Mutual Fund Administration PDF

Canadian Investment Funds Course Unit 8: Mutual Funds Administration Introduction As a Dealing Representative, it is important that you have an understanding of how mutual funds are administered. This unit describes mutual fund administration and structure. This unit takes approximately 2 hours and...

Canadian Investment Funds Course Unit 8: Mutual Funds Administration Introduction As a Dealing Representative, it is important that you have an understanding of how mutual funds are administered. This unit describes mutual fund administration and structure. This unit takes approximately 2 hours and 55 minutes to complete. Lessons in this unit: Lesson 1: Mutual Fund Organization Lesson 2: Purchasing Mutual Funds Lesson 3: Redeeming Mutual Funds Lesson 4: Fee Structure Lesson 5: Disclosure Lesson 6: Account Types © 2021 IFSE Institute 261 Unit 8: Mutual Funds Administration Lesson 1: Mutual Fund Organization Introduction As a Dealing Representative, you are expected to know how mutual funds are structured. In this lesson you will learn about the different ways in which mutual funds can be formed. You will also learn about the components of the mutual fund organization and the role of each one. This lesson takes approximately 30 minutes to complete. By the end of this lesson you will be able to: explain how mutual funds can be formed as trusts or corporations describe the roles of the different components that are involved in day-to-day operations of a mutual fund: - 262 investment fund manager portfolio manager custodian distributor transfer agent independent review committee © 2021 IFSE Institute Canadian Investment Funds Course Mutual Funds as Corporations or Trusts The mutual fund is a separate entity from the company that manages the fund. Mutual funds may be structured either as a corporation or as a trust. Investors in a mutual fund corporation are referred to as shareholders. Investors in a mutual fund trust are referred to as unitholders. Currently, the majority of mutual funds are structured as trusts. As a result, the term unitholders will be used throughout this unit to refer to mutual fund investors. The table below summarizes the characteristics of each type of mutual fund organization. Mutual Fund Corporation Mutual Fund Trust Investors are referred to as shareholders. Investors are known as unitholders rather than shareholders. A board of directors governs the fund. Trusts or trustees govern the fund. There is no board of directors. The board of directors is elected by the shareholders at the fund's annual general meeting. Investors or unitholders typically do not have the authority to appoint the trustee(s). Mutual Funds Complex Behind every mutual fund is a series of organizations and individuals that are responsible for the day-to-day operations of the fund. Their duties range from investment strategy and selection, to the safekeeping of investor assets, to the sale and redemption of fund units. This group of organizations and individuals is known as the mutual funds complex. The relationship between the mutual funds complex and the rest of the mutual fund organization is as follows: © 2021 IFSE Institute 263 Unit 8: Mutual Funds Administration Role of the Investment Fund Manager Depending on how a fund is structured, either the board of directors (in a corporation) or the trustees (in a trust) are responsible for the management of the fund's investments, as well as the day-to-day operations of the fund. Some funds hire a separate investment fund manager rather than hiring staff in-house. The investment fund manager may be a wholly-owned subsidiary of a parent corporation. Banks often do this. Typically, the investment fund manager looks at the fund's investment objectives and selects a portfolio manager with related experience. Some investment fund managers provide internal portfolio management based on similar criteria, while others use a combination of internal and external portfolio managers. Investment fund managers are paid an annual management fee for their services. The name of the investment fund manager for a fund is disclosed in a document called the prospectus. The prospectus will be discussed in detail later in this unit. The investment fund manager can also be referred to as the investment fund management company or mutual fund company. Role of the Portfolio Manager A portfolio manager is responsible for the investment decisions of a fund, including purchasing and selling securities and determining the mix of assets. In return, the portfolio manager receives management fees from the mutual funds that he or she oversees. Portfolio managers are guided by the fund's investment objectives as stated in the prospectus. Portfolio managers may use specialists to help them make investment decisions. The aim of all portfolio managers is to generate the best rate of return for the fund's investors while operating within the fund's investment objectives. The name of the portfolio manager for a fund is disclosed in the prospectus. 264 © 2021 IFSE Institute Canadian Investment Funds Course Role of the Custodian The custodian is responsible for safekeeping the cash and securities belonging to the fund. The custodian is also responsible for holding the income earned by the fund until it is reinvested or distributed to fund investors. The custodian makes payments and receives monies or securities as directed by the investment fund management company. By law, to protect investors, custodial functions of a mutual fund must be kept separate from those of the investment fund management company. This way, the management company does not have access to the securities held by the mutual fund. They are not available for any purpose other than the investment objectives of the fund. The name of the custodian for a fund is disclosed in the prospectus. Under National Instrument 81-102, a mutual fund custodian must be one of the following: a Canadian chartered bank a Canadian trust company with shareholder equity of not less than $10 million a Canadian chartered bank or Trust company affiliate with shareholder equity of not less than $10 million, and incorporated under Federal or Provincial law A custodial agreement between the fund and the custodian outlines how the custodian holds the fund assets and how the two parties interact with each other. Custodians can appoint a sub-custodian to hold assets of the fund. This is more common for funds that have assets in other countries. Role of the Distributor The distributor is the sales and marketing arm of the mutual fund company responsible for bringing assets to the fund through sales to investors. The distributor sells units to investors and transmits redemption requests to the investment fund management company. © 2021 IFSE Institute 265 Unit 8: Mutual Funds Administration As a Dealing Representative, you are part of the distribution network. The actual distribution can be structured in different ways: Proprietary, or in-house, organizations that sell only their own mutual funds. They may also offer complementary products, such as insurance and GICs. Dealing Representatives associated with a mutual fund dealer that has distribution agreements in place with multiple mutual fund companies. The Dealing Representatives are either employees or agents of the mutual fund dealer. Stockbrokers employed by investment dealers. Employees of financial institutions such as banks, trust companies, credit unions, or caisses populaires. These people are licensed to sell mutual funds, but likely perform other duties associated with their institution. Employees of mutual fund companies that deal directly with the public. Market Share of Mutual Fund Assets This graph illustrates the market share of mutual fund assets by distribution channel. Source: Investor Economics Household Balance Sheet Report, various years Role of the Transfer Agent The role of the transfer agent is usually performed by a trust company. This can be the investment fund management company itself, or the custodian, or is sometimes a contracted third party. The name of the transfer agent for a fund is disclosed in the prospectus. 266 © 2021 IFSE Institute Canadian Investment Funds Course The transfer agent maintains the register of unitholders and records all transfers of ownership. This register changes daily as fund units are purchased and redeemed. The transfer agent may also offer a dividend distribution service. Role of the Independent Review Committee The securities regulation National Instrument (NI) 81-107 Independent Review Committee for Investment Funds is the harmonized regulation made by the Securities Regulators through the Canadian Securities Administrators. NI 81-107 requires all publicly offered mutual funds and investment funds to have an Independent Review Committee. The role of the Independent Review Committee is to oversee potential conflict of interest decisions involving the manager of an investment fund. NI 81-107 enhances investor protection by ensuring that an independent body focuses on the interests of the investment fund in situations where a manager of an investment fund is faced with a conflict of interest. In NI 81-107, a “manager" means a person or company that directs the business, operations and affairs of an investment fund. © 2021 IFSE Institute 267 Unit 8: Mutual Funds Administration Lesson 2: Purchasing Mutual Funds Introduction Understanding how investors can purchase mutual funds is essential in your role as a Dealing Representative. In this lesson, you will learn how the net asset value per unit (NAVPU) is calculated, and about different approaches to purchasing mutual funds. This lesson takes approximately 20 minutes to complete. By the end of this lesson you will be able to: explain how the net asset value per unit (NAVPU) is calculated differentiate between valuation and settlement date of a transaction describe how mutual funds can be purchased (lump sum, voluntary accumulation plans) describe the concept of dollar cost averaging 268 © 2021 IFSE Institute Canadian Investment Funds Course Net Asset Value Per Unit The net asset value per unit (NAVPU) is critical to a mutual fund because it represents the price at which units are bought and sold on any particular day. The NAVPU is important for investors, because it has a direct bearing on how many units their money purchases, or how much cash they receive when they redeem their fund units. Investors may also use the NAVPU to help them calculate the value of their mutual fund investment at