Mutual Funds Performance Evaluation PDF

Mutual Funds Performance Evaluation 7 CONTENT AREAS Price or NAVPU Determination Taxation of Mutual Fund Income Performance Measurement Effect of Payment of Distributions on Cli...

Mutual Funds Performance Evaluation 7 CONTENT AREAS Price or NAVPU Determination Taxation of Mutual Fund Income Performance Measurement Effect of Payment of Distributions on Client’s Account LEARNING OBJECTIVES 1 | Show how NAVPU is calculated, and explain how the offering or purchase price is calculated. 2 | Discuss and explain the basics of the taxation of mutual fund income. 3 | Explain basic and advanced concepts of performance measurement, including total return, volatility, standard deviation, beta, benchmarks, and combination performance measures. © CANADIAN SECURITIES INSTITUTE 7 2 BRANCH COMPLIANCE OFFICER’S COURSE KEY TERMS Key terms are defined in the Glossary and appear in bold text when they first occur in the chapter. active investment ex-dividend day bear market internal rate of return beta maximum drawdown book value offering price compounded rate of return preferred share discount rate standard deviation distribution total return © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 3 INTRODUCTION In this chapter, we explain how to assess the performance of mutual funds and introduce the most common tools used to do so. We start by explaining how to calculate the value of a mutual fund, then we focus on the basics of taxation of mutual fund income. Finally, we present some basic and advanced concepts of performance evaluation, including benchmarks, total return, volatility, and some measures of risk, including beta and standard deviation. PRICE OR NAVPU DETERMINATION Although the order execution process is normally administered at head office, you and your sales representatives should have an in-depth understanding of the pricing of mutual funds. Sales representatives should be able to explain precisely how the net asset value per unit (NAVPU) is calculated and how the price the client pays or receives is determined. OFFERING OR PURCHASE PRICE Clients often ask sales representatives how they arrived at the price they are charged for mutual fund units. The sales representatives should be able to explain their process. The funds offered by mutual fund dealer affiliates operating in branches of financial institutions are generally in the “no-load” category, which means they do not charge commissions on purchase or redemption. The funds can, however, charge a penalty fee of up to 2% on redemptions made within 90 days of purchase. The offering price (or purchase price) of a mutual fund is its NAVPU, which is the market value of the fund’s assets minus liabilities divided by the number of units outstanding. Most funds calculate the NAVPU daily after securities markets close, typically at 4:00 p.m. Eastern Time (ET). For exchange-listed securities, the fund’s assets are valued at the closing sale price for the day. Securities that did not trade that day or that are listed over the counter are valued at the mean of the bid/ask price. Funds that calculate their NAVPU daily are prepared to redeem units on a daily basis as well. Make sure that redemption orders are transmitted to your head office promptly for execution. Usually, orders received before 4:00 p.m. ET are redeemed at that day’s NAVPU, and orders received after 4:00 p.m. ET are redeemed at the NAVPU for the next day’s close. Payment for the redeemed units must be made within three business days after the NAVPU is determined. Some mutual fund dealers that operate within branches of financial institutions sell third-party mutual funds, which may include both no-load and load funds. The offering price for a load fund is calculated as follows: Net Asset Value Per Unit (1.0 − Sales Charge) For example, if the NAVPU is $16.50 and the sales charge is 3%, the offering price is calculated as follows: 16.50 = $17.01 (1.0 − 0.03) Note that this $0.51 commission represents 3.09% of the amount invested. The load equivalent as a percentage of the amount invested is calculated as follows: Load % × 100 (1.0 − Load) © CANADIAN SECURITIES INSTITUTE 7 4 BRANCH COMPLIANCE OFFICER’S COURSE For a 3% load, the calculation is as follows: 0.03 × 100 = 3.09% (1.0 − 0.03) The sales charge must be expressed in both the fund facts document and the simplified prospectus as a percentage of the amount paid by the investor (e.g., 3%), and also as a percentage of the amount invested (e.g., 3.09% above). Your sales representatives should be able to explain to clients how these rates are calculated. REDEMPTIONS Securities regulations require that mutual funds make payments on redemptions