chapter 10 (without answers)

8/8/2019 Chapter 10 (Without Answers)

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SESSION 9 - OUTLINE

Disadvantages and Advantages of Investing in Mutual Funds

Structure of Mutual Funds

How Mutual Fund Units or Shares are Priced

Charges Associated With Mutual Funds

Redeeming Mutual Fund Units or Shares

Who Regulates Mutual Funds

Types of Mutual Funds

Fund Management Styles

Performance and Risk Analysis


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What is Mutual Fund

Investment vehicle operated by an investment company Pool contributions from investors and invests these proceeds into a variety

of securities.

Stocks, bonds, and money market instruments

Unitholders or shareholders share in the income, gains, losses and

expenses the fund incurs.

2


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MER

Whats the big dealabouta 1% Shortfall?

$10,000 at 8%=$100,627 over 30 years

$10,000 at 9%=$132,677 over 30 years

$10,000 at 10%=$174,494 over 30 years

Another Example:

$500,000 in mutual fund with MER 2%, If you would like to pay $10,000every year just to hold a bunch of stocks or bonds for you?

Management Fees:

No loads does not mean no fees, all mutual funds charge annual

management fees. Mutual fund price that you see has already had a small amount shaved off

to reflect the fees charges.


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Unfair Taxation

Tax bill on gains you did not receive. Distribution on Capital gain, notthe

capitalloss!!!

Example:

Bob puts $10,000 on non-RRSP account with Canadian equity fund on Nov

1st

, NAV=$10, no change until the end of year. The whole year, capital gains amounting $1 per unit. On Dec 31st, fund

distribute to each unit holders $1/unit in capital gains.And the value of

each unit will fall by $1 to $9

So what happens?

Bob needs to pay tax on the $1, 000 capital gains even though he did not

get anything.


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The Herd Mentality

Investors tend to bail out when the funds dont perform well.

Not fully invested

Fund manager must sell stocks owned to raise the cash.

Downward pressure to the stocks held in the fund, and can reduce the value

of the fund for the remaining investors.

Massive outflow can hurt you seriously


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Other Disadvantages

1. Unsuitable as a short-term investments, not including the money market

fund.

2. Unsuitable as an emergency reserve, especially during the declining or

cyclically low markets when aloss of capital could result from emergency

redemption or sale.


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Advantages of Investing in Mutual Funds

1. Professional Management-manage the portfolio on a continues basis.

2. Diversification-Consisting of 60 to 100 or more different securities in 15 to

20 industries

3. Variety oftype of funds/transferability

4. Variety of purchase and redemption plans-one time, regular purchase.


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The Structure of Mutual Funds

1. Mutual Fund Trust

Open-end trust

Trust structure enables the trust avoid taxation

Any interest, dividends or capital gains income, net fees and expenses, is

passed to unit holders

2. Mutual Fund Corporations Set up as federal or provincial corporations

Under theIncome Tax Act, eligible for a special rate of taxation

Lack the flow-through status of investment fund trusts


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The Organizational Structure ofa Mutual Fund

1. Directors

Hold the ultimate responsibility for the activities of the fund.

Contract out the business of running the fund to an independent fund

manager.

2. The Fund Manager

Day-to-day supervision of the funds investment portfolio. Maintain a portion of fund assets in cash and short-term highly liquid

investments to be able to redeem fund shares on demand or purchase new

portfolio.

Calculation of the funds NAV


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The Organizational Structure ofa Mutual Fund

3. Distributors

Investment advisors in securities firms, e.g. BMO Nesbitt Burns, CIBCWood Gundy, etc.

Sales force in some organizations that control both management and

distribution groups, e.g. IG

Independent direct sales organizations and by in-house distributions, e.g.

Banks or Credit Unions

4. Custodian

Independent financial organization, usually a trust company.

