Chapter 3 Investment Funds

1. Chapter 3Investment Funds

2. Learning objectives • Distinguish between direct and indirect investing. • Define open-end and closed-end investment funds. • State the major types of mutual funds and give their features. • Define exchange-traded funds (ETFs). inguish between direct and indirect investing. • Define open-end and closed-end investment funds. • State the major types of mutual funds and give their features. • Define exchange-traded funds (ETFs).

3. Indirect Investing • Refers to buying and selling the shares of intermediaries that hold a portfolio of securities • Shares are ownership interest in the underlying portfolio • Shareholders are entitled to portfolio income • Shareholders also pay expensesefers to buying and selling the shares of intermediaries that hold a portfolio of securities • Shares are ownership interest in the underlying portfolio • Shareholders are entitled to portfolio income • Shareholders also pay expenses

4. Investment Fund • Financial company or trust fund that sells shares to the public and uses the proceeds to invest in marketable securities • Acts as conduit for distribution of dividends, interest, and realized gains • Offers the benefits of diversification • Offers professional management Offers professional management

5. Fund Types • Unit Investment Trust: an unmanaged, fixed-income security portfolio put together by a sponsor and handled by an independent trustee • Passive investments designed to be bought and held with capital preservation as a major objective • Currently represent a very small part of total investment company assetsUnit Investment Trust: an unmanaged, fixed-income security portfolio put together by a sponsor and handled by an independent trustee • Passive investments designed to be bought and held with capital preservation as a major objective • Currently represent a very small part of total investment company assets

6. Fund Types • Closed-end investment fund: No additional shares sold after initial public offering • Share prices determined and traded in a secondary market • Price may not equal Net Asset Value of the shares • Net Asset Value (NAV): Total market value of the security portfolio divided by total shares

7. Fund Types • Open-end investment fund: Shares continue to be sold to the public at NAV after initial sale that capitalizes the company • Shares may be sold back (“redeemed”) to the company at NAV • Capitalization constantly changes • Popularly called mutual funds

8. Types of Mutual Funds • Money Market Funds • Objectives of income and liquidity • Short-term money market instruments • Low risk and high liquidity • (a) Mortgage Funds • Investment terms may be  5 years • Riskier than money market (more interest rate risk), but less risky than bond funds (shorter maturities) (b) Bond Funds • Objectives of income and safety • Subject to capital gains/losses due to interest rate risk

9. Types of Mutual Funds • (a) Balanced Funds • Objectives of safety, income and capital appreciation • Min./max. rules apply for percentage invested in each asset class. (b) Asset Allocation Funds • Similar objectives as balanced funds, but typically not restricted by asset class percentage rules • Equity/Common Stock Funds • Objective of capital gains • Bulk of assets are in equity, but other assets held for liquidity, income and diversification purposes • May vary greatly in degree of risk and growth objectives

10. Types of Mutual Funds • Growth Funds • Tend to invest in small-cap stocks, i.e. small companies with growth potential • Riskier than equity funds (small firms pay no dividends) • Specialty Funds • Objective of superior capital gains (through minimal diversification) • Tend to focus on one industry, market, or segment • International/Global Funds, for example, invest in foreign securities (and carry the risk of foreign exchange exposure)

11. Types of Mutual Funds • (a) Real Estate Funds • Invest in income-generating properties for long-term growth and capital gains • Portfolio valuation is based on infrequent external appraisal • Less liquid than other funds – investors may need to give advance notice when selling (b) Ethical Funds • Relatively new type of fund • Investments are guided by moral criteria (e.g., not investing in tobacco-related firms)

12. Types of Mutual Funds • Index Funds • Objective is to mirror the performance of a market index (e.g., S&P/TSX 60) • Generally lower management fees than other funds. • Dividend Funds • Objective of tax reduction through favourable treatment of dividend • Inappropriate for RRSPs or RRIFs • Price changes are driven by interest rates and market trends

13. Types of Mutual Funds • ranked from lowest risk/return to highest risk/return as follows: • Money market • Mortgage • Bond • Balanced • Dividend • Equity • Real estate • Specialty http://finance.yahoo.com/funds