within three business days after the NAVPU is determined. A mutual fund can suspend or defer a unitholder’s right to redemption, but only under highly unusual circumstances, which are specified in the bylaws of the fund. They normally include events such as a suspension in trading on an exchange where more than 50% of the value of the securities owned by the fund is traded. A severe decline in market values could also trigger a suspension of redemptions. Although suspensions are extremely rare, you should be able to explain to a client the conditions under which one might occur. Your head office will normally advise you of any such suspensions and the reasons for them. DID YOU KNOW? Redemptions of a number of funds were suspended after the attack on the World Trade Center in September 2001 and during the financial crisis of 2008. TAXATION OF MUTUAL FUND INCOME The two types of mutual fund organizations are trusts and corporations. Although they are subject to different rules, they normally generate similar tax consequences for investors. Most mutual funds in Canada are organized as trusts and are exempt from tax as long as all of their income and most of their realized capital gains are distributed to the unitholders. As the income flows through the trust, it retains its investment nature; that is, net interest income flows through as interest income, dividends flow through as dividends, and so on. Before March 31 of each year, the trust mails to each of its unitholders a T3 form setting out the amount of each type of distribution you received during the previous taxation year. The various types of distributions you could receive from a mutual fund trust are as follows: Domestic net interest These distributions are reported in Box 26 of your T3 as “other income” and are taxable income distributions as interest income at your marginal tax rate. Foreign interest and These amounts, normally designated as foreign source income, are translated into dividend income Canadian dollars and are taxable as interest income. They are lumped together and reported on the T3 in Box 25. The amounts are shown gross before withholding taxes. The withholding tax paid is reported on the T3 in Box 34 and is eligible as a foreign tax credit. The dividends, however, are not eligible for the dividend tax credit. © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 5 Dividends earned and These amounts are reported in Box 23. The dividend income from the fund is afforded paid out by the fund the special treatment that dividend income receives in Canada. That is, they are treated from eligible taxable as if they were earned directly and are taxable as dividends, subject to the 38% gross-up Canadian corporations and the dividend tax credit (15.02% of the grossed-up dividend). Capital gain dividends These amounts are paid from net realized capital gains if the fund sold assets at a profit during the year. They are reported in Box 21 of the T3 and are subject to the 50% exclusion rule. Only 50% of an eligible gain is included in income. Taxable capital gains may be offset by allowable capital losses. The amount included is taxed at the investor’s marginal tax rate. Occasionally, a fund makes distributions in excess of its income. These are identified as returns of capital and are not taxable when received. However, they do reduce the cost base of the units. Alternatively, if units are sold for an amount in excess of their original cost (as adjusted for returns of capital), the seller will also incur a capital gain. Note that a capital gain dividend is not the same as the gain realized on the sale of a mutual fund unit. The sale of a mutual fund unit will capture the unrealized and accrued amounts. When units are sold, the seller receives a T5008 supplemental indicating the proceeds of disposition from the redemption. The sale of the unit is treated in the same manner as other capital property. From the sale proceeds, the adjusted cost base of the units is deducted (i.e., the original cost plus load, if any, plus reinvested dividends). This amount must be included in the seller’s taxable income for that year. Mutual fund corporations (MFCs) are taxed on their entire income. Most MFCs, however, pay out all of their income and, because tax has already been paid, the payouts are considered dividends (regardless of their source). As such, they are eligible for the dividend tax credit. The dividends paid by the MFC are subject to a refundable tax. The tax paid is refunded to the corporation on the basis of $1 per $4 paid. Capital gains dividends are based on the non-distributed cumulative net capital gains realized by the corporation after 1971. The corporation receives a tax