any given time, and to monitor the performance of their securities. The investment fund manager has the responsibility of calculating the NAVPU, usually daily. It involves assessing the value of all the fund's assets and liabilities, as well as the number of shares or units outstanding at the close of business on each valuation day. Assets market value of fund's investment portfolio cash near-cash investments (those that can be quickly converted to cash) accounts receivable (owed) from dealers Liabilities expenses incurred for the valuation period dividends payable to investors redemption amounts owed to investors Accurate market values for securities are obtained by doing the following: recording the closing price of a security on the financial market where most of its trading activity takes place setting reliable bid and ask quotations if a security is not traded, in accordance with the stated policies of the fund in the case of mortgages, setting a price that reflects the current rates for equivalent mortgages All costs are accrued and expensed in accordance with International Financial Reporting Standards (IFRS). The auditor of the fund is required to confirm annually that proper valuation techniques were employed. Mutual funds, like public corporations, must be audited by an independent auditor. Calculating the Net Asset Value Per Unit (NAVPU) After assessing the value of all the fund's assets and liabilities, the fund manager calculates the difference between total assets and total liabilities. This result is known as the fund’s net asset value. The net asset value is then divided by the number of shares or units outstanding to determine the net asset value per unit (NAVPU). The NAVPU is calculated using the following formula: © 2021 IFSE Institute 269 Unit 8: Mutual Funds Administration NAVPU = (total assets – total liabilities) ÷ number of units outstanding Example At the close of trading on Monday, October 4, the fund manager for the Delta Equity Mutual Fund determines that the fund held $11,000,000 worth of securities, $1,400,000 of cash and $400,000 of liabilities. The fund has 1,000,000 units outstanding. As a result, the NAVPU at the close of trading yesterday is $12, calculated as (($11,000,000 + $1,400,000) - $400,000) ÷ 1,000,000. Valuation Date and Settlement The valuation date of a mutual fund purchase or redemption is the date following receipt by the fund of a purchase or redemption request. For instance, if a purchase request is received on June 1 st at 5 p.m. Eastern time, the valuation date is June 2nd. Some investors expect the price they receive to be based on the daily fund unit values reported in the press. You need to make your clients aware that there may be a difference between their valuation date and the one published. Requests must be received before 4 p.m. Eastern Time if the investor wants to receive that day's NAVPU. The calculation of the NAVPU may be delayed because of an administrative problem or valuing securities in a different time zone. There is no common practice for reporting the NAVPU for funds holding international securities. Settlement is the date of the actual clearing of the transaction, in essence the payment of the funds and the delivery of the securities. Nowadays, settlement for most securities is almost exclusively performed on an electronic basis. For purchases, you have until the settlement date to provide payment. In the case of redemptions, you will not receive your proceeds until the settlement date. Settlement for most funds is the trade date plus three business days, often expressed as T+36. For money market funds, settlement is usually the next business day (or sooner, if chequing privileges are available). 6 Effective September 05, 2017, Canada and the United States adopted a T+2 (trade date plus 2 business days) settlement cycle for all investment products which previously traded on a T+3 cycle, including mutual funds. Further updates will be reflected in the next version of this course. For exam purposes, the content in this version of the course will apply. 270 © 2021 IFSE Institute Canadian Investment Funds Course Example On Monday, October 4, Julie calls a Dealing Representative at 1:00pm Eastern Time to make a purchase in the amount of $2,400 for units in the Delta Equity Mutual Fund. The purchase price per unit is the NAVPU of that day, which we had calculated in the previous example as $12 per unit. Assuming no additional transaction costs, Julie will be able to purchase 200 units of the Delta Equity Mutual Fund, calculated as $2,400 ÷ $12. Julie must have the funds available by 12:00 AM Thursday to pay for the units. Since many mutual fund companies process transactions overnight on the date of purchase, funds must be available before the transaction is processed. Methods of Purchasing Mutual Funds One of the main advantages of mutual funds is ease of investment. Fund units can be purchased easily on any business day. Mutual funds are available through banks, investment dealers, fund companies, and a variety of other sources. The fund prospectus and Fund Facts must describe how units can be purchased and how the fund is valued. They must also indicate that the purchase price will be the next NAVPU calculated after receipt of the purchase order. Funds that publish the NAVPU in the press have to ensure that the current NAVPU is provided on a timely basis. There are two common methods for purchasing mutual funds: single lump-sum purchases and regular investment plans. Single Lump-Sum Purchases A single purchase can generally consist of any lump-sum amount, subject to the minimum purchase requirements established by individual funds. Minimum initial investments range from $500, for most funds, to $150,000. for premium funds. Lower limits often apply to purchases for RRSPs and other tax-deferral plans. Once an account has been opened, subsequent purchase requirements are generally much lower. Regular Investment Plans Many mutual fund sales organizations offer regular investment plans whereby an investor can make regular automatic purchases of mutual fund units. A minimum purchase is generally required and additional contributions can often be made for as little as $25. Minimum amounts vary from fund to fund. Voluntary Accumulation Plans With a voluntary accumulation plan, an investor agrees to invest a pre-determined amount on a regular basis (usually weekly, monthly, or quarterly). The amount of contributions can be changed at any time, and the investor can withdraw from the plan at any time. © 2021 IFSE Institute 271 Unit 8: Mutual Funds Administration To encourage continuing participation, these plans try to make contributing as easy as possible through preauthorized payments from bank accounts. Acquisition charges are deducted at the time of each contribution. This plan is commonly known as pre-authorized chequing (PAC) plans. Dollar-cost Averaging Investors with pre-authorized chequing (PAC) plans can take advantage of a risk mitigation strategy called dollar-cost averaging. With dollar-cost averaging, investors invest the same amount of money in the same mutual fund at regular intervals, such as monthly or quarterly. When unit prices are low, more units are purchased. Consequently, when unit prices are high, fewer units are purchased. Dollar-cost averaging encourages a disciplined investing approach. After purchasers set the amount and frequency of the plan, payments can be automatically withdrawn from their bank accounts. Dollar-cost averaging also helps investors avoid the temptation of market timing. Some investors attempt the impossible task of timing the top or the bottom of the market. With dollar-cost averaging, purchases are made on a regular basis despite market conditions. Example Bernie would like to invest an additional $6,000 in XYZ Canadian Equity Fund, a mutual fund in which he has owned units for a number of years. Tara, a Dealing Representative, recommends that Bernie open a pre-authorized chequing (PAC) plan, which will allow him to gradually purchase units of XYZ Canadian Equity Fund over a number of months. Since he is investing regularly, this strategy will help Bernie maintain a disciplined investment approach. In addition, the table below demonstrates that the average cost per unit of Bernie’s purchases will actually be lower than $52.80, his cost per unit had he invested the whole $6,000 in month 1. The difference is due to the manner in which the fund’s NAVPU fluctuated during the 6 month period. Of course, a different fluctuation pattern could have resulted in a higher cost per unit. 272 © 2021 IFSE Institute Canadian Investment Funds Course Month Investment Amount NAVPU Units Purchased 1 $1,000 $52.80 18.9394 2 $1,000 $54.83 18.2382 3 $1,000 $51.26 19.5084 4 $1,000 $50.34 19.8649 5 $1,000 $48.73 20.5212 6 $1,000 $53.80 18.5874 Totals $6,000 115.6595 After fully investing his $6,000, Bernie will own 115.6595 units of XYZ Canadian Equity Fund. His average cost per unit is only $51.88, calculated as $6,000 ÷ 115.6595. By making purchases on a regular basis, Bernie does not have to be concerned with the regular fluctuations in the fund’s NAVPU. © 2021 IFSE Institute 273 Unit 8: Mutual Funds Administration Lesson 3: Redeeming Mutual Funds Introduction As with the purchase of mutual funds, a thorough understanding of how mutual funds are redeemed is central to your role as a Dealing Representative. In this lesson, you will learn about the different ways in which mutual funds can be redeemed. You will also learn about how investors can switch between different mutual funds within a fund family, and also gain an understanding of the tax consequences of redeeming or switching funds. This lesson takes approximately 30 minutes to complete. By the end of this lesson you will be able to: describe how mutual funds can be redeemed (lump sum, systematic withdrawal plans, series T) understand the tax consequences of redeeming mutual funds explain the concept of a mutual fund switch 274 © 2021 IFSE Institute Canadian Investment Funds Course Mutual Fund Redemptions Mutual funds provide liquidity for investors. Mutual funds can be redeemed easily and investors can receive their money quickly. On an annual basis, the fund manager must provide to investors the requirements to redeem fund units. This information is set out in the prospectus and outlines the criteria for redemption requests to be considered in “good order”. Some of the items needed for a good order redemption request include: order received before the time stipulated in the prospectus order placed by the rightful owner of the units or shares to be redeemed The fund manager must also provide information to investors on how often the fund is valued and how the redemption price is calculated. Lump Sum Withdrawals A single withdrawal can generally consist of any lump-sum amount, subject to the funds being available in the mutual fund. Purchases and redemptions are based on the valuation date following the receipt by the fund of a purchase or redemption request, and settlement of most funds is trade date plus three business days (T+3 7). For money market funds, settlement is usually the next business day (or sooner, if chequing privileges are available). Example On Friday, July 16, Bernard makes a redemption order at 6pm Eastern Time for units of his Precious Metals Fund. The valuation day for his trade will be Monday, July 19 since his order came after 4pm. The funds must settle in his account by the close of business Thursday, July 22, although he may receive them sooner. Systematic Withdrawal Plans Systematic withdrawal plans (SWPs) are redemption programs that allow investors to receive a regular cash flow from their holdings. These plans provide investors with three advantages: Withdrawals can be tailored to the client’s specific cash flow needs, providing assets are sufficient to support the payout level. 