Collects money received from the buyers and from portfolio income and

arranges for cash distributions

Calculation of the funds NAV


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How Mutual Fund Units or Shares are Priced

Offering/Redemption price

Purchase the shares/units directly from the fund

Sell back to the fund when the investor redeems units

Offering price - Net asset value per share (NAVPS)

Redemption price - subject to the deferred charge

NAVPS

NAVPS = (Total assets - Total liabilities) / Total # of shares or units outstanding

If there is no sales commission or any defer sales charges

Most funds calculate the offering or redemption price at the close of the

market each day.


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1. Front-End Load

Loads are charged when investors initially makes the purchase.

Expressed as a percentage of the purchase price orNAVPS

Reducing the actual amount invested. E.g. $1,000 investment in a mutual

fund with a 4% front-end load means that 40% goes to the distributor while

the remaining $960 is actually invested.

To determine a funds offering price with a front-end load charge. Offering or purchase price=NAVPS/(100%-sales charge), e.g offering

price=12/(100%-4%)=$12.5

This load is negotiable with sales person, especially a big lump sum

purchase.


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2. No-Load Funds

Usually, offered by direct distributions companies, e.g. banks/trustcompanies

Some discount brokers might charge administration fees.

Check if they charge higher management fees

3. Back-End Load/Deferred Sales Charges Load are charged at redemption.

Not negotiable, as it is set by the dealer.

If the back-end load is based on the original purchase amount:

Selling/redemption price = NAVPS - Sales commission = NAVPS -

(NAVPS1*sales percentage)

IF the back-end load is based on the NAVPS at the time of redemption:

Selling/redemption price=NAVPS-(NAVPS2*sales percentage)


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4. Trailer Fees/Service Fee

Fund manager pay to the distributor that sold the fund.

Sales person provides ongoing services to investors, such as investment

advice, tax guidance and financial statements.

Potential conflict of interests

5. Other Fees Set-up fee, small number of funds

Early redemptions fees, discourage short-term trading and to recover the

transaction costs.

6. Switc

hing Fees

Exchange units of one fund for another in the same family or fund

company.

Negotiable with investment advisor

Can not switch from front-end to back end fund


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7. Management Fees

Usually between less than 1% and 3%

Money market, 0.5%~1%, while equity fund, 2%~3%, which requires

ongoing research

A straight percentage of the net assets under management. Has been

criticized because it rewards fund managers not on the performance of the

fund, but on the level of assets managed.

Management expense ratio (MER) represents the total of all management

fees and other expenses charged to a fund.

A percentage of the funds average net asset value for the year.

MER=Aggregate fees and expenses payable during the year/average Net

Asset Value for the Year.

All expenses are deducted directly from the fund. E.g a fund reports acompound annual return of 8% and an MER of 2%, it has a gross return of

roughly 10%.

Published rates of return are calculated after deducting the MER


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Calculating Redemption/Selling Price

Back-end load charges or no load.

Tax Consequences

Mutual fund generate taxable income in two ways:

1. Distribution of interest income, dividends

2. Capital gains realized by the fund; through any capital gains realizedwhen the fund is eventually sold.

Annual distributions

o Outside of registered plan (RRSP or RRIF)

o T3- trust form, unit holder

o T5- corporate form, shareholdero Why generate capital gains? Because the fund manager buys and

sells stocks throughout the year for the mutual funds


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Distribution Triggering Unexpected Taxes

Capital gains are distributed to investors, but not the capital loss.

E.g. Investors purchased a fund on Dec 1st at a NAVPS of $30. earned

capital gain of $6 per share.

After distribution, the NAVPS will fall by the amount of distribution to $24.

The $6 distribution is taxable in the hands of the new investor. So be

careful, when you buy mutual fund at the year end.

Adjusting the Cost Base

Automatically reinvest fund income in additional non-registered fund units.

Be careful about the double tax

E.g investor buys $10,000 of fund units, investor reinvest the distributions

over the years. Total value rises to $18,000 and sell the fund.


