offer series that represents ownership in the same portfolio of securities, but with different MERs
• Other: operating expenses, 12b-1 charges

ALL THESE CHARGES SHOW UP IN LOWER NAVS

Question 15

Fees and mutual fund returns

Answer 15

• the rate of return on an investment in a mutual fund is measured as the increase od decrease in the NAV plus income distributions such as dividends or disitrubiotns of capital gains
• this measure of rate of return ignors any commissions, such as front-end loads paid to purchase the fund. On the other hand, the rate of return is affect by the fund’s expenses. This is because such charges are periodically deducted from the portfolio, which reduces NAV

Question 16

Mutual fund fees in Canada

Answer 16

• a typical investor in a canadian equity fund pays 2% to 2.5% in fees annually, or about double the fees of a U.S. fund

–> expensive in Canada because the MER includes the “trailer fee”

• trailer fee is paid to the adviser/broker who sold the fund and which continues as long as the investor holds it

Question 17

Mutual fund performance

Answer 17

• there is some evidence of fund performance if you look at before cost returns. But some argue that this is largely due to momentum trading - after taking into account costs, there is no evidence that mutual fund managers add value on average
• no evidence that in general active management is worth the price
• passive market indexes earn exactly the market return, imlpying that any excess returns generated by active managers must come from other active managers

Question 18

Which mutual funds to invest in?

Answer 18

• look for mutual funds with low expenses, low tunrover, exposure to the types of stocks or assets you want exposure in

Question 19

Taxation of Mutual fund income

Answer 19

– under Canadian tax laws, investment returns of mutual funds are taxed in the hands of the investor in the mutual fund and are not paid by the fund itself

• the pass-through of investment income has one important disadvantage: if you manage your own portfolio, you decide when to realized capital gains and losses on any security; therefore, you can time those realizations to efficiently time those realizations to manage you tax liabilities. When you invest through a mutual fund, however, the timing of the sale of securities from the portfolio is out of your control, reducing your ability to engage in tax management

Question 20

What are ETFs?

Answer 20

• hybrid vehicle legally classified as mutual fundsm but trade on exchanges like closed-end funds. ETFs can be bought/sold in realtime at intraday prices
• an ETF combines the valuation feature of a mutual fund with the tradeability feature of a closed-end fund
• ETF prices only differ from NAVs by very small amounts
• for ETF, there are authorized participants who can create or remove shares in the ETF and trade them for the underlying assets to ensure the market price of ETF stays very close to the nAV of the unerlying asset
• ETFs are easy to short

Question 21

What are leveraged ETFs?

Answer 21

A leveraged exchange-traded fund (ETF) is a marketable security that uses financial derivatives and debt to amplify the returns of an underlying index. While a traditional exchange-traded fund typically tracks the securities in its underlying index on a one-to-one basis, a leveraged ETF may aim for a 2:1 or 3:1 ratio.

Question 22

What is an inverse ETF?

Answer 22

An inverse ETF is an exchange traded fund (ETF) constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Investing in inverse ETFs is similar to holding various short positions, which involve borrowing securities and selling them with the hope of repurchasing them at a lower price.

Question 23

what are synthetic ETFs?

Answer 23

A synthetic exchange-traded fund (ETF) is a pooled investment that invests money in derivatives and swaps rather than in physical stock shares.

Question 24

Advantages of ETFs over Mutual funds

Answer 24

1. a mutual’s NAV is quoted, and therefore, investors can buy or sell their shares in the fund - only once a day. In contrast, ETFs are traded continously. ETFs can be sold short or purchased on margin
2. Also offers a potential tax advantage over mutual funds. When large numbers of mutual fund investors redeem their shares, the fund must sell securities to me the redemptions. This can trigger capital gains taxes, which are passed through to and must be paid by the remaining shareholders. In contrast, when small investors, with no need for the fund to sell any of the underlying portfolio. Large investors can exchange their ETF shares for shares in underlying portfolio; this form of redemption also avoids a tax event
3. ETFs are often cheaper than mutual funds. Investors who buy ETFs do so through brokers rather rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses may translate into lower management fees