7 Effective September 05, 2017, Canada and the United States adopted a T+2 (trade date plus 2 business days) settlement cycle for all investment products which previously traded on a T+3 cycle, including mutual funds. Further updates will be reflected in the next version of this course. For exam purposes, the content in this version of the course will apply. © 2021 IFSE Institute 275 Unit 8: Mutual Funds Administration Investments remaining in the fund continue to generate returns. Depending on the type of funds held, income may be eligible for preferential income tax treatment. A fund that offers systematic withdrawal plans must describe them in its prospectus. As well, the prospectus must specify if there is a minimum level of holdings, such as $50,000 or $100,000, before investors can take advantage of these plans. Payment options SWPs provide clients with flexible payment options. They can be set up to pay out at regular intervals such as monthly, quarterly, or annually. Clients can also choose to redeem: a ratio or percentage of holdings a fixed dollar amount Ratio Withdrawal Plan In this type of plan, the investor receives a cash flow based on a percentage of his or her portfolio's value, such as 8% or 12%. The amount paid is calculated as a fixed percentage of the average daily NAVPU during the previous payment period, or the value of the account on the last day of the previous payment period. The withdrawal ratio is flexible, which is ideal for the investor who has immediate cash needs but whose income needs may change in the future. If an investor's withdrawals are less than the growth of the portfolio, the investments continue to grow and the investor can withdraw more in later years without depleting the investment. However, if an investor's withdrawals exceed the fund's return or the investor excessively increases the withdrawal percentage, then the portfolio's growth is adversely affected and begins to deplete the capital. Example Benjamin, an investor, owns 1,000 units of a fund and sets up a ratio withdrawal plan to withdraw 10% on the 15th day of each month. The table below shows that on January 15 th, the NAVPU for the fund is $20, creating a portfolio value of $20,000, calculated as 1,000 units x $20. The 10% withdrawal of $2,000 requires that 100 units of the fund be sold. With no additional distributions from the fund, the number of units owned before the next withdrawal decreases from 1,000 units to 900 units. 276 © 2021 IFSE Institute Canadian Investment Funds Course Date Jan.15 Units Owned NAVPU Portfolio Value Withdrawal Amount Units Sold 1,000 $20 $20,000 $2,000 100 Feb. 15 900 $16 $14,400 $1,440 90 Mar.15 810 $22 $17,820 $1,782 81 The withdrawal amount and number of units sold varies depending on the fund's NAVPU at redemption. In this case, Benjamin could vary the withdrawal ratio to meet his cash flow needs while also ensuring that the portfolio continues to grow. Fixed-dollar Withdrawal Plans With this type of plan, the investor chooses to receive a fixed amount at specified intervals, such as monthly or quarterly. Investors who have financial commitments that are relatively stable may choose this type of plan. The fund sells enough units, depending on the price, to produce the payment. Since the price may vary for each payment, it is therefore possible to experience the same risk mitigation effect for de-investing as dollarcost averaging produces when investing. In other words, as prices fall, more units are redeemed and when prices rise, fewer units are redeemed. Example Using the information from our previous example, assume Benjamin owns 1,000 units of a fund and sets up a fixed-dollar withdrawal plan to receive $2,000 per month. Date Units Owned NAVPU Portfolio Value Withdrawal Amount Units Sold Jan.15 1,000 $20 $20,000 $2,000 100 Feb. 15 900 $16 $14,400 $2,000 125 Mar.15 775 $22 $17,050 $2,000 90.9091 The number of units sold varies depending on the fund's price at redemption. © 2021 IFSE Institute 277 Unit 8: Mutual Funds Administration Taxation on Lump Sum or Systematic Withdrawal Plans With a systematic withdrawal plan (SWP) or lump sum withdrawal, all distributions are taxed in the year received. The prospectus must disclose the tax consequences from mutual fund dispositions. In most cases, the fund company provides tax reporting to the investor that includes: the average cost of units held the number of units redeemed during the year the total dollar value of payments made during the year It is required by law to withhold tax on redemptions made from tax-sheltered registered plans (for example, RRSPs). The tax rates depend on the total dollar amount of the redemption. In compliance with the Canada Revenue Agency, the appropriate withholding tax rate is applied on the basis of the full or aggregate amount (minus fees and charges). The rate is based on the total amount of the transactions per request in an account, not on the individual transactions. Series T Many fund managers have launched series of mutual funds that may be used as alternatives to SWPs. These series are usually known as Series T, where T stands for Tax. The name of the series indicates the payout percentage. Thus, Series T6 pays an annual payout of 6% of the fund’s year-end net asset value per unit (NAVPU), Series T8 an annual payout of 8%, etc. With Series T, it is not necessary to redeem units in order to provide the required cash flow. Instead, the required cash flow is provided by means of capital, which is not taxable. NOTE: Series T distributions do not always have a return of capital. For instance, if a fund is a T4 and the portfolio earns 4%, there will be no return of capital. A distribution is characterized as return of capital when the amount of the distribution exceeds the taxable income of the fund. The taxable income of a mutual fund consists of Canadian dividends, foreign dividends, interest income and net realized gains. Any distribution that does not fall in one of these categories is treated as a return of capital for tax purposes. Example A fund has taxable income of $0.04 per unit in a given year and pays a distribution of $0.10 per unit. This means that $0.06 constitutes a return of capital. Sustainability of Payout In order to be sustainable, the payout rate should approximate the average long-term return of the fund, taking into account its asset allocation and investment objectives. For example, a mutual fund with 80% equity 278 © 2021 IFSE Institute Canadian Investment Funds Course normally has a higher average long-term return than a fund with 40% equity. The key word here is long-term. Over any given period, it is quite possible that either fund would outperform the other. If distributions consistently exceed the fund’s long-term return, the fund will eventually be depleted. This is the same result as with SWPs. Over the long-term, there will be some years with positive returns and other years with negative returns. In addition to the average long-term return, the sequence of the returns also matters. For a given average return, it is preferable for the positive returns to occur early in retirement and for the negative returns to occur later. This is because the portfolio is usually largest at the beginning of retirement. The portfolio decreases over time as withdrawals are made over the investor’s retirement years. It is preferable for the positive returns to benefit the portfolio when it is large and the negative returns to hit the portfolio when it is small, rather than the other way around. Example On December 31, Raj and Kiran retire. They have each set aside $100,000 in an investment account to use during the first five years of retirement. They have decided to withdraw $20,000 per year from their respective accounts. In addition, they will each need to withdraw the funds at the beginning of the year in order to meet their lifestyle needs. The table below provides an illustration of how the sequence of returns could affect their portfolios. Raj's Investment Portfolio Year © 2021 IFSE Institute Withdrawal Portfolio Value Annual Return Year-end Balance 1 $20,000 $80,000 7.20% $85,760 2 $20,000 $65,760 -8.71% $60,032 3 $20,000 $40,032 17.61% $47,082 4 $20,000 $27,082 35.10% $36,588 5 $20,000 $16,588 -33.00% $11,114 279 Unit 8: Mutual Funds Administration Kiran's Investment Portfolio Year Withdrawal Portfolio Value Annual Return Year-end Balance 1 $20,000 $80,000 -33.00% $53,600 2 $20,000 $33,600 35.10% $45,394 3 $20,000 $25,394 17.61% $29,865 4 $20,000 $9,865 -8.71% $9,006 5 $9,006 $0 7.20% $0 Both Raj and Kiran had invested in an all-equity portfolio. As a result of a large negative return in her first year of retirement, Kiran was unable to withdraw $20,000 during the last year of her 5-year investment horizon. The negative returns that Raj experienced did not occur until later on in his investment horizon. As a result, Raj was able to withdraw $20,000 per year with some money left over. Switching Series It is possible for an investor to change the payout rate by switching from one series to another. For example, by switching from Series T8 to Series T6, the investor reduces the annual payout rate from 8% to 6%. The switch constitutes a redemption of the Series T8 units and will trigger a taxable capital gain or allowable taxable loss. However, some Series T funds have been established under the umbrella of a mutual fund corporation instead of a mutual fund trust. It is possible to switch from one class of shares to another within a mutual fund corporation without immediately triggering a taxable capital gain. Mutual fund corporations will be examined in greater detail later in the course. Switching Funds Most fund companies allow you to sell units in one mutual fund to purchase units in another mutual fund among its own offerings. This transaction is called switching. 