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A careless investor mightassume thata capital gain of $8,000 has been

incurred. Incorrect! Capital gains have two parts:

1. Reinvestment of income (already paid the tax)

2. Capital gain

Reinvestment of income must be added to the original investment of

$10,000 to come up with the correct adjusted cost base for calculating thecapital gain

If the reinvestment is $3,500. the adjusted cost base=13,500, the capital

gain is then $4,500, not $8,000

Buying by Reinvesting Distributions

Many funds automatically reinvest distributions into new shares of the fund

at the prevailing net asset value without sales charge on the shares

purchased.

The investors owns more units, but the units are each worth less.


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Provinces

Each Province has its Own Securities Act

Code of Ethics

Mutual fund sales person must use proper care and exercise professional

judgment. Mutual fund salespeople should conduct themselves with trustworthiness

and integrity.

Mutual fund salespeople should be professional

Mutual fund salespeople must act in accordance with the SecuritiesAct of

the province and SROs.

Mutual Fund salespeople must hold client information in the strictest

confidence.


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Self-Regulatory Organizations (SROs) Investment firms are members of SROs, the registered employees of such

member firms are subject to the rules and regulation of these SROs.

Mutual Fund DealerAssociation (MFDA) is the mutual fund industrys

SRO for the distribution side of the mutual fund industry.

National Instruments 81-101 and 81-102

National instruments 81-101 deals with mutual fund prospectus disclosure

National instruments 81-102 contain requirements and guidelines for the

distribution and adverting of mutual funds


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General Mutual Fund Requirements:

I. A simplified prospectus

II. The annual information form

III. The annual audited statements or interim un audited financial statements

IV. Other information required by the province where the fund is distributed,

such as material change reports and information circulars

V. The simplified prospectus was required to delivered to the investors

I. The Simplified Prospectus

Must be filed with the securities commission annually.

Investors purchasing a mutual fund for the first time must be provided with

the simplified prospectus and any other information required by the

province.


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The mailing or delivery of the prospectus must be made to the purchaser

not later than midnight on the second business day after the purchase. The investor has the right to withdraw within two business days after the

document has been provided.

The simplified prospectus consists oftwo sections:

1. PartA: introductory information about the mutual fund, general

information

2. Part B: specific information about the mutual fund.

II. TheAnnual Information Form

Available to investors on request

Tax status of the issuer

Significant holding in other issuers

Directors, officers and trustees of the fund


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III. Financial Statements

Available to investors on request.

Balance sheet

The income statement

Statement of investment portfolio: provides details on the securities

Statement of changes in NetAsset

Statement of portfolio transactions

Registration Requirements for the Mutual Fund Industry

Mutual fund managers, distributors and sales personnel must all be

registered with the provincial securities commissions

The commission need to be informed within 5 business days of anyimportant change in personal circumstances.

Salespeople must have passed a Mutual Funds course, such as CSC or

Canadian Funds Course, or IFICs course.


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Registration Requirements for the Mutual Fund Industry

Generally, mutual fund salespersons must be employed by the distributioncompany

Mutual Fund salespersons are not permitted to carry on other forms of

employment without the prior of the appropriate administrator and the in

industry associations.

Applicants must complete a detailed application about their past businesses,

employment and conduct and submit to a police review.

Renewal of registration, usually annually renew.

Mutual Fund Restrictions

A. Prohibited Mutual Fund Practices

Purchases of no more than 10% of the total securities of a single issuer

or more than 10% of a companys voting stock

Funds cannot buy shares in their own company

No borrowing for leverage purposes

No margin buying or short selling


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Normally a prohibition on commodity or commodity futures purchases

Limitations on the percentage holdings of illiquid securities such as thosesold through private placement and unlisted stocks.

B. Use of Derivatives by Mutual Funds

Allowed to use derivatives as part of the portfolios

1. Hedge against risko Purchase the put options on the S&P/TSX60 index fund if the

market declines

o Or sell call options

2. Facilitate market entry and exit-its cheaper and quicker to enter the

market using derivatives rather than purchasing underlying securities.

10% maximum as a percentage of the net assets of a fund


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C. Prohibited Selling Practices

Unacceptable to regulators, which lead to a loss of registration

1. Quoting a future price

o When purchasing mutual fund, the price/unit is not known.

o It is unlawful for a salesperson to backdate an order in an attempt

to buy shares/units at a previous days price.

