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Chapter 3
Investment Funds
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).
Learning objectives
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
Indirect Investing
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
Investment Fund
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
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
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
Fund Types
1. Money Market Funds Objectives of income and liquidity Short-term money market instruments Low risk and high liquidity
2. (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
Types of Mutual Funds
3. (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
4. 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
Types of Mutual Funds
5. 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)
6. 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)
Types of Mutual Funds
7. (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)
Types of Mutual Funds
8. 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.
9. 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
Types of Mutual Funds
ranked from lowest risk/return to highest risk/return as follows:
1.Money market2.Mortgage3.Bond4.Balanced5.Dividend6.Equity7.Real estate8.Specialty
http://finance.yahoo.com/funds
Types of Mutual Funds
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
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
Mutual Fund Categories
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
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
Equity Funds
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
Exchange-Traded Funds (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%
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
Canadian-Based ETFs
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
Differences between ETFs and Mutual 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
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
Other Funds
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
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
Performance
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
International 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
New Directions in Funds