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Mutual Funds What are they and how do they work? Important Terms • Mutual fund • MER (management expense ratio) • NAVPS (net asset value per share) • Open-end fund • Closed-end Fund Where can Mutual Funds Be Purchased? • Mutual funds are sold by most financial institutions: • Credit unions (ethical funds) • Banks • Insurance Companies • Investment Companies • Brokerage Houses • Trust Companies • Independent Mutual Fund Dealers • You can usually set up a regular savings plan through your own financial institution…saving as little as $25.00 per month. • You can invest in mutual funds outside or inside your RRSP. Who Can Sell Mutual Funds? • The organization that markets (sells) mutual funds must be licensed in the province where it offers these products. • In addition, the person working for the licensed organization must also be licensed under either: – MFDA (Mutual Fund Dealers Association) – IDA (Investment Dealers Association) • In order to qualify for licensing, the individual must complete an accredited course of studies, have completed a supervised 90 day training program and have satisfied the accrediting body of their personal integrity through a thorough background check. For example: – the MFDA will expect you to have completed the Canadian Investment Funds Course through the Investment Funds Institute of Canada, or the Investment Funds in Canada Course through the Institute of Canadian Bankers or the Canadian Securities Course through the Canadian Securities Institute. What is a Mutual Fund? • A financial organization that accepts funds from hundreds, if not, thousands of investors, pools these funds and Mutual invests them in bonds, Fund stocks, real estate, precious metals or other investments. What is a Mutual Fund? • It is a ‘pooled’ investment • Pooled investments are managed portfolios that groups of investors invest in. Mutual • Other examples include Fund pension funds, labour sponsored venture capital corporations, segregated funds, etc. What is a Mutual Fund? • A mutual fund is a financial organization that accepts funds from numerous investors, pools these funds and invests them in bonds, stocks, real estate precious metals and other Mutual investments. It then issues Fund shares or units to investors in proportion to the funds each investor contributes. • Conceptually, it is not a stock or bond, it’s a way of investing. Legal Structures of Canadian Mutual Funds The Mutual Fund Complex • A series of organizations and individuals responsible for the day to day administration of the mutual fund, its investment strategies, the safe keeping of unit holders’ contributions and investments held by the fund and the selling and redemption of fund units. Typical Mutual Fund Complex • Consists of four things: • The mutual fund itself • The mutual fund manager & portfolio advisor • The custodian • The distributor About The Mutual Fund • Can be organized in two ways • As a corporation • As a unit trust Mutual Fund Complex Net asset value Pays management fee to (price of shares/units) FUND Management Contract Trustees Contract Company General or and/or Distributor (Board of Directors) (Officers) Investment Adviser C Provides o administration n t research and r investment Sells shares/units to a investors either through c supervision t investment dealers or through own direct sales Custodian organization/employees (Provides physical safekeeping of fund assets) The Mutual Fund Complex • Behind every mutual fund is a series of organizations and individuals that are responsible for the day-to-day administration of the fund, its investment strategies, the safekeeping of ‘unitholders’ contributions and investments held by the fund, and the selling and redemption of fund units. • Together, we refer to this series of organizations and individuals as a mutual fund “complex.” A typical fund complex consists of: – the fund itself – the mutual fund manager and portfolio advisor – the custodian – the distributor The Mutual Fund Complex The Fund Organization • Mutual funds may be organized as either a unit trust or as a corporation. • Some funds may operate in isolation, while others are part of a “family” of funds that includes a variety of mutual funds that specialize in different financial markets or have different investment objectives. • Corporate Form of Organization • an incorporated fund is subject to the Canada Business Corporations Act or similar provincial legislation. • Certain types of income (e.g. interest income) earned by an incorporated fund may be taxable first as income to the fund, and then in the hands of investors in the fund. The Mutual Fund Complex The Fund Organization • Unit Trusts • is the most common form of open-ended mutual fund organization today (largely because of a 1972 change in tax laws which permitted income earned by unit trusts to flow through to investors without being taxed in the hands of the trust.) • organizational structure formed by a declaration of trust and is subject to trust laws • the right to vote on certain matters concerning the fund is guaranteed in the legislation under which the fund is created, through National Policy Statement No. 39 • a trustee or a number of trustees act as the governing body. • Trustees may be individuals or a corporate entity that has the power to act as a trustee (such as a trust company) • Trustees are responsible for the supervision of the fund’s operations and adherence to its investment policies. They have the power to enter into contracts on behalf of the fund for any required services. The Mutual Fund Complex The Fund Manager and Portfolio Advisor • Regardless of organizational structure, directors and trustees are ultimately responsible for the management of a mutual fund’s investment portfolio as well as the day-to-day operations of the fund. • To assist with this latter task, the directors or trustees of the fund may enter into a contract with a management (investment) company to provide management services, rather than hiring staff to perform day-to-day administration. A firm that provides these services is commonly known as an administrative manager. Trustees and managers are often the same company. The Mutual Fund Complex The Custodian • To protect investors and as a part of internal control mechanisms, the administrative and custodial functions of mutual funds are kept separate. • The custodian is responsible for the safekeeping of all the fund’s investments. • National Policy Statement No. 39 requires that a mutual fund’s cash and securities be deposited with, and held by, a custodian. • The custodian must be a Canadian chartered bank, a Canadian trust company having shareholder’s equity of not less than $10 million, or in some cases a subsidiary of a Canadian Chartered bank or trust company that meets prescribed financial qualifications. • The custodian also holds all income earned