2. Offer to repurchaseo Salespeople may not make offers to repurchase securities in an

attempt to insulate investors from downturns in price.

3. Selling without a license

4. Advertising the registration

5. Promising a future price

6. Sales made from one province into another province or country

o Selling mutual funds to clients in another province, or to non-

Canadian residents may result in the cancellation of the mutual

fund salespersons registration.


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7. Sale of unqualified securities

o Its illegal for a mutual fund salesperson to sell products for which thesalesperson is not registered. E.g a mutual fund salesperson cannot sell

individual securities or insurance unless licensed to do so.

D. Distribution of Mutual Fund Securities by a Financial Institution

Control of registrant:o A FI can sell mutual fund securities in its branches only through a

registered corporation (dealer)

Registration of employee:

o Only registered salespersons can sell mutual funds

Dual employment:

o Dual employment is permitted by the legislation


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Conflicts of interest:

o Arise as a result of dual employment.

o Dually employed salespersons are paid salary only

o Dually employed salesperson can not make loans to finance the

purchase of mutual funds sold by that salesperson.

o Any loans mentioned in the above need to be approved by a senior

lending officer.

In-house funds:

o Only mutual fund securities traded by the dealer through branches of

the FI will be those issued by a mutual fund sponsored by the FI

Premises and disclosure:

o The investment is not insured by the CDIC or any other government

deposit insurer

o Is not guaranteed in whole or part by the FI


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1. Cashand Equivalent Funds/Money Market Funds

Invest in near-cash securities or money market instruments

E.g. Treasury bills, bankers acceptances, short-term bonds.

Branches only through a registered corporation (dealer)

Add liquidity to a portfolio and provide a moderate level of income and

safety of principal

A constant share or unit value, often $10 Risk is low, mainly subject to the interest risk.

Distributions received are taxable as interest income when held outside of a

registered plan


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2. Fixed Income Funds

Designed to provide a steady stream of income rather than capitalappreciation.

Bond Funds

Mainly invest in good quality, high yielding government and corporate debt

securities.

Main risks: interest risk, default risk if the fund also invests in corporatebonds.

Source of returns: interest income and capital gains

3. Mortgage Funds

Generate income while maintaining safety of principal

Investors hold a share of group mortgages

Main risk: interest risk

Less default risk as usually holds over 8,000 individual mortgages

Mortgage payments are paid monthly while bond income is received semi-

annually, mortgage funds are less volatile or risky compared to bond funds.


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4. Balanced Funds

Invest in both stocks and bonds to provide a mix of income and capitalgrowth.

Rarely 50%-50%, manager adjust the percentage of each part of the total

portfolio in accordance with current market conditions and future

expectations.

5. AssetAllocation Funds

Similar to balanced funds

Manager do not have to hold a specified minimum percentage of the fund

in any class of investments.

Manager has great freedom to shift the portfolio weighting among equity,

money market and fixed income securities


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6. Equity Funds

Equity Fund

o Objective: long-term capital growth.

o Invest primarily in the common shares of publicly-traded companies.

o Mainly exposed to market risk.

o E.g. Canadian equity, U.S. equity, emerging market funds

Small Cap and Mid Cap Equity Fundso Small cap: $250 million ~$1 billion

o Mid cap: $1 billion~$9 billion

o These companies usually do not pay dividends

Dividend Funds

o Invest in preferred shares as well as high-quality common shares thathave a history of consistently paying dividends.

o Riskier than bond funds, but less risky than equity funds.


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7. Specialt

ya

nd Sector Funds

More focused on one main area-a specific industry or region.

E.g. Natural resources, precious metals, real estate, financial services.

Real estate funds

o

Invest in income-producing real property in order to achieve long-term growth through capital appreciation and reinvestment of income.

o Problem of redemptions, less liquidity

Ethical funds

o Avoid investing in companies that profit from tobacco , alcohol and

armaments.


