Canadian Investment Funds Course Portfolio Management PDF

Canadian Investment Funds Course Unit 7: Portfolio Management Introduction A portfolio is the collection of securities held in a mutual fund. As a Dealing Representative it is very important that you have a good understanding of the approaches and methodologies used in selecting and managing the inv...

Canadian Investment Funds Course Unit 7: Portfolio Management Introduction A portfolio is the collection of securities held in a mutual fund. As a Dealing Representative it is very important that you have a good understanding of the approaches and methodologies used in selecting and managing the investments within a mutual fund portfolio. In this unit you will learn about different investment styles and investment management strategies. You will also learn about financial analysis, as well as mutual fund performance, mutual fund risk, and the relationship between performance and risk. This unit takes approximately 1 hour and 15 minutes to complete. Lessons in this unit: Lesson 1: The Portfolio Manager Lesson 2: Financial Analysis Lesson 3: Mutual Fund Performance and Risk © 2021 IFSE Institute 231 Unit 7: Portfolio Management Lesson 1: The Portfolio Manager Introduction A portfolio is a collection of securities held in a mutual fund. Portfolio management refers to the science of creating and managing a portfolio in order to achieve a specific investment goal. In this lesson you will learn about the role of a portfolio manager, and the different approaches and methodologies that portfolio managers use to select and manage a mutual fund’s investments. This lesson takes approximately 25 minutes to complete. By the end of this lesson you will be able to: describe the role of the portfolio manager explain the difference between active and passive portfolio management differentiate between top-down and bottom-up investing describe the three major investment styles (value, growth, and growth at a reasonable price) explain the difference between technical and fundamental analysis discuss modern portfolio theory and the efficient frontier 232 © 2021 IFSE Institute Canadian Investment Funds Course Role of the Portfolio Manager One of the advantages of mutual funds is that investors can take advantage of the services of professional money managers. Each mutual fund has specific investment objectives as laid out in the simplified prospectus. It is the responsibility of the portfolio manager(s) to ensure that those objectives are met. Their goal is to attain the highest return possible while complying with the stated investment objectives and risk constraints of the mutual fund. The portfolio manager selects the securities held in a mutual fund. Some mutual funds have a single portfolio manager while others use a team approach. They may be employees of the investment fund manager or an outside entity that specializes in portfolio management. Some investment fund managers have in-house portfolio managers for their Canadian funds, while using outside specialists for foreign mutual funds, which require familiarity with those markets. Investors can receive updates on the most recent investment decisions and actions taken by the portfolio manager in the mutual fund’s commentary or Management Report and Fund Performance (MRFP). Portfolio Manager Qualifications Portfolio managers are required to be registered with the provincial securities commissions in the provinces in which they choose to operate. Registration is only granted to individuals who satisfy certain educational and experience requirements as specified in National Instrument 31-103. In terms of education, portfolio managers must obtain an approved designation such as the Chartered Financial Analyst® (CFA)® designation, which is bestowed by the CFA Institute. The Charter is granted to those who have completed an intensive course of study, passed a series of rigorous exams, and fulfilled a work experience requirement. In addition, regulators require portfolio managers to have relevant investment management experience. They must show that they have performed portfolio management duties for a minimum length of time. Investment Management Strategies There are two general strategies for mutual funds: passive portfolio management active portfolio management Knowing whether a portfolio manager uses an active or passive strategy can help you manage your client’s expectations. The investment strategy of a mutual fund is typically described in the simplified prospectus under the fund’s Investment Strategies section. © 2021 IFSE Institute 233 Unit 7: Portfolio Management Passive Portfolio Management Portfolio managers that use a passive portfolio management strategy choose securities according to a specific benchmark. The benchmark represents a specific market, such as a stock index (e.g. S&P/TSX composite index). It is often used as a peer group standard to measure the performance of an investment. Passive portfolio managers do not intend to outperform the benchmark. Rather, their goal is to replicate, or track, the return of that benchmark as closely as possible. They can achieve this by either purchasing the exact same securities in the same proportion as the index, purchasing a sample of those securities, or by using derivatives. A passive investment strategy greatly reduces the amount of trading within a mutual fund. Once the initial investments are made, no further trades are usually required unless the make-up of the underlying benchmark changes. This results in lower transaction costs, which translates to lower management expense ratios (MERs) for passively managed funds when compared to actively managed funds. The passive investment strategy is based on the Efficient Market Hypothesis (EMH) theory. The theory states that market prices of securities already reflect all publicly available information. This being the case, it would be futile for anyone to attempt finding mis-priced securities (i.e. securities that are not fairly priced) that may provide a higher return. For instance, some practitioners of passive portfolio management believe that securities of large U.S. companies are fairly priced. Large U.S. companies are closely followed by analysts and financial journalists. Any information that is related to their value is likely to be reported and disseminated to the public, at which point the market price of the security will quickly adjust to reflect the new information. Passive Portfolio Management Considerations A passively managed fund is required to mirror the performance of a market index. Therefore, it will be exposed to all of the ups and downs of the market index. When the market index performs well, the passive mutual fund will benefit. Of course, the return of the mutual fund will be slightly less from the management fees and any discrepancies between the actual portfolio and the underlying market index. There is a risk associated with passive investments. If the market index drops, the passive mutual fund will suffer. In this situation, the portfolio manager is unable to protect against the downside risk of the market index since they only adjust the portfolio when there is a change to the benchmark. This limitation also affects the portfolio manager's ability to take profits by selling securities that perform well in their portfolios. They are not able to capture these gains when they occur. 