by the fund until it is reinvested or distributed by the fund. The custodian makes all payments for the fund’s investments. The Mutual Fund Complex The Distributor • The distributor is the sales and marketing arm of the mutual fund organization. • It is responsible for bringing in assets to the fund in the form of new fund units. • Securities laws require each mutual fund to designate a principal distributor to assume the distribution responsibilities, usually under contract with the fund’s administrative manager. • In many cases, the administrative manager will assume the role of principal distributor, and will distribute or arrange for distribution by carrying out its distribution responsibilities through its employees or by subcontract with one or more of the following distribution channels: The Mutual Fund Complex The Distributor • the following distribution channels: – Proprietary (in-house) selling organizations that market only the funds offered by one mutual fund group. (eg. Investors Group) – Mutual fund specialists employed by a mutual fund dealer who is not aligned or affiliated with any particular fund. – Stockbrokers employed by investment dealers. – Employees of financial institutions such as banks, trust companies, credit unions, and caisses populaires or their securities subsidiaries. – Employees of mutual fund groups that deal directly with the public and exclusively market their proprietary funds. The Mutual Fund Complex The Registrar and Transfer Agent • This entity carries out two duties: – Registrar: the role of the Registrar is to safeguard against excess distribution of units or shares which would dilute the value of the fund. This is particularly important when share or unit certificates are reissued. Since issuance of share or unit certificates is now the exception rather than the rule, the role of the registrar is decreasing in importance. – Transfer Agent: maintains the register of owners of units or shares of the fund and records all transfers of ownership of units. This register is constantly changing as investors buy and redeem units. The transfer agent may also provide dividend distribution services. • These functions are usually provided by a trust company or other third- party service provider. In many cases, the same trust company that acts as the fund’s custodian will perform these duties. Management Fees • The costs of managing the fund are borne by the fund itself. • These include: – Bank charges – Commissions – Investment analysis costs – Salary and bonuses for the portfolio manager • Investors need to be advised of the management fees • Easiest way to compare management expenses is by using the management expense ratio (MER) MER • The Management Expense Ratio is reported in annual percentage terms. • For example: • 2.5% or 250 bps (basis points) • If the fund earned a gross return of 10% and it incurred an MER of 2.5%, then the net return to the unitholder is 7.5% • If the fund earned a gross return of 0% and it incurred an MER of 2.5%, then the net return to the unitholder is -2.5% Standard Costs - MERs • Range from .2% to > 3%, depending upon the type of fund. – The lowest MERs are for money market mutual funds – The highest MERs are typically for balanced mutual funds • Consists of management salaries and administrative expenses • May contain a 12B-1 fee to cover the funds advertising expense • High MERs don’t necessarily translate to above average returns Standard Costs - Loads • There are no-load funds…but remember, there will still be MER expenses borne by such a fund and potentially, back-end fees…be sure to check the fine print! • Front-end load • Back-end load (often decreasing) – These ‘loads’ or fees equate to a sales commission paid to the financial intermediary – They reduce/inhibit the investment’s liquidity NAVPS • Net asset value per share is the ‘price’ of the mutual fund. Total Market Value of Assets - Fund Liabilitie s NAVPS • It is calculated at the end Number of Units Outstanding $10,350,000 $180,000 NAVPS $1.57 of each business day on a 6,500,000 unit basis and then reported in the press. • It is like the ‘share price’ that you see reported for a common stock. Advantages of Mutual Funds Over Direct Investment • Professional Management • Broad Diversification • More Reliable Estimates of Risk and Return • Past Performance Record • Record Keeping and Safekeeping • Flexibility of Purchase and Sale • Automatic Reinvestment Plan Disadvantages of Mutual Funds Over Direct Investment • Management Fees • High Cost for Short-term Investment • Vulnerable to Massive Redemption • Professional Management is Not Infallible • Tax Implications Mutual Fund Types • Open-ended vs. Closed-ended • Vary by: Asset Classes, Investment Strategy, etc. – Examples include: Sector, Index, Regional, Growth, Balanced, Socially-Responsible Fund Links • Talvest Mutual Funds • CI Funds • Investors Group • Franklin Templeton Investments • Morningstar – an organization dedicated to following and reporting on mutual fund performance Please note – these are just samples of organizations – there are thousand of others like these organizations. Segregated Funds • Segregated funds are often viewed as mutual funds…however, they do have special features that distinguish them from a common mutual fund. • Nevertheless they are pooled investments offered by Insurance companies. Segregated Funds • Segregated Funds are an insurance product, combining a mutual fund-like investment with the protection of an insurance policy. As with mutual funds, an investor's money is pooled with the contributions of other investors to purchase a portfolio of securities. The value of the units purchased is based on the value of the underlying securities and will change in response to market conditions. Sources of Information • globeinvestor Internet Links and On-Line Resources • What’s your risk tolerance. Take quizzes at the Investor Education Fund. • You can compare the risk of a particular stock or your portfolio with the overall market with this tool at RiskGrades. • Starmine Investor – discover which securities analysts have been most accurate in estimating a company’s earnings. • Find the meaning of investment terms at InvestorWords.com. • Learn about the American Depositary Receipt (ADR) market at J.P. Morgan’s site. • Financial Times website for information on overseas business news. • Learn about investment clubs at investorguide. • Find out what companies offer Dividend Reinvestment Plans at Computershare Website. • “Investing in Bonds” at the Bond Market Association’s website. • Learn about Canada’s mutual funds through the Mutual Funds Dealers Association of Canada Website. • Brill’s Mutual Fund Interactive Interviews with top mutual fund managers. • Learn more about iShares through Barclays. • Visit EFTConnect.com to get price quotes and find the right ETF for you. Web Links • Mutual fund data on Morningstar.ca