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8. Index Funds

Sets up to match the performance of a broad market index, such as

S&P/TSX composite index for equity index, and Scotia Mcleod Universe

Bond index for a bond index fund

E.g. BMO represents 0.75% of S&P/TSX index, the fund will hold 0.75%

BMO in the fund.

Lower management fees, passive investment strategy

Long-term growth, but subject to the market risk.


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1. Passive strategy

Some form of indexing to a market or customized benchmark.

2. Active strategy

Most equity styles are active

Company selection, over weighting in favoured segments of industry

sectors Usually, recommend the diversify a clients portfolio. Volatility is reduced.

Comparative Performance

1. Benchmark Comparison

S&P/TSX composite index for broad-based Canadian equity

Scotia Capital Universe Bond Index for bond funds

Underperform: Fund return < Index

Outperform: Fund return > Index

2. Peer Group Comparison

A peer group is made up of mutual funds with a similar investment mandate.


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Comparative Performance & RiskAnalysis

Issues When Comparing Performance

Compare the funds, apples with apples.

The name or class of fund may not accurately reflect the actual asset base

of the fund. (gold fund, equity fund, different percentage)

RiskAnalysis ofa Mutual Fund The standard deviation of the funds returns-measures how volatile a fund

has been over a past period, (5% vs 20%)

Beta-measures the extent to which a fund is more or less volatile than the

underlying market.


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Attentions When Evaluating Performance

1. Past performance is not indicative of future performance and there is no

guarantees that the fund will maintain the past performance.2. Fund performance is direct relevant to the fund manager, so pay attention to the

manager change.

3. Average returns for a peer group of funds are useful measures, averages may

artificially high because of Survivorship bias poorly performance funds might

be discontinued or merged.

4. Mutual fund performance evaluation should take into account both the type of

fund and its investment objectives.

5. Beta-mutual fund with high betas are considered riskier than comparable funds

with lower betas.

6. Standard deviation-measures the dispersion of historic prices of specific stock,

higher standard deviation, the higher risk.7. Time horizon for rating risks and returns- usually, at least 3 years, usually, 5-10

years.


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What do I do if I have an inquiry or a complaint?

1. Contact your advisor to see if he or she can answer your question2. Contact your advisors supervisor, compliance officer, or manager.

3. Contact your provincial securities regulator:

Ontario Security Commission

Telephone: 416-593-8314

Toll free: 1-877-785-1555

If it sounds too good to be trueit is!!!


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Questions

3. Trailer fees are usually paid out ofamutual fund's management fee to

the distributor who sold the fund. What is the justification for payingthis fee?

A. Encourages investors to stay in a fund.

B. Compensates the salesperson for providing ongoing advice to the investor.

C. Reduces the overall fees paid by an investor.

D. Compensates the salesperson for initially selling the fund.

4. An investor purchased mutual fund units for $25,000 and sold themfive years later for $48,000. She earned $12,000 in reinvesteddistributions fromthe fund over this time period. What capital gainwas realized on the sale?

A. $11,000

B. $23,000

C. $35,000

D. $48,000


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Questions

5. Can mutual fund unit-holders have a capital gain froma fund, evenwhen they have not sold any oftheir units?

A. Yes, deemed capital gains from increases in the value of the fund.

B. Yes, capital gains made on the sale of securities within the fund itself.

C. Yes, any income distributed to unit-holders is considered to be capital gains.

D. No, capital gains can only be earned when units of the fund are sold.

6. Which ofthe following statements about withdrawal plans is incorrect?

A. High constant dollar withdrawals may encroach upon the principal.

B. Ratio withdrawal plans are suitable for using the proceeds to pay a mortgage.

C. Life withdrawal plans do not always result in constant dollar payouts.

D. Under fixed period withdrawal plan, the yearly amount withdrawn may vary.


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Questions

7. Why do some advisors caution investors against buying amutual fund

just

priorto ye

ar-end

?