234 © 2021 IFSE Institute Canadian Investment Funds Course Example Susan invests in an index fund that tracks the Standard & Poor’s (S&P)/Toronto Stock Exchange (TSX) Composite Index. The index fund holds the same securities as those listed in the S&P/TSX Composite Index. Susan benefits from the low management expense ratio of 0.30% charged by the mutual fund. In the first year, the S&P/TSX Composite Index returns 5.5%. Susan's index fund returns 5.2%. The following year, the S&P/TSX Composite Index falls by -10.4% and Susan's mutual fund also drops but by -10.7%. The portfolio manager is prevented from making any defensive move to protect investors like shifting the portfolio to cash. Susan will experience all the ups and downs of the benchmark with her index fund. Active Portfolio Management In contrast to passive portfolio management, active portfolio management is based on the idea that not all information about securities is widely known. Hence, there are opportunities to discover securities that are not properly priced because of this market inefficiency. Practitioners of active portfolio management believe that through their skill in research and analysis they can find these securities. By relying on their abilities to pick securities and construct a portfolio, active portfolio managers attempt to outperform the benchmark. For instance, an active portfolio manager may discover through research and analysis that a large U.S. company has a competitive advantage over its peers in making products at lower cost, which will increase the company’s earnings and security value over time. This information about the company is not commonly known, nor is it yet reflected in the security’s current market price. The portfolio manager sees an opportunity for higher returns by investing in this security, which the portfolio manager believes is mis-priced, compared to one that is already fairly priced. An active portfolio management strategy has the flexibility to select securities as long as they are aligned with the investment mandate of the mutual fund. Example Cheri invests in an actively managed Canadian equity fund that is compared to the S&P/TSX Composite Index. In the first year, the portfolio manager finds opportunities in the resource and retail sectors and begins to choose securities in these industries. He also decides that a couple of the holdings in the mutual fund are underperforming; he sells those and re-allocates the cash to other investments. The S&P/TSX Composite Index returns 5.5%. Cheri's mutual fund returns 9.8%. The following year, the portfolio manager takes profit in some of his holdings and begins to hold cash in the portfolio as a defensive move. The S&P/TSX Composite Index falls by -10.4% but Cheri's mutual fund only drops by -7.2%. © 2021 IFSE Institute 235 Unit 7: Portfolio Management Active Portfolio Management Considerations The fact that active portfolio managers select the securities in a mutual fund has its advantages and disadvantages. Since active managers control their transactions, they decide what to buy or sell and when. This flexibility allows them to seize new investment opportunities when they arise and realize profits at favourable times. They are not restricted by the market index. Alternatively, they can adopt defensive strategies to protect the portfolio from market downturns. The risk of being able to pick and change the securities of the mutual fund is that the portfolio manager may select a poorly performing security or miss an investment opportunity. Due to an increased amount of trading, actively managed funds incur more transaction costs than those that are passively managed. Their management expense ratios (MERs) are also higher since there is a cost to the portfolio manager performing research and analysis. However, many feel that if the fund is outperforming its benchmark, these costs are acceptable in exchange for higher returns. Active Management Approaches Active portfolio managers generally use one of two approaches to select securities for their mutual funds: top-down bottom-up Top-Down Approach The top-down approach begins with looking at the overall economy and current market trends to determine the industries, markets and/or countries that are expected to perform well. Portfolio managers look at macroeconomic variables such as the Gross Domestic Product (GDP) of various countries, interest rates and employment rates. From there, they narrow down their search by identifying the industry, sector, or countries that look favourable considering the economic conditions. Finally, they select companies that they feel have the most potential and meet the mutual fund’s investment objectives. Example Donna is a portfolio manager for Bedrock International Growth Fund. She employs a top-down investment strategy to pick securities for the mutual fund. She begins by looking at the overall health of various countries around the world, studying data such as gross national product (GNP), unemployment, and inflation. Donna decides that the German economy seems quite robust and has good growth prospects. Having decided that Germany will be her target economy, Donna next looks at the various industry sectors in Germany. As a result of her research, Donna decides that the strongest economic sectors are banking and steel. Finally, she analyzes the various companies in the banking and steel sectors and decides that Commerzbank and ArcelorMittal are the best prospects in their respective industry sectors. She decides to make investments in both of these companies. 