280 © 2021 IFSE Institute Canadian Investment Funds Course Example Mr. Ajax is comfortable with a portfolio composed of 60% equity funds and 40% bond funds. Because equity funds have lately performed better than bond funds, equity funds now represent 70% of the market value of his portfolio and bond funds 30%. Mr. Ajax is uncomfortable with this heavy exposure to equity funds and decides to rebalance his portfolio. He does this by switching 10% of the portfolio from the ABC Equity Fund to the ABC Bond Fund. A fund's prospectus outlines whether this service is available and whether a switch fee can be charged. If your client purchased a mutual fund with a deferred sales charge, there are no redemption fees charged if the client switches to another fund. In general, your client maintains the same deferred sales charge schedule as if he or she had not made the transaction. As well, if your client had purchased the mutual fund with a front-end load, there is no sales charge applicable at the time of the switch. However, there may be an early redemption charge for redemptions or switches made within a certain time period, often the first 90 days after purchase. If your client purchased a mutual fund with an early redemption fee and decided to switch to another fund within the early redemption period, he or she would be subject to that early redemption charge. Additionally, the dealer may charge a commission of up to 2% for executing a switch transaction, regardless of whether the original units were purchased with a sales charge or a deferred sales charge. © 2021 IFSE Institute 281 Unit 8: Mutual Funds Administration Lesson 4: Fee Structure Introduction Understanding the fee structure of mutual funds will help you to advise clients about funds which are suitable to their investment goals and time horizons. In this lesson you will learn about the management expense ratio (MER) and how it is calculated. You will also learn about fee based vs. commission-based models, no-load funds, and other fee structures. This lesson takes approximately 35 minutes to complete. By the end of this lesson you will be able to: understand the types of costs associated with mutual funds explain how the management expense ratio (MER) is calculated explain how the MER impacts a mutual fund’s performance describe the concept of trailer fees differentiate between a fee-based model and a commission based compensation model describe the various commission fee options - front-end sales charge - deferred sales charge - low-load sales charge explain the concept of the 10% free redemptions discuss the costs associated with no-load funds describe the fee structure for fund of funds describe the administrative fees associated with mutual funds or types of accounts 282 © 2021 IFSE Institute Canadian Investment Funds Course Three Important Costs There are three important costs related to mutual funds: 1. Management fees and operating expenses, paid by the fund for professional portfolio management, investment research, marketing, accounting, record keeping, and legal advice. 2. Trailer fees, fees paid by the fund to mutual fund dealers. 3. Loads or commissions, paid by investors when they buy and sell mutual funds. Mechanics of Management Fees A management fee is the sum a mutual fund pays its investment fund manager for supervising the portfolio and administering its operations. Although the investor does not pay the management fee directly, it is paid by the mutual fund. Investors should be concerned about management fees because they reduce the rate of return earned for investors in a fund. For instance, if a fund earns a 10% return over a year before management fees, and then pays out a 1.5% management fee to its management company, the return to investors will be only 8.5%. The higher the management fee, the larger the reduction and the lower the investors' return. When the net asset value per unit (NAVPU) or rates of return are given for a fund, management fees have already been deducted. For instance, the unit values and rates of return printed in financial publications or advertisements have already taken management fees into account. Despite the above, investors need to be advised by their Dealing Representative that returns will be affected by management fees. In fact, when choosing investments for your clients, it is prudent to compare management fees of similar funds that share the same financial objectives. Management Expense Ratio (MER) To help investors compare management expenses for different funds, the Management Expense Ratio (MER) provides a standardized measure that expresses the costs of a fund as a percentage of its average net asset value during the fiscal year. To look at it another way, the MER allows you to calculate what percentage of each dollar of fund assets is being used to pay for management services. Mutual funds are required to calculate the management expense ratio by reference to the financial statements for a financial year or an interim six-month period. The management expense ratio is obtained by dividing the total expenses of the fund before income taxes, as shown in the Statement of Operations, by the daily average net asset value for the relevant period. © 2021 IFSE Institute 283 Unit 8: Mutual Funds Administration MER = (Total Annual Fund Expenses per Statement of Operations ÷ Average Net Asset Value for the Year) x 100 *For the purposes of MER calculation, total fund expenses are before income taxes and do not include commissions or portfolio transaction costs. National Instrument 81-106 (NI 81-106) requires a fund to disclose the MERs for the last five years in its management report of fund performance. Components of the Management Expense Ratio (MER) The MER includes the total expenses paid by a fund to a management company and other service providers including the following: 1. management fee, including: a. administration of fund operations b. portfolio advisory services c. marketing and promotion d. financing costs 2. trailer fees 3. operating expenses, including: a. registrar and transfer agency fees b. safekeeping and custodial fees c. accounting, audit, and legal fees d. fund valuation costs e. costs associated with registered plans f. independent review committee fees and expenses g. costs of preparing investor communications h. regulatory filing fees i. bank and interest charges 4. interest charges and taxes (GST and sales tax) Although commissions or brokerage fees and other portfolio transaction costs are shown as an expense in the Statement of Operations, they are excluded from the calculation of the management expense ratio. These fees are captured in the Trading Expense Ratio (TER) and can be found in documents such as the Fund Facts. 284 © 2021 IFSE Institute Canadian Investment Funds Course Impact of Fees and Expenses on MER This chart displays the impact of the various fees and expenses on the overall MER. NI 81-106 also requires disclosure of any fees or expenses absorbed or waived by the fund manager, as well as the impact of such actions on the MER. The MER calculation must also include management fee rebates to investors. Note: The chart reflects cost components of typical mutual fund. Although trailer fees are typically embedded in the net management fee; for illustration purposes, trailer fees are shown as a separate component. Overall cost shown of 2.4% reflects asset-weighted average MER of load paying equity funds at December 2011 (Source: Investor Economics Insight Report – Jan 2012). How Fund Assets Affect Fees Because fees are based on assets under management, portfolio managers have a strong incentive to increase fund assets. The more successful they are, the more they earn in fees. For instance, the manager of a fund with $100 million in net assets and a management fee of 1.5% earns $1.5 million in a year. If those assets are doubled to $200 million, the fund manager earns $3 million. This growth in assets can take place in two ways: capital appreciation of the existing assets, or an increase in the sales of fund units A fund manager can also increase profits by controlling the costs associated with operating a fund, although these controls have less of an impact on profitability than increasing assets. When costs are lower, there are more assets available for investing against which management fees can be charged. MERs and Performance The MER is used to express what it costs to manage mutual funds. Funds that are actively managed, such as equity funds and asset allocation funds, tend to have MERs of 2.5% on average. Money market funds and passively managed funds designed to replicate a particular market index tend to have MERs at or below 1%. When mutual fund performance data is published, the rates of return reflect the funds' returns after the MERs have been deducted. Therefore, two funds with the same returns before expenses, but with different MERs, will have different returns after the management expenses have been deducted. The fund with the higher MER will have lower net returns. © 2021 IFSE Institute 285 Unit 8: Mutual Funds Administration The management expenses are charged whether or not the fund is performing well, even if it is going down in value. To the mutual fund investor, it is the net rate of return that determines how much his or her investment will be worth, while staying invested in a fund. Example Rodel, age 25, is considering investing in three different equity mutual funds, Omega, Beta, and Epsilon. The three equity funds own the same securities in identical amounts. As a result, each fund is expected to earn an average annual rate of return of 9%. The only difference between the funds is in their management expense ratios; Omega, Beta, and Epsilon have MERs of 1.5%, 2.0%, and 2.5%, respectively. Rodel understands that the fund with the higher MER will have lower net returns. However, since the MERs of these funds