refund on capital gains previously paid if it pays a capital gain dividend or distributes capital gains on the redemption of its shares. This refundable tax mechanism is the equalizer between the taxation of a trust and an MFC. SUITABLE TAX ADVICE When clients ask sales representatives for tax advice, the sales representatives should direct the client to consult a tax professional for most questions. However, they can explain some simple facts that are not tailored to a client’s specific situation, such as the definition of capital gains and the form of income reporting. PERFORMANCE MEASUREMENT To hold a meaningful discussion with a client about the merits of various mutual funds, the sales representative should have a solid understanding of the tools and techniques used to measure performance. The most valuable measure is the annual compounded rate of total return. This measure indicates the change in net asset value plus all distributions (in the form of interest, dividends, foreign dividends, and capital gains) for the entire period under evaluation, which are assumed to be reinvested upon distribution. The measure can be used to compare the returns realized by the fund manager with the returns that could have been obtained if an appropriate alternative passive portfolio (referred to as a benchmark portfolio) had been selected. It also can be used to compare the performance of the mutual fund against other active investments as long as the comparison is fair. Absolute measures are misleading; only relative returns count. © CANADIAN SECURITIES INSTITUTE 7 6 BRANCH COMPLIANCE OFFICER’S COURSE To be useful, balanced, and relevant, an analysis of the historic performance of a fund must consider not only its total return but also the associated risk. Risk is described by a dispersion measure such as standard deviation, which measures the variation from (or volatility of) the average return over time. The calculation of the compounded rate of return, ex-dividend day price adjustments, risk measures, the characteristics of benchmarks, and combined performance measures are discussed in the following sections. CALCULATING RATES OF RETURN There are several ways to calculate the rates of return on a mutual fund. To illustrate, we will assume that the fund has no sales charges, commissions, or loads. The following information is used for the next two illustrations: Year One The fund had a unit value of $10.00 on January 1 of Year 1 and a unit value of $10.50 on December 31 of Year 1. During the year, a distribution of $0.45 was issued. Year Two The fund had a unit value of $10.50 on January 1 of Year 2 and a unit value of $10.25 on December 31 of Year 2. During the year, a distribution of $0.75 was issued. SIMPLE RATE OF RETURN To calculate the simple rates of return for each year, use the following formula: P1 + C1 − P0 R= P0 P1 = value at end of year P0 = value at the start of the year C1 = distribution value during the year Year 1: 10.50 + 0.45 − 10.00 R= = 9.50% 10.00 Year 2: 10.25 + 0.75 − 10.50 R= = 4.76% 10.50 ARITHMETIC MEAN RETURN The arithmetic mean return method is a simplified and somewhat inaccurate method of calculating average returns. It merely adds up the returns for each year and then divides them by the number of years in question, as follows: 9.50 + 4.76 = 14.26 / 2 years = 7.13% per year Time-Weighted Return (Geometric Mean Return) To calculate the time-weighted return (also called the geometric mean return), begin by first calculating the simple rate of return for each year individually. Then apply the following formula to the results: TWR = (1 + R1 ) × (1 + R2 ) − 1 R1 = Simple return in the first year R2 = Simple return in the second year © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 7 For example: TWR = (1 + 0.095) × (1 + 0.0476) − 1 = (1.095) × (1.0476) − 1 = 1.1471 − 1 = 1.0710 − 1 = 0.0710 or 7.10% INTERNAL RATE OF RETURN Suppose that mutual fund A’s initial net asset value was $10.00. Assume that over the next 10 years, the dividend distributions allow for the purchase of 80% more units. The net asset value at the end of the period is $28.00. The annual compounded rate of return, R, is calculated as 17.56%, as follows: Initial investment = $10 New units purchased =.80 × 1 =.8 new units Terminal value of investment = $28 × (1 + New units purchased) = $28 × (1 +.8) = $50.40 To find the annual compounded rate of return, find the discount rate that equates the value of the initial investment to the terminal value of the investment, as follows: 10 10(I + R) = (28.00)(1.80) = $50.40 10 (I + R) = $5.04 10 R= 5.04 − 1 R = 0.1756 or 17.56% Where R is the internal rate of return Sales charges, commissions, and loads are