14. Mutual Fund Categories • Money market mutual funds invest in a portfolio of money market securities • Treasury bills • Commercial paper • Short-term government bonds • Low risk • Not insured by the federal government

15. Mutual Fund Categories • Equity, bond, and income funds invest in portfolios of securities consistent with the objectives of the particular fund • Objectives set by the fund’s board • Disclosure of objectives to investors through a prospectus

16. Equity Funds • Most mutual fund assets are in equity funds rather than bond or income funds • Most equity funds are either: • Value funds, which invest in undervalued stocks as determined by fundamental financial analysis • Growth funds, which invest in stocks of firms expected to show future rapid earnings growth

17. Equity Funds • Closed-End Funds • NAV > market price, selling at a discount • NAV < market price, selling at a premium • If the value of the portfolio remains unchanged, an investor can gain or lose if the discount narrows or widens over time • Trade at premiums and discounts across time, and variance is great

18. Exchange-Traded Funds (ETFs) • Units of these trusts hold shares of firms in market indices in proportion to their weights in the index • Differences from traditional mutual funds: http://finance.yahoo.com/etf • Traded throughout the day on exchanges • Lower management fees (e.g., 0.08% to 0.25% versus 2.5% average for active equity funds versus 0.75% average for Index funds) • Lower portfolio turnover – reduces capital gains income and taxes payable • Permit short-selling • May be purchased on margin

19. Canadian-Based ETFs • I-60s • Represent units in the S&P/TSX 60 Index • Trade on the TSX (ticker: XIU).; units are valued at 1/10th the value of the S&P/TSX 60 Index; for example, if index is valued at 450, each unit is valued at $45 • Dividends are paid every quarter; MER is 0.17% • DJ40s • Represent units in the Dow Jones Canada Index Participation Fund, which hold stocks that mimic those of the Dow 40 Index; MER is 0.08%

20. Canadian-Based ETFs • TD S&P/TSX Index Fund • The S&P/TSX Composite Index is the underlying index; MER is 0.25% • There are now a growing number of small-cap, mid-cap, industry-based, style-based, and bond ETFs available • There are now a growing number of small-cap, mid-cap, industry-based, style-based, and bond ETFs available

21. Differences between ETFs and Mutual Funds • ETFs • Trade all day on exchanges, can be bought on margin, and can be shorted • Currently passive in nature • Can be traded at discount or premiums. • Offer an important advantage over funds with regard to flexibility on taxes • Mutual Funds • Bought and sold at the end of the trading day when the NAV is calculated • Most are actively managed • Trade at NAV • Mutual fund mangers may have to sell shares to pay those who want to leave the fund, thereby generating capital gains

22. Other Funds • Segregated funds • Provide death benefits • Must guarantee a minimum percentage (75% is required, 100% is usually offered) of investor’s payments will be returned at fund maturity (or at death of owner) • Structured to prevent fund assets from being seized by creditors if investor declares bankruptcy • Upon owner’s death, assets may be transferred to beneficiaries without being subject to probate fees

23. Other Funds • Labour Sponsored Venture Capital Corporations (LSVCCs) • No 10% maximum ownership restriction • Restrictions on transferability and redemption • Valuation may not be based exclusively on market prices • Tax advantages – federal & provincial tax credits offered

24. Performance • Reported on a regular basis (usually daily) in the popular press • Measured over a given time period as a percentage of initial investment • Total returns include reinvested dividends and capital gains • Average annual return reflects the mean compound growth rate of investment over a given time period

25. Performance • Investors relate the performance to some benchmark to judge relative performance • An important issue is expenses: funds with low MERs provide better returns in the long run • Mutual fund ratings: best known rating system is provided by Morningstar

26. International Funds • Some mutual funds specialize in international securities • Canadian investors can participate in emerging market economies • International diversification • International funds or global funds emphasize international stocks • Single-country funds concentrate assets • Actively or passively managed

27. New Directions in Funds • Mutual fund “supermarkets” • Various mutual fund families can be purchased through a single source • Brokerage account may provide access • “Supermarket” managers earn fee • On-line investment services • Internet used to provide mutual fund information and to make transactions