are reasonably close together, he believes that it does not matter that much which fund he decides to invest $100,000 in. After doing some calculations, see the table below, Rodel realizes that even small differences in MER can make a big difference – especially if you hold your investments for a long period of time! Portfolio Value of $100,000 using Different Investment Horizons and MERs (Rate of return is 9% before MERs) Investment Horizon Omega Equity Fund Beta Equity Fund Epsilon Equity Fund MER = 1.5% MER = 2.0% MER = 2.5% 10 years $206,103 $196,715 $187,714 20 years $424,785 $386,968 $352,365 30 years $875,496 $761,226 $661,437 40 years $1,804,424 $1,497,446 $1,241,607 If Rodel invests in the Epsilon Equity Fund, he will earn 30% less money than he would have if he had invested in the Omega Equity Fund. Limitations of the MER It is important to be aware of the limitations of the management expense ratio. Although the MER is an extremely helpful measure of the cost of owning mutual funds, it falls short of being all-inclusive. For instance, it does not include: commissions paid on the purchase of units under the front-end sales charge method redemption fees when redeeming units purchased under the deferred sales charge method 286 © 2021 IFSE Institute Canadian Investment Funds Course fees payable directly by the investor to the dealer International Comparison of MERs It is sometimes argued that the management expense ratios of Canadian mutual funds are among the highest in the world. The truth is that the international comparison of MERs is very difficult. The MER reflects the prevailing commercial practices, which differ from country to country. Managers and dealers are rewarded differently from one country to another. Unitholders use mutual funds for different purposes. In some countries, mutual funds are long-term investments. In other countries, they are used as substitutes for chequing accounts. For these reasons, it is very difficult, if not impossible, to adjust for all the differences in commercial practices to allow a meaningful comparison. Trailer Fees As shown earlier, trailer fees represent approximately 40% of the management expense ratio, MER, for the typical load paying equity fund. The loads, or commissions, associated with a mutual fund are explained later in this unit in the discussion about commission-based models. At present, it is important to understand that trailer fees are designed as an incentive to Dealing Representatives and mutual fund dealers to continue servicing fund clients after sales have been made. Trailer fees are paid by the investment fund management company to its distributors and are in addition to sales commissions. All, or a part, of these fees then flow to the mutual fund dealer and, ultimately, to the Dealing Representative who is currently servicing the client. The dealer can receive a trailer fee for as long as the investor holds the units of the fund. The trailer fee is paid by the manager out of the management fees and is expressed as a percentage of the dealer’s assets under administration, i.e. the market value of the units of the fund sold through the dealer and not redeemed. The size of the trailer fee depends on the option under which the units were sold. Those figures apply to equity, specialty and balanced funds. Bond funds and money market funds command lower trailer fees. Does a fund’s management expense ratio (MER) include trailer fees? Above, we listed the fees and expenses included in the MER. Although trailer fees were separated from management fees for illustration purposes, and are not otherwise explicitly included, the manager pays trailer fees out of management fees. As a result, trailer fees are indeed included indirectly in the MER. © 2021 IFSE Institute 287 Unit 8: Mutual Funds Administration Short-Term Trading and Fund of Fund Fees Short-Term Trading Fees Mutual funds are intended to be held as medium to long-term investments. In order to discourage short-term trading in mutual funds, a short-term trading fee is applied by fund managers. In general, short-term trading is defined as selling or switching a mutual fund within a few days, usually between 30 to 90 days, of purchase. The fee charged is between 1-3% and is paid directly to the mutual fund itself. As such, short-term trading fees benefit other investors who are holding the fund for a longer period of time. Short-term trading fees are usually not applied to money market mutual funds. Fund of Fund Fees A fund of funds is an investment portfolio where money is pooled and invested in a number of other funds. This type of investment can potentially increase investor diversification and access to investment opportunities. However, the fees charged will include the management fees for the underlying funds as well as a fee for managing the fund of funds. The cost of the higher management fees needs to be considered alongside the benefits of additional diversification access to investment opportunities. Commission-Based Model Commissions, also known as loads, are fees that are paid directly by the client. Since loads can take a number of forms, the client decides at the time of purchase how he or she wants to pay this fee. The investor has the choice of either front-end or deferred charges. The time the investor expects to hold the units will be the main factor influencing his or her decision. For a short-term purchase, the front-end option may be preferable, since the percentage charged is likely to be less. However, for a long-term investment the deferred charge may be best because potential redemption charges will gradually decline or be eliminated. Front-end Sales Charge The front-end sales charge is a percentage, between 0% and 9%, of the amount of the purchase, payable to the distributor from the investor's investment amount at the time of purchase. This fee is also known as a front-end load. It is usually negotiable and generally decreases as the size of the purchase increases. The following formula is used to calculate the purchase price of a front-end sales charge transaction: Purchase Price per Share = NAVPU ÷ (1 - Front-end Sales Charge) 288 © 2021 IFSE Institute Canadian Investment Funds Course Example Leslie invests $10,000 in a mutual fund with a 2% front-end load. The sales charge is $200, calculated as $10,000 x 2%. The current NAVPU is $10 per unit. To determine how many units she will receive, we use the above formula to determine the purchase price. purchase price = Net asset value per unit (NAVPU) ÷ (1 - front-end sales charge) purchase price = $10 ÷ (1 - 2%) purchase price = $10 ÷ 0.98 purchase price = $10.20 We then divide Leslie's investment amount of $10,000 by the purchase price. She will receive 980 units, calculated as $10,000 ÷ $10.20. Do not clear your calculator for a more accurate calculation. Deferred Sales Charge (DSC) Deferred sales charges (DSC)8 are redemption charges that decline the longer an investor owns units or shares. Most deferred sales charges (also known as contingent deferred charges) start at 6% or 7% and fall to zero over time. A redemption fee schedule illustrates how the deferred sales charge decreases the longer you hold on to the mutual fund. Since the fee is not payable until the fund is redeemed, a deferred sales charge is also known as a back-end load. These charges may be calculated based on the price of the original purchase or on the market value of units or shares when redeemed. Deferred sales charges are paid by the investor to the manager of the fund. Example Four years ago, Bethany purchased 2,500 units of Gamma International Equity Fund at a NAVPU of $32.67. The NAVPU of the fund has increased to $44.46, and Bethany has decided to sell all 2,500 units that she currently owns. The mutual fund purchase was made on a deferred sales charge basis. Since she is redeeming units in the fund before her redemptions charges fall to zero, Bethany will use the fee redemption schedule below to determine how much she must pay to the fund manager. In addition, the deferred sales charge is calculated based on the market value of the units held. 8 DSC Funds will be banned in all jurisdictions effective June 1, 2022. Further updates will be reflected in the next version of this course. For exam purposes, the content in this version of the course will apply. © 2021 IFSE Institute 289 Unit 8: Mutual Funds Administration Redemption Fee Schedule Year Funds are Redeemed Deferred Sales Charge Year 1 6% Year 2 Year 3 4.5% 3% Year 4 Year 5 1.5% 0% The market value of Bethany’s investment is $111,150, calculated as 2,500 units x $44.46. Since she is redeeming her fund units in year 4, her redemption charge will be $111,150 x 1.5% = $1,667.25. Dealing Representatives need to be aware of the ban on Deferred Sales Charge (DSC) Funds effective June 1, 2022. Low-load Sales Charge This fee model is similar to the DSC option described above since redemption charges are payable when units of the fund are redeemed. However, the fee redemption schedule is shorter in length, and the value of the deferred sales charges begins at a lower amount. Dealing Representatives need to be aware of the ban on Deferred Sales Charge (DSC) Funds, including LowLoad Sales Charge Funds, effective June 1, 2022. 10% Free Redemptions As mentioned earlier, fund units purchased using a deferred sales charge option are subject to redemption fees for the first few years. However, many fund companies allow investors to redeem up to 10% of the value of the fund each year. The amount that may be redeemed will vary among fund companies. In some instances, an investor may be able to redeem 10% of the original purchase price; in other instances, an investor may be able to redeem 10% based on the market value – usually based on the value as of December 31st of the previous year. The 10% redemption amount may be calculated based on the number of units purchased or the dollar value of the investment. The redemption amount is commonly allowed once per year and cannot be carried forward to subsequent years. 