not considered in the calculations. There is an arithmetic curiosity associated with rates of return. If a mutual fund rises in value by 25% and then falls in value by 25%, the investor has lost 6%. To illustrate, if the original investment is $10,000, it will end up as only $9,375 ($10,000 × 1.25 × 0.75 equals $9,375). The same result holds if the investment first loses 25% and then gains 25%; the final value is still $9,375. EX-DIVIDEND DAY PRICE ADJUSTMENTS Your sales representatives should be able to explain to their clients how the net asset value is adjusted when dividends are paid. © CANADIAN SECURITIES INSTITUTE 7 8 BRANCH COMPLIANCE OFFICER’S COURSE For example, an investor owns 10,000 units (purchased at $6.00 a unit) in a balanced mutual fund that has 500,000,000 units outstanding. The fund starts the year with the following values: Assets Liabilities and Equity Bonds $1,000,000,000 Liabilities $0 Preferred shares 400,000,000 Unitholder equity 3,000,000,000 Growth common shares 1,600,000,000 Total $3,000,000,000 Total $3,000,000,000 The NAVPU is $6.00 ($3,000,000,000/500,000,000 = 6.00). Over the next 12 months, the fund earns $80,000,000 in interest on its bonds and $24,000,000 in dividend income on its preferred shares. It sells common shares for a capital gain of $1,000,000. Furthermore, the bonds, preferred shares, and common shares grow to $1,100,000,000, $430,000,000, and $1,900,000,000 respectively. As of December 30, the fund looks like this: Assets Liabilities and Equity Cash $105,000,000 Liabilities $0 Bonds 1,100,000,000 Unitholder equity 3,535,000,000 Preferred shares 430,000,000 Growth common shares 1,900,000,000 Total $3,535,000,000 Total $3,535,000,000 The result is that the NAVPU has risen to $7.07 ($3,535,000,000/500,000,000 = 7.07), an increase of $1.07 per unit. The investor’s 10,000 units are now worth $70,700. Assume the fund now distributes its income as follows: Type Amount Per Unit Income distribution $80,000,000 $0.16 Dividend $24,000,000 $0.048 Capital gain dividend 1,000,000 $0.002 Total $105,000,000 $0.21 After the distribution, the balance sheet looks like this: Assets Liabilities and Equity Cash $0 Liabilities $0 Bonds $1,100,000,000 Unitholder equity $3,430,000,000 Preferred shares $430, 000,000 Growth common shares $1,900,000,000 Total $3,430,000,000 Total $3,430,000,000 © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 9 The NAVPU is now $6.86 and has dropped by exactly the $0.21 per unit total distributions held as cash. Let us also assume that the investor sells the units right after the distribution. The resulting tax position on 10,000 units is as follows: Received Add to taxable income Interest income $1,600.00 $1,600.00 Dividend income $480.00 662.40 (480 × 138%) Dividend tax credit 99.49 (15.02%) Capital gain dividend $20.00 10.00 (20 × 50%) Capital gain [(10,000 × 6.86 − 6.00)] $8,600.00 4,300.00 (8,600 × 50%) Total received $10,700.00 or $1.07 per unit If the fund pays out a dividend as cash, it reduces the fund’s assets, and the NAVPU drops as the number of units is not reduced. Remember that NAVPU is calculated as follows: (Total assets − Total liabilities) NAVPU = Number of units outstanding The day on which new purchasers of a mutual fund are not entitled to receive the dividend is called the ex-dividend date. For example, the XYZ mutual fund declares a dividend of $0.25 per unit payable to unitholders of record as of January 15. Although the record date is specified as January 15, the ex-dividend date will be on January 13 (always two business days before the record date). To appear on the record books of the mutual fund company and receive the dividend, an investor must be holding the units just before the ex-dividend date. For most mutual funds, distributions are automatically reinvested unless the unitholder specifically requests distributions in cash (by way of cheque or electronic transfer). If all the distributions are reinvested, then the total shareholders’ equity remains the same. When our investor’s dividend is reinvested, the number of units increases as $10,700 is invested in the fund with a NAVPU of $6.86. The number of units outstanding increases by 1559.77 ($10,700/$6.86), and each unitholder gets a pro-rata share of the new units. The total assets of the fund have not been reduced because the money distributed returns immediately as reinvested dividends. However, the number of units has increased, meaning the NAVPU must be lower than before the distribution. The unitholders’ pro-rata shares of the fund have not been reduced; they each have more units, but each unit is worth less. The only significant change is that distributions to unitholders, even if reinvested