A. Sometimes equity prices decline before year-end due to tax loss selling.

B. The investor might not receive the appropriate year-end distribution.

C. Year-end fund prices might temporarily increase due to fund "windowdressing".

D. A large year-end distribution could trigger an unexpected tax payment.

8. Which ofthe following statements regarding the formation ofmutualfunds are correct?

i) Funds may be established either as a company or as a trust.ii) Unit owners may or may not have voting rights.iii) Units are the trust equivalent to shares in an incorporated fund.iv) Shareholders of an incorporated fund usually have the right to vote andelect members to the board.

A. i) and ii) only.B. ii) only.

C. i) and iii) only.

D. i), ii), and iii).


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Questions

11. The management expense ratio (MER) is deducted directly fromthe

funda

nd decrea

sesth

e ult

imat

e return e

arned by

the fund.

Whatexpenses are included in the MER?

A. Trading costs.

B. Switching and sales fees

C. Trailer fees.

D. Management fees.

12. Subjectto strict regulatory controls, mutual fund managers are

allowed to use derivatives as part oftheir portfolio. Whatare the mostsignificant use(s) of derivatives?

A. Hedge against risk.

B. Facilitate market entry and exit.

C. Create clone funds.

D. All of the above.

13. What is the maximum percentage ofthe netassets ofa fund that can beinvested in derivatives?

A. 10%

B. 20%

C. 25%

D. 50%


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Questions

14. All ofthe following documents are typically included as part ofthe

simplified prospectus system, except:A. Statement of Portfolio Transactions

B. Annual information form

C. Annual audited statements

D. Statement of Investment Portfolio

15. Which ofthe following statements could be made by amutual fund

sal

esperson?

A. I will refund your money if this fund does not increase by 20% in the next 60

days!

B. Your purchase price will be yesterday's closing NAVPS.

C. Based on past performance, this share should double within the year.

D. None of the above are acceptable.

16.What

isth

e nam

e ofth

em

ut

ual

fund indust

ry's SRO forth

e dist

ribut

ionside ofthe mutual fund industry?

A. Mutual Fund Dealers Association.

B. Investment Dealers Association.

C. Mutual Fund Institute.

D. Securities Fund Association.


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Questions

17. If interest rates were to move up rapidly, the prices of which of the

foll

owing securities wou

ld be

le

as

t affec

ted

?

A. Preferred share funds.

B. Bond funds.

C. Mortgage funds.

D. Money market funds.

18. Which ofthe following statements regarding balanced funds is incorrect?

i) Expected returns on balanced funds should be higher than the return onmoney market funds.ii) When interest rates fall, balanced funds should out perform equity funds.iii) When interest rates fall, balanced funds should under perform equity funds.iv) Balanced funds are equally balanced between bonds, preferreds and equity.

A. i), ii), iii), and iv).

B. i) and ii).C. i), iii), and iv).

D. iii) and iv).


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Questions

19. What investment strategy does a multi-manager style use?

A. The main trading activities of the fund are handled by several fundmanagers.

B. The portfolio is divided into two or more portions, with each portionusing a different investment style.

C. A team of managers identifies themes in the economy and companiesthat will benefit from these themes.

D. A maximum of three different managers focus on one style of selectingequities or bonds.

20. Which ofthe following accurately ref lects the characteristics ofanindexing investment style?

A. Low-cost, long-term, buy-and-hold.

B. Low-cost, short-term, buy-and-hold.

C. High-cost, long-term, active trading.

D. High-cost, short-term, active trading.


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Questions

21. For mutual funds other than money market funds, standard

performa

nce data

for com

pounda

nnual

returns inc

ludes w

hic

hof

thefollowing?

A. 1-year, 3-year, 5-year and 10-year time periods.

B. 1-year, 5-year and 10-year time periods.

C. The fund must quote for 1-year, 2-year, 5-year and 10-year periods.

D. The fund company can decide what periods to report.

22. Standard deviation ofa mutual funds returns is one measure used toquantify volatility. Which ofthe following has the greatest impact on afunds standard deviation?

A. The average return earned over the period.

B. The time period being analyzed.

C. The consistency of a funds return.

D. The size of a funds assets.

chapter 10 (without answers)

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