290 © 2021 IFSE Institute Canadian Investment Funds Course The amount redeemed can be used for a number of purposes, including: purchasing front-end load versions of the same mutual fund purchasing other mutual funds offered by the fund management company transferring the redemption value to other investments available with other companies Many fund companies will automatically switch investors’ 10% free redemption amount into a front-end load fund version of the same mutual fund. In order to comply with MFDA rules, these automatic switches must be done with the consent of the client and with full disclosure of any increase in trailer fees or taxes that will result. No-load Funds Some funds, known as no-load funds, charge no commission or service fees. A mutual fund is considered to be a no-load fund if an investor does not have to pay any fee or charge to buy or redeem securities of the fund. However, some fees and charges that may be levied when an investor buys units of a no-load fund include the following: optional fees or charges for specific services redemption fees for funds that are not money market funds if redemption occurs within 90 days after purchasing the fund an account set-up or closing fee to cover the initial administrative costs of opening or closing the account No-load funds are generally sold by banks and trust companies, although some independent mutual fund firms now offer no-load funds. Fee-Based Model As explained above, under the commission-based model, the dealer is compensated by means of: commissions as front-end loads, or deferred sales charges trailer fees paid by the fund manager Under the fee-based model, the dealer is compensated by means of an overall fee paid directly by the client. The overall fee is expressed as an annual percentage of assets under administration and covers all services provided by the dealer, whether in respect of advice or transactions. There are no additional commissions when the client purchases or redeems his or her mutual fund units. © 2021 IFSE Institute 291 Unit 8: Mutual Funds Administration Example Mr. Jojo is a client of a mutual fund dealer and has a fee-based account. The dealer charges a flat annual fee amounting to 1% of Mr. Jojo's assets. The dealer provides advice to Mr. Jojo and purchases and redeems mutual fund units on his behalf. Mr. Jojo pays no commission to the dealer on these transactions. 292 © 2021 IFSE Institute Canadian Investment Funds Course Lesson 5: Disclosure Introduction Before investors purchase mutual funds, dealers are required to disclose specific information about the funds. In this lesson you will learn about the disclosure requirements as well as the disclosure documents that must be provided to investors. This lesson takes approximately 25 minutes to complete. By the end of this lesson you will be able to: describe the disclosure documents related to mutual funds: - Fund Facts - simplified prospectus - annual information form - financial statements - management reports of fund performance - other disclosure documents describe the rights of investors © 2021 IFSE Institute 293 Unit 8: Mutual Funds Administration Rationale for Mutual Fund Disclosure The protection of investors is one of the primary objectives of securities legislation. Full disclosure of information material to investors' decisions is the most important means to attain this objective. Canada has a comprehensive disclosure regime for mutual funds. Funds are required to make disclosure necessary to evaluate: the suitability of the fund for a particular investor the value of the investor's interest in the fund Disclosure Documents The main disclosure documents prepared by a mutual fund are: a Fund Facts for every class or series of a mutual fund the simplified prospectus the annual information form annual and interim financial statements annual and interim management reports of fund performance In order to have a complete picture of a mutual fund, it is necessary to look at all five sets of documents. Historically, the simplified prospectus was the most important of these documents and it was delivered to every person who invested in a mutual fund. Although it incorporates the other documents by reference, the simplified prospectus is a lengthy document within which investors have trouble finding and understanding the information they need. In the case of mutual funds, the obligation to deliver a prospectus is replaced with an obligation to deliver the Fund Facts. The Fund Facts is an investor friendly summary of the key features of the mutual fund and it must be delivered to clients before the mutual fund is purchased. This is known as “point of sale disclosure” or “presale delivery” and it provides clients with an opportunity to review important information about the mutual fund before they purchase the fund. All the above documents are filed with the securities commissions and can be found online at The System for Electronic Document Analysis and Retrieval (SEDAR). It is also always possible to obtain a copy without charge by contacting the fund manager. 294 © 2021 IFSE Institute Canadian Investment Funds Course Rights of Investors Securities legislation in some jurisdictions gives investors the right to withdraw from an agreement to buy mutual funds within two business days of receiving the Fund Facts, or to cancel their purchase within 48 hours of receiving confirmation of their order. Securities legislation in some jurisdictions also allows investors to cancel an agreement to buy mutual funds and get their money back if they do not receive the Fund Facts, or to make a claim for damages if the Fund Facts misrepresents any fact about the fund. The above rights must usually be exercised within certain time limits. IMPORTANT: Rules may differ from province to province. Make sure that you are familiar with the legislation in your jurisdiction. Fund Facts The delivery of the most recently filed Fund Facts is a requirement under securities regulations. As mentioned earlier, the Fund Facts provides investors with important information, written in plain language that can be used to determine the appropriateness of a mutual fund purchase. Before you accept an order from a client or enter a trade, you are first expected to provide and explain the Fund Facts document to the client. The Fund Facts includes the information below. Section Information Provided Fund Name the name of the investment fund Quick facts fund code, series start date, value of fund, MER, investment fund manager (IFM), portfolio manager (PM), distributions, minimum investment required What does the fund invest in? top 10 holdings, a pie chart of the investment mix (depending on the fund, by asset class, business sector, or geographic region) How risky is it? an explanation of volatility, the fund’s risk rating (from low to high), reference to the risk section of the prospectus, a statement that the fund is not guaranteed How has the fund performed? a bar chart of the year-by-year returns for the past 10 years (or years available if less than 10), best and worst 3-month returns, average return (annual compounded return over the past 10 years) Who is this fund for? the objectives of an investor who should invest in the fund, the objectives of an investor who should not invest in the fund © 2021 IFSE Institute 295 Unit 8: Mutual Funds Administration Section Information Provided A word about tax general statement advising of potential taxes payable in registered and nonregistered plans How much does it cost? Sales charge option (front-end or DSC), fund expenses (management expense ratio (MER), trading expense ratio (TER)), other fees (short-term trading fee, switch fee, change fee), and trailer fees What if I change my mind? Investor rights including right to withdraw from the agreement to purchase, right to cancel purchase, right to claim damages For more information contact information for the investment fund manager (IFM), who to contact for the fund’s prospectus and other disclosure documents, link to CSA “Understanding Mutual Funds” brochure Simplified Prospectus Before a security may be offered for sale, a prospectus must be filed and approved by the provincial or territorial securities regulators of those jurisdictions where the securities are to be sold. Its purpose is to give the investor important information in a standard format to facilitate a decision whether to buy or sell units of the fund. The prospectus is an extremely important document because it provides full disclosure of the material facts relating to a new issue of a stock, bond, mutual fund, or other type of security. Material facts are those that have, or may have in the future, a significant impact on the market value of the securities in question. However, acceptance or clearance of the prospectus by security regulators does not guarantee that the investment is sound or provide any opinion about the merits of the investment. It only means that investors are given the material facts upon which to base an investment decision. The simplified prospectus covers important matters such as: general risks of investing in mutual funds and the specific risks applicable to the fund fees and expenses payable by the fund compensation to dealers organization and management of the fund, including the composition of the Independent Review Committee and a summary of its mandate fundamental investment objectives investment strategies legal rights of investors 296 © 2021 IFSE Institute Canadian Investment Funds Course Depending on the jurisdiction, you are required to provide a simplified prospectus to a client upon request. Annual Information Form (AIF) Mutual funds are required to file an annual information form (AIF) with the Fund Facts and simplified prospectus. Like the simplified prospectus, there is no obligation to deliver the AIF to every investor, but investors may always ask for a copy. The AIF supplements the information in the simplified prospectus. It covers matters such as: the investment restrictions to which the fund is subject a description of the units of the fund and their characteristics the methods used to value the various types of portfolio securities details of service providers conflicts of interest, including disclosure of the total ownership of the members of the Independent Review Committee in the units of the mutual fund (if more than 10%), and in the shares of the manager and any service provider of the manager or the fund fund governance, including the mandate and responsibilities of the Independent Review Committee the remuneration of the members of the Independent Review Committee Amendments to Documents If there is a material change in a fund, such as a new commission fee structure, the Fund Facts, prospectus and annual information form must be amended and the amended Fund Facts should be provided to investors prior to the purchase of fund units. Financial Statements Mutual funds are required to file annual and interim (semi-annual) financial statements. The financial statements of a mutual