immediately, result in tax liabilities for the unitholders (unless the units are held in a tax-deferred account such as an RRSP). RISK OR VOLATILITY Risk measures that can be used to evaluate fund performance include standard deviation, beta, and maximum drawdown. These measures are all based on past performance. The terms are defined in detail as follows: © CANADIAN SECURITIES INSTITUTE 7 10 BRANCH COMPLIANCE OFFICER’S COURSE Standard deviation Standard deviation measures the historical degree of variability (or volatility) of the mutual fund’s rate of return against its average rate of return over a defined period. It also shows a measure of the risk inherent in the fund. The higher the standard deviation, the greater the variability of returns and the greater the risk. In general, the fund’s annual return falls within one standard deviation of its average return about 68% of the time and within two standard deviations about 95% of the time. For example, if a fund’s average return over the last 50 years was 7%, and the performance of the fund had a standard deviation of 5%, one would expect that in 34 of the 50 years (or 68% of all the years in question), the fund’s return would be between 2% and 12%. The merit of the standard deviation is that it is simple to calculate and relatively simple to understand. The financial press often provides a broad measure of standard deviation by classifying funds as either average, above average, or below average in this risk measure relative to all of the funds seen to be in the same category. Beta Beta is calculated by regressing the return on the fund against an appropriate market index. In non-technical terms, this means that it is an indicator of how a fund’s value has fluctuated relative to past changes in an appropriate benchmark. (A Canadian equity fund, for example, might be compared to the S&P/TSX Composite Index). The higher the fund’s beta, the greater the degree of fluctuation for any given change in the benchmark. A high-beta equity fund, therefore, would be expected to realize high rates of return when the benchmark stock market is rising but will suffer relatively large losses when the market is in decline. A low-beta fund would be expected to have relatively lower rates of return when the market is rising and suffer smaller losses when the market is in decline. Maximum drawdown Maximum drawdown calculates the greatest amount an investor would have lost if a fund was bought at its peak and sold at its lowest point. Although helpful for ultra-conservative investors, it means little for an investor selecting equity funds for a balanced, long-term portfolio. A variation on this theme is the value at risk, which determines how much of a fund’s portfolio will vary in reaction to a particular event (e.g., if oil rises by $1 a barrel or if interest rates rise by 100 points). BENCHMARKS It is possible to rank portfolios in deciles by return and risk, but a more precise measure is needed. Categories and benchmarks should reflect what managers do, rather than what they say they do. A good benchmark should have the following characteristics: Unambiguous The Standard & Poor’s Composite Index is an unambiguous benchmark. Its composition is published, and investors can easily find out which stocks are included in the index and how its value is determined. Investable The benchmark should represent a passive alternative to a money manager. You should be able to actually trade it or buy a proxy for it. © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 11 Measurable The benchmark should be calculated and published periodically and subject to precise calculations. Appropriate The benchmark selected should match the investment. An index equity fund should be benchmarked by the index it replicates, whereas a small cap fund should be benchmarked by a small cap index. COMBINED PERFORMANCE MEASURES Return and risk measures can be combined to create a single measure of fund performance. Performance should be based on standardized periods such as six months, one year, two years, and up to 10 years. National Instrument 81-102, (section 15) indicates that performance should be based on “fresh” numbers. These are numbers prepared no more than 45 days after the end of the period in question for any advertisement in which it is included, or not more than three months before the date of the first publication of any other sales communication in which it is included. PERFORMANCE MEASURES – USES AND ABUSES Performance measures can be used to evaluate performance during both bull and bear markets. However, determining the appropriate benchmark and selecting an appropriate time frame is not a simple matter. Studies