fund are made up of: a Statement of Net Assets, supported by a Statement of Portfolio Investments a Statement of Operations a Statement of Changes in Net Assets related notes The annual financial statements must be audited but an audit of the interim financial statements is not mandatory. © 2021 IFSE Institute 297 Unit 8: Mutual Funds Administration Management Reports of Fund Performance (MRFPs) Mutual funds must also file annual and interim management reports of fund performance (MRFPs). The MRFP contains a discussion and analysis of the fund's financial statements and discloses transactions with related parties. It also contains a wealth of statistical data, including the management expense ratio (MER) and the historical performance of the fund. Other Disclosure Documents In addition to the Fund Facts, simplified prospectus and the documents incorporated by reference, mutual funds must make certain other disclosures: Quarterly Portfolio Disclosures Quarterly portfolio disclosures must be prepared and posted on the fund's website. The disclosures should include a summary of the fund's investment portfolio at the quarter-end together with the net asset value of the fund at the same date. Annual Proxy Voting Record An annual proxy voting record, showing how the fund voted in respect of matters for which it received proxy materials, must be prepared and posted on the fund's website. Material Change Report A news release must be promptly issued and filed if a material change occurs in the affairs of a mutual fund. A material change is generally a change that would be considered important by a reasonable investor in determining whether to buy or sell the units of the fund. An example of a material change would be the replacement of a sub-adviser. Annual Report of the Independent Review Committee The Independent Review Committee is required to prepare an annual report to the unitholders that describes the Committee and its activities. The report must be filed with the securities commissions and posted on the fund's website. Example In the evening of Halloween 2006, Finance Minister Flaherty announced that he was introducing a tax on income trust distributions. The tax certainly had a material impact on income trusts and their investors. However, the introduction of the tax constituted a general change affecting all income trusts rather than a change to the business and affairs of an issuer. Consequently, the announcement did not constitute a material change for the purpose of securities legislation and there was no obligation on income trusts to issue a press release or file a material change report. 298 © 2021 IFSE Institute Canadian Investment Funds Course Lesson 6: Account Types Introduction There are a number of different registered and non-registered accounts that investors can use to meet different objectives. In this lesson you will learn about the different account types, their features and requirements. This lesson takes approximately 35 minutes to complete. By the end of this lesson you will be able to: differentiate between client and nominee accounts differentiate between registered and non-registered accounts explain the main features of registered education savings plans (RESPs) explain the main features of registered disability savings plans (RDSPs) explain the main features of tax-free savings plan (TFSA) © 2021 IFSE Institute 299 Unit 8: Mutual Funds Administration Client Name Accounts vs. Nominee Name Accounts A mutual fund dealer is required to record and maintain adequate records of client information and trade instructions, whether those instructions have been executed or not. How mutual fund transactions take place among the client, the mutual fund and the mutual fund company depends on the custodial agreement. The custodial agreement refers to how property, in this case a mutual fund, is held on behalf of a client. Mutual funds are held in two types of accounts: client name accounts and nominee name accounts. When a mutual fund transaction is administered through a client name account the registered/legal owner of the mutual fund is the client. When a client account is established in ‘nominee name’, also known as ‘street name’, the registered/legal owner of the mutual fund is the dealer. In this case, the mutual fund dealer holds the mutual fund in trust for the actual owner, the client. An LTA form is not required when an account is established in nominee name. Regardless of how mutual funds are held, a dealer must record and maintain adequate records of trade instructions. Discretionary trading, where a dealer can complete transactions without client consent, is not permitted. The table below highlights the key characteristics of each account type. Client Name Nominee Registered/legal owner of purchased mutual funds Client Dealer Limited trading authorization (LTA) form required No, but optional No Client instructions required Yes Yes Discretionary trading permitted No No Registered and Non-Registered Accounts Registered accounts are savings plans that are defined in the federal Income Tax Act, registered with the Canada Revenue Agency (CRA), and administered by various financial institutions. These types of plans are granted special tax status wherein contributions may be tax deductible and taxes payable on any investment earnings may be deferred. There are also a number of limitations/restrictions on these plans including limits on the amount that may be contributed, the types of investments that may be held in the plan, the tax treatment of withdrawals, and how long the plan may remain open, The main types of registered accounts are: registered education savings plans (RESP) registered disability savings plan (RDSP) tax-free savings accounts (TFSA) registered retirement savings plans (RRSP) registered retirement income fund (RRIF) 300 © 2021 IFSE Institute Canadian Investment Funds Course Non-registered accounts have no restrictions. You can save any amount and the plan can hold almost any kind of investment. However, there are no particular tax benefits associated with non-registered accounts. Contributions are not tax deductible and you must pay tax on the plan's investment income as you earn it. The main types of non-registered accounts are: cash accounts margin accounts Registered Education Savings Plans Registered education savings plans (RESPs) are attractive, tax-sheltered investment plans that allow anyone to save money for a qualified post-secondary education for anyone else, including themselves. Although anyone can open an RESP, the plan is most likely to be used to support a child’s qualified post-secondary education. Usually, parents or grandparents will open an account for their child or grandchild. The child or grandchild must have a social insurance number in order to be a beneficiary of a RESP. Contributors, also known as subscribers, may contribute a lifetime maximum of $50,000 per beneficiary to an RESP. The contributions that are made to an RESP are not deductible from a subscriber’s income for the purpose of calculating income taxes payable. In other words, contributions are not tax deductible. There is no annual limit to the amount that can be contributed to an RESP. Example George and Maria, who live in Regina, have just opened up an RESP account for their 3 year-old daughter, Alyssa. They believe she'll start university at age 18. As the contributors, George and Maria decide to contribute $2,000 per year for the next 15 years. If they have additional money available, they can contribute that amount as long as they stay within the $50,000 lifetime maximum. They cannot deduct their RESP contributions from their income for tax purposes but any growth on their money will be taxsheltered while in the plan. Canada Education Savings Grant The Government of Canada assists families with the cost of post-secondary education by offering the Canada Education Savings Grant (CESG). The CESG is available until the end of the calendar year in which the child turns 17, as long as: the child is a Canadian resident an RESP has been opened in his or her name a request is made for the CESG © 2021 IFSE Institute 301 Unit 8: Mutual Funds Administration The federal government will match 20% on the first $2,500 annual contribution (i.e. up to $500 CESG). If you cannot make a contribution or do not receive the full CESG in any given year, you may be able to catch up in future years. Qualified beneficiaries are eligible to accumulate $500 of CESG each year up to a lifetime limit of $7,200. However, the federal government will only pay a maximum of $1,000 of CESG each year per beneficiary and only up to the age of 17. Example Jose and Marie, who live in Vancouver, have just opened up an RESP for their new born son, Damian. The couple contributes $1,000 into the RESP and receives a CESG payment of $200, calculated as $1,000 x 20%. Damian qualifies for $500 of CESG but only receives $200 based on the contribution. He can carry forward the $300 CESG room, calculated as $500 - $200, to a future year. The following year, Jose and Marie contribute $4,000 into the RESP. Damian will receive a CESG payment of $800, calculated as the combination of: current year available grant room $500 = $2,500 x 20% previous year available grant room $300 = $1,500 x 20% In addition to the CESG, residents of Saskatchewan, Alberta, and Quebec may be eligible for provincial education savings grants. Additional Canada Education Savings Grant (A-CESG) The federal government offers additional CESG (A-CESG) payments on contributions made by families with adjusted family net income below a certain threshold income. Adjusted net family income limits are updated every year. For 2013, the additional A-CESG is determined as per the following table: Additional CESG (A-CESG) Adjusted Family Net Income 20% $43,561 or less 10% Between $43,561 and $87,123 0% More than $87,123 The A-CESG is payable on the first $500 of annual contributions made within the year. The CESG lifetime maximum of $7200 does not change if A-CESG payments are made. Example George and Maria have an adjusted family net income of $25,000. As a result, their annual $1000 contribution to their 3 year-old daughter’s RESP account will also generate a $100 A-CESG payment, calculated as $500 x 20%. 