have shown that funds that perform well one year are all too often the big losers the next year. Some funds outperform the averages in strong markets but underperform in weak ones. A key criterion in selecting a good fund is consistency of performance (i.e., how well the fund performs in both good and bad markets). Wherever possible, evaluate mutual funds on the basis of an examination of annual performance over an extended period, such as five or ten years, rather than on the basis of one year or less. Above all, try to avoid the all-too-common mistake of selecting funds strictly on the basis of recent quarterly or annual performance. The star performers this quarter or this year are often the laggards the next period. COMPOUNDED RATE OF RETURN P1 + C1 − P0 Return = × 100 P0 Where: P1 = Unit price at end of period P0 = Unit price at beginning of period C1 = Current period’s distribution John bought 100 units of the Fund in January Year 1 at a NAVPU of $10.00. During the year, he received income distributions totalling $0.50. The NAVPU on Dec. 31, Year 1, was $11.00. Calculate the total annual return for Year 1. P1 + C1 − P0 Total return for Year 1 = × 100 P0 $11.00 + $0.50 − $10 = × 100 $10.00 $1.50 = × 100 $10.00 = 15.00% © CANADIAN SECURITIES INSTITUTE 7 12 BRANCH COMPLIANCE OFFICER’S COURSE John continued to hold his investment in the fund throughout Year 2. During the year he received income distributions totalling $1.00. The NAVPU on Dec. 31, Year 2, was $10.75. What was the total annual return for Year 2? $10.75 + $1.00 − $11.00 Total return for Year 2 = × 100 $11.00 $0.75 = × 100 $11.00 = 6.80% We have calculated that the total return for Year 1 was 15.0%. We have also calculated that the total return for Year 2 was 6.8%. What would John’s investment be worth at the end of Year 2? He initially invested $1,000 at the beginning of January Year 1. His total return for that year was 15%, so to find the value of his investment at the end of the first year, we must multiply his $1,000 by 1.15. This gives us an answer of $1,150 as the value of his investment at the end of Year 1. Let us assume that John reinvested his income distribution of $0.50 back into the fund. So, at the beginning of Year 2, he has $1,150 invested in Super Fund. We know that in Year 2 he made a total return of 6.8%, so to determine the value of his investment at the end of Year 2, we must multiply $1,150 by 1.068, which gives us a value of $1,228.20. We now would like to find John’s average return for the two years. Let’s try taking the simple average (the arithmetic mean return) of the two returns: (15.0% + 6.8%) 2 = 10.9% Now let’s check to see if $1,000 invested at 10.9% for two years gives us the same ending value of $1,228.20: ($1,000 × 1.109) × 1.109 = $1,229.88 Investing $1,000 for two years at 10.9% gives us more than the value of $1,228.20 that we are looking for, so 10.9% is too high to be an accurate answer. Let’s try 10.8% to see if that gives us $1,228.20: ($1,000 × 1.108) × 1.108 = $1,227.66 10.8% is too low We have determined that John’s average return for the two years must be somewhere between 10.8% and 10.9%. Now we are now looking for the rate of return that will give us a value of $1,228.20 after two years and be the same in both years. We call that return the annual compound return. $1,000 × (1 + ACR) × (1 + ACR) = $1,228.20 We have already calculated what John’s initial investment was worth after two years using the following formula: $1,000 × (1 + Total return in year 1) × (1 + Total return in year 2) Or $1,000 × (1 + 0.15) × (1 + 0.068) These two formulas must be equal, so we can make them into an equation: $1,000 × (1 + ACR) × (1 + ACR) = $1,000 × (1 + 0.15) × (1 + 0.068) © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 13 We can simplify the equation by dividing each side by 1000, which leaves us with: (1 + ACR) × (1 + ACR) = (1 + 0.15) × (1 + 0.068) Or 2 (1 + ACR) = 1.15 × 1.068 We can further simplify this by taking the square root of each side: 12 (1 + ACR) = (1.15 × 1.068) We can further simplify the equation by subtracting 1 from each side, which gives us: 12 ACR = (1.15 × 1.068) −1 Or 12 ACR = (1.2282) −1 Calculating the square root of 1.2282 we get: ACR = 1.1082 − 1 ACR = 0.1082 To convert that to a percentage, we multiply by 100: ACR = 0.1082 × 100 ACR = 10.82% Remember we estimated that John’s average return had to be between 10.8% and 10.9%. We can state the formula for calculating a two-year annual compound return this way: æ 1 ö ACR = çç((1 + R1 )(1 + R2 )) 2 - 1÷÷ ´ 100% è ø Or ACR = ( (1 + R1 )(1 + R2 ) - 1) ´ 100% Where R1 = the total return in year 1 R2 = the total return in year 2 To calculate the annual compound return for a period of greater than two years, we would first calculate the total return for each year separately and then use the following formula: æ 1 ö ACR = çç((1 + R1 )(1 + R2 )(1 + R3 )(1 + Rn )) n - 1÷÷÷ ´ 100 çè ø Where: n is equal to the number of years in the period © CANADIAN SECURITIES INSTITUTE 7 14 BRANCH COMPLIANCE OFFICER’S COURSE EFFECT OF PAYMENT OF DISTRIBUTIONS ON CLIENT’S ACCOUNT Your sales representative should also be able to explain to a client how a distribution of income affects the holdings in an account. This subject is often poorly understood by clients and sales representatives alike. Let us assume that an investor invests $1,000 just before the ex-dividend date in a fund that pays out annual distributions of income. As shown in Table 1, the NAVPU on December 28th is $10.00. Therefore, our investor is able to purchase 100 units of the fund with his initial investment of $1,000. Because this is a non-registered account, our investor can choose either to reinvest any distributions back into the fund or to take them out in cash and have the distributions deposited to his bank account. Upon opening the account, he has chosen to reinvest his distributions to purchase more units. On December 31st, the fund pays out an income distribution for the year of $2.00 per unit to all unitholders of record on December 29th. Remember that the NAVPU of a fund is calculated by adding up the value of all the assets in the fund, minus any liabilities, and dividing that amount by the number of units outstanding at the end of that business day. For that reason, when a distribution is paid out of those assets to unitholders, the NAVPU will fall by exactly the same amount as the distribution paid out. This effect on the NAVPU may be disguised by other changes in the value of the fund’s assets as a result of changes in the underlying market. In our example in Table 1, we assumed that there were no other fluctuations in the unit price between the ex-dividend date and the payment date to better illustrate the effect of the payment of a distribution. Our investor has received $200 in a distribution of income, which he has chosen to reinvest in the fund. Because the NAVPU has dropped by $2.00 by virtue of the payment of the income distribution, our investor can now reinvest his $200 in the fund at the new price of $8.00 per unit. This allows him to purchase 25 additional units. So, he now has a total holding of 125 units of the fund valued at $8.00 per unit, which gives him a total plan value of $1,000. In the new year, our investor receives a T3 form from the mutual fund company for the $200 he received in income distributions in the previous year. He must now include that $200 of income in his taxable income for the year. He continues to hold his 125 units of the fund until November 15th of the following year, when the NAVPU has increased to $12.00. He decides to take his profits and sell all his units. His proceeds from this sale are $1500. What is his capital gain? (See Table 7.2 for details.) We know he initially invested $1,000 in the fund, but he also invested the $200 he received as an income distribution, so in total he has invested $1,200 in the fund. Therefore, his book value or adjusted cost base is $1,200, and his capital gain will be equal to the proceeds of the sale of his assets, $1,500, minus his adjusted cost base of $1,200, or $300. This calculation is based on the principle that taxes should not be incurred on the same amount of money twice. Our investor has already had to include the $200 income distribution in his taxable income for the previous year, so he should not be liable for taxes on that $200 again when he sells his units. What happens when an investor chooses to take the income distributions out in cash? Let’s examine tables 3 and 4 to see. Let us also assume that all factors remain the same as in the previous scenario, except for the fact that our second investor has chosen to receive her income distributions in cash and not reinvest them back into the fund. After an initial investment of $1,000 in the fund just before the ex-dividend date, the fund pays out a distribution of $2.00 per unit. Our investor has the $200 distribution deposited into her bank account. Therefore, after the distribution, she still has the same number of units as before the distribution. She now has total holdings in the fund of 100 units, which, after the distribution, are worth $8.00 per unit for a plan value of $800. In the new year, our second investor also receives a T3 form for the $200 income distribution she received, which she must include in her taxable income for the previous year. She also continues to hold these units in the