302 © 2021 IFSE Institute Canadian Investment Funds Course Canada Learning Bond (CLB) The Canada Learning Bond (CLB) is additional money offered by the federal government for families that receive the National Child Benefit Supplement (NCBS). The maximum amount that a beneficiary may receive in their RESP account from CLB payments is $2,000, calculated as $500 payable immediately plus $100 each year until the child is 15 years old. To help cover the cost of opening an RESP, the CLB program will pay an extra $25 with the first $500 CLB payment. In order to receive CLB payments, the beneficiary must be born after December 31, 2003. CLB payments are in addition to the amount that is available from the CESG program. Example At an adjusted family net income of $25,000, George and Maria are eligible for the National Child Benefit Supplement (NCBS). As a result, they will receive an additional $525 from the Canada Learning Bond (CLB) program; $500 payable immediately plus an additional $25 to set up the RESP. In total, the couple is eligible to receive additional money from all three federal programs - the CESG, the A-CESG, and the CLB. During the year in which they open the RESP account for their daughter Alyssa, they are eligible to receive $825, calculated as: $200 from the CESG, calculated as $1,000 x 20%, $100 from the A-CESG, calculated as $500 x 20%, and $525 from the CLB. In addition, they will continue to generate a $200 CESG for Alyssa on their annual RESP contribution of $1000. Also, depending on their adjusted family net income, they may be able to generate an additional $200 of A-CESG and CLB towards Alyssa’s education savings. RESP Withdrawals Once a beneficiary is accepted into a qualified post-secondary educational institution, they become eligible to make withdrawals from their RESP. These withdrawals are called Educational Assistance Payments (EAPs). The taxable payments may consist of the CESG, A-CESG, CLB, and any investment earnings on all contributions. In addition, the contributions made by the subscriber, which are not taxable, may be paid to the beneficiary or returned to the subscriber at any time. Withdrawals from an RESP may be used for a number of expenses related to the beneficiary’s post-secondary education, such as tuition, books, accommodation, transportation, and computers. If the beneficiary does not immediately attend a qualified post-secondary education program, the money in the plan, with the exception of the CLB, can be transferred to a brother or sister’s RESP. The CLB is non-transferable and would have to be returned to the federal government. If transferring the plan is not an option, the contributions may be refunded to the contributor and the CESG money must be returned to the government. Any investment earnings from the RESP is paid to the subscriber as an Accumulated Income Payment (AIP) and becomes taxable income for the subscriber. It’s important to note that RESPs can remain open for up to 36 years. So, you may want to wait to close the plan just in case the beneficiary decides to go to school later on. © 2021 IFSE Institute 303 Unit 8: Mutual Funds Administration Example Kiran and Pavan are twins. When they were a year old, their parents opened an RESP account for each of them. 18 years later, Kiran has been accepted to a qualified post-secondary institution and Pavan has decided that any additional schooling would be a waste of time. Kiran can apply for Educational Assistance Payments from her RESP. Although EAPs are taxable, Kiran has no other income and it is unlikely that she will pay very much, if any, tax. In addition, Kiran can withdraw, at any time, the tax-free contributions her parents made to her RESP. Since Pavan is not going to school anymore, her parents have decided to transfer her RESP benefits to her twin sister. If Pavan received any CLB payments in her RESP, these would have to be returned to the federal government. Types of RESPs There are two basic types of RESPs: Individual or family self-directed RESPs Group or scholarship plans Individual or family self-directed RESPs provide the subscriber with more flexibility and control over their contributions and investment options. The individual plan is ideal if you want to maintain separate RESP accounts for your children. If one child does not use their benefits, the benefits may be transferred to the other child. The individual plan also allows you to open an RESP account for children that you are not related to you. You can also use this plan to open a plan for yourself or another adult. The family plan is ideal if you have more than one child. Within a family plan, each child has their own account, but benefits may be easily shared if one or more children do not attend a qualified post-secondary institution. Under a family plan, the subscriber and beneficiary must be related, either by blood or adoption. With a group or scholarship plan, individual contributions are pooled with other participants. Usually, you must make regular contributions and the investments are determined by the scholarship plan dealer. Each group plan is different and has its own rules. Registered Disability Savings Plan (RDSP) A registered disability savings plan (RDSP) is a savings plan that is intended to help parents and others save for the long-term financial security of an individual who is eligible for the Disability Tax Credit. In order to be eligible for the Disability Tax Credit, a qualified practitioner must certify that the individual has a prolonged impairment. Usually, contributors to an RDSP will be the beneficiary or a legal parent/guardian if the beneficiary is a minor (or an adult but not competent to enter into a contract). Contributions are not tax deductible and anyone can make contributions to an RDSP with the written permission of the plan holder. Contributors to an RDSP are 304 © 2021 IFSE Institute Canadian Investment Funds Course not entitled to a refund of their contributions. There is no annual maximum contribution limit; however, the lifetime limit is $200,000. Contributions may be made until the end of the year in which the beneficiary turns 59 years of age. Example Vernon is aged 45 and disabled. He opens an RDSP. In order to help him in his old age, his foster mother Bernice contributes $3,000 to the RDSP. This contribution is only available to Vernon. Even if Bernice subsequently changes her mind, she cannot request a return of the contribution. Depending on their family income, a beneficiary is eligible to receive a Canada disability savings grant and/or a Canada Disability savings bond. RDSP Withdrawals Payments from an RDSP must begin by the end of the year in which the beneficiary turns age 60. Payments from an RDSP are referred to as Disability assistance payments (DAPs). For tax purposes, the beneficiary must report any interest income, grants, and bonds paid out as part of a DAP. Tax-free Savings Account The tax-free savings account (TFSA) provides a way to earn investment income tax-free. Whereas other registered accounts allow the deferral of tax on income earned within the plan; the TFSA is unique in that any investment income earned within the plan is tax-free when it is withdrawn. In order to open a TFSA account, you must have reached the age of majority, defined as age 18 or 19, for the province or territory in which you live. The types of investments permitted in a TFSA include: Cash Mutual funds Securities listed on a designated stock exchange Guaranteed investment certificates (GICs) Bonds Certain shares of small business corporations TFSA Contribution Limit The annual TFSA dollar limit was established at $5,000 in 2009, the year that TFSAs were introduced as a registered account. Depending on the rate of inflation, the annual dollar limit will be periodically increased by $500. For example, in 2013, the annual dollar limit was increased to $5,500. © 2021 IFSE Institute 305 Unit 8: Mutual Funds Administration If an individual over contributes to a TFSA in any month, a 1% penalty tax is payable in that month on the highest balance recorded during that month. The 1% penalty tax will be applied every month until the over contribution is withdrawn, or the excess amount is absorbed in the following year’s contribution room limit. If an individual does not contribute to a TFSA, the contribution room is carried forward until it is used. There is no age limit as to how long you can contribute to a TFSA. Contributions to a TFSA are not tax deductible. Example Fernando turned 18 in 2007 and has never opened a TFSA. Now, in 2014, he has some extra savings and would like to begin contributing to a TFSA. Since he was already 18 or older when the TFSA program started in 2009, his annual TFSA dollar limit will include amounts for all the years since 2009. Based on the table below, his TFSA dollar limit for 2014 is $31,000, calculated as $5,000 + $5,000 + $5,000 + $5,000 + $5,500 + $5,500. 2009 $5,000 2016 $5,500 2010 $5,000 2017 $5,500 2011 $5,000 2018 $5,500 2012 $5,000 2019 $6,000 2013 $5,500 2020 $6,000 2014 $5,500 2021 $6,000 2015 $10,000 Withdrawals from a TFSA The rules for withdrawing your money from a TFSA are very flexible. You can make withdrawals at any time. In addition, the amount that you withdraw, including any investment income earned, can be recontributed starting January 1st of the following calendar year. All withdrawals are tax-free. Since contributions can be carried forward and withdrawals can be rec-contributed, the contribution room for a TFSA in any given year has three components: the maximum contribution for the current year, i.e. $5,500 plus indexation, if applicable any unused contribution room in the previous year withdrawals made from the TFSA in the previous year 306 © 2021 IFSE Institute Canadian Investment Funds Course Example When he turned 18 in 2011, Marco contributed the maximum of $5,000 to a TFSA. In August 2012, his investment had earned $1,000 of investment income. He decided to withdraw the entire amount of $6,000 to go on a vacation. He did not make any contributions in 2012. In 2013, his contribution room is: © 2021 IFSE Institute Maximum contribution room for 2013 $5,500 Unused contribution room in 2012 $5,000 Withdrawals made in 2012 $6,000 Contribution room for 2013 $16,500 307 Unit 8: Mutual Funds Administration Summary Congratulations, you have reached the end of Unit 8: Mutual Funds Administration. In this unit you covered: Lesson 1: Mutual Fund Organization Lesson 2: Purchasing Mutual Funds Lesson 3: Redeeming Mutual Funds Lesson 4: Fee Structure Lesson 5: Disclosure Lesson 6: Account Types Now that you have completed these lessons, you are ready to assess your knowledge with a 10-question quiz. To start the quiz, return to the IFSE Landing Page and click on the Unit 8 Quiz button. 308 © 2021 IFSE Institute