fund until November 15th of the following year, when she decides to sell all 100 units at the current NAVPU of $12.00. Her proceeds from this sale are $1,200. What is our second investor’s capital gain? (See Table 7.4). © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 15 This investor’s initial investment in the Fund was $1,000, but she chose not to reinvest the distribution, so she did not make any further investments in the fund. Therefore, her book value, or adjusted cost base, remains at $1,000, and her capital gain is equal to the proceeds of the sale of her units, which is $1,200 minus her adjusted cost base of $1,000, or $200. Table 7.1 | Distributions with Reinvestment Unit cost Total # units Plan value Dec. 28, Year 1 Investor purchases $1000 of Fund. $10.00 100 $1,000 Dec. 31, Year 1 Distribution of $2.00 per unit is paid. Investor receives $200 ($2.00 × 100 units) $8.00 125 $1,000 which is reinvested at new price to purchase 25 more units. Nov. 15, Year 2 Unit price has increased to $12.00, and the $12.00 125 $1,500 investor decides to sell all units. Table 7.2 | What is Investor’s Capital Gain? With Reinvestment of Distributions in a Non-Registered Account Dec. 28, Year 1 Initial investment $1,000 Dec. 31, Year 1 Income distribution $200 Total book value (adjusted cost base) $1,200 Nov. 15, Year 2 Proceeds of sale of 125 units @ $12.00 $1,500 Minus book value or adjusted cost base $1,200 Capital gain $300 Taxable capital gain is 50% of $300 or $150 The investor already received T3 for tax Year 1 for income distribution of $200 Table 7.3 | Distributions Received in Cash Unit cost Total # units Plan value Dec. 28, Year 1 Investor purchases $1,000 of Fund. $10.00 100 $1,000 Dec. 31, Year 1 Distribution of $2.00 per unit is paid. The investor receives $200 ($2.00 × 100 units) in $8.00 100 $800 cash which is deposited to bank account. Nov. 15, Year 2 Unit price has increased to $12.00, and the $12.00 100 $1,200 investor decides to sell all units. © CANADIAN SECURITIES INSTITUTE 7 16 BRANCH COMPLIANCE OFFICER’S COURSE Table 7.4 | What is Investor’s Capital Gain? With Distributions Received in Cash Dec. 28, Year 1 Initial investment $1,000 Total book value (adjusted cost base) $1,000 Nov. 15, Year 2 Proceeds of sale of 100 units @ $12.00 $1,200 Minus book value or adjusted cost base $1,000 Capital gain $200 Taxable capital gain is 50% of $200 $100 The investor already has received T3 for tax Year 1 for an income distribution $200 of $200 © CANADIAN SECURITIES INSTITUTE  CHAPTER 7 MUTUAL FUNDS PERFORMANCE EVALUATION 7 17 SUMMARY Now that you have completed this chapter, you should be able to meet the following objectives: 1. Show how NAVPUs are calculated, and explain how the offering or purchase price is calculated. The NAVPU is the assets of the fund at market minus its liabilities divided by the number of units outstanding. 2. Discuss and explain the basics of the taxation of mutual fund income. There are different types of mutual fund distributions: Interest income, dividend income and capital gain. Capital gain can also be generated when units are sold. Before March 31 of each year, the mutual fund mails to each of its unitholders a T3 setting out the amount of each type of distribution paid during the previous taxation year. At redemption of mutual fund units, a T5008 supplemental is sent which indicates the proceeds of disposition from the redemption. 3. Explain basic and advanced concepts of performance measurement, including total return, volatility, standard deviation, beta, benchmarks, and combination performance measures. Total return is a measurement of the change in net asset value, plus all distributions (in the form of interest, dividends, foreign dividends, and capital gains). Volatility is described by a dispersion measure, which measures the variation of returns from the average return over time. Standard deviation is a measure of the historical variability (or volatility) of a mutual fund’s returns against its average return over a period of time. The higher the standard deviation, the greater the variability of returns and the greater the risk. Beta is a measure of the volatility of mutual funds’ returns in comparison to the market as a whole. The higher the beta, the greater the fund’s fluctuation for any given change in the benchmark. Benchmark is usually an index against which the performance of a mutual fund can be measured. Mutual funds should be benchmarked by the index they replicate. Return and risk measures can be combined to create a single measure of fund performance and should be based on standardized periods such as six months, one year, two years, and up to 10 years. © CANADIAN SECURITIES INSTITUTE