236 © 2021 IFSE Institute Canadian Investment Funds Course Bottom-Up Approach Portfolio managers that take the bottom-up approach focus on individual companies, the economy and market cycles are secondary considerations. They believe good companies can succeed even if a particular industry, country, or region is struggling. Part of the portfolio managers’ investment process includes reviewing a company’s business prospects, meeting with its management team, and evaluating its financial statements. Example Jenny manages the European Value Fund with a bottom-up approach. She starts by looking for companies with good prospects. From her research, Jenny identifies two excellent prospects: Kredietbank, a Belgian financial company, and Peroni Company, an Italian brewing concern. Although the Belgian and Italian economies may not be the strongest in Europe, Jenny decides that the prospects for these companies are very good and the management is solid. Therefore, she decides to make investments in each of these companies. © 2021 IFSE Institute 237 Unit 7: Portfolio Management Investment Styles Investment styles impact how portfolio managers make their trade decisions. The following are the basic investment styles. Investment Style Growth Description This style of investing looks for securities of companies with above-average growth potential than their peers. Growth securities are often represented by growing or expanding companies. Growth managers believe that growth in a company's earnings or revenues will directly correlate to an increase in the share price. As a result, they are willing to pay a higher price for these securities as long as there is growth potential. Value Value style investing looks for securities of good-quality companies that are undervalued. Securities may be undervalued because the sector or company has experienced some bad news or is currently out of favour. Value managers decide what they believe a company's shares are worth (its intrinsic value) and then compare it to how it is actually trading. If it is trading below intrinsic value, it is a bargain and the value manager will buy them. Value managers believe that the market is either unaware of a company's true value or has beaten the price down unfairly. When the share price corrects, the value manager will profit. 238 © 2021 IFSE Institute Canadian Investment Funds Course Investment Style Growth at a Reasonable Price (GARP) Description Growth at a Reasonable Price (GARP) combines the principles of growth and value investing, while avoiding the extremes of either approach. GARP managers seek investments with a consistent above-average earnings record, and potential for continued growth in the future. GARP managers will purchase these growth investments at prices that are lower than their industry peers, but not at the bargain prices that value managers seek. Investment Selection Methodology Technical and fundamental analyses are the two types of security selection methodologies that portfolio managers use for finding and analyzing securities. Technical Analysis Technical analysis is a method of evaluating securities based on studying past trends in market activity, prices, and volume. Technical analysts look for patterns or indicators to predict future price movements. Technical analysts are often referred to as chartists since they rely heavily on charts of share-price behaviour and trading volume to make their extrapolations. Fundamental Analysis Fundamental analysis involves looking at the fundamentals of a company such as revenues, assets, profits, and competitive position. Fundamental analysts study a company's financial statements, may speak with its management, customers and suppliers, and consider macroeconomic factors such as the economy, inflation and the interest rates that could impact a company’s earning potential. They attempt to predict the future prospects of a company by becoming intimately acquainted with the details of the company. © 2021 IFSE Institute 239 Unit 7: Portfolio Management Modern Portfolio Theory Although the concept of diversification has been around for a long time, it was the introduction of the Modern Portfolio Theory that really brought this concept into the forefront of the investment world. Modern portfolio theory explains the benefits of taking a portfolio approach to investments rather than focusing on single investments. Accordingly, investments should not be evaluated only on their own characteristics, but also in relation to other types of investments. If investors diversify their portfolio, they can effectively reduce the overall risk within their portfolios and enhance their potential return. Modern portfolio theory provides a mathematical framework for constructing a diversified portfolio. For instance, bonds and equities generally do not perform similarly. In addition, various types of risks affect them differently. Considering their dissimilarities, combining bonds with equities can help reduce the overall volatility of the portfolio, thereby protecting the portfolio from suffering large losses. Efficient Frontier Since Modern Portfolio Theory provides a mathematical approach to portfolio construction, it then becomes possible to determine the optimal portfolio. The optimal portfolio is one that provides the highest return given a particular level of risk. Because investors have different risk levels, there are a multitude of optimal or efficient portfolios. These optimal portfolios can be plotted on a graph called the efficient frontier. All portfolios on the efficient frontier provide the highest return for a given amount of risk. Portfolios that are below the frontier are considered inefficient and inferior because they either offer portfolios with the same return but at a higher risk, or they offer lower return for the same level of risk. 240 © 2021 IFSE Institute Canadian Investment Funds Course Lesson 2: Financial Analysis Introduction Financial analysis enables portfolio managers to gauge the past and current performance of companies, in order to assess the value and potential future performance of companies and their securities. In this lesson you will learn about financial statements and financial analysis ratios that portfolio managers use in determining which investments to include in a mutual fund portfolio. This lesson takes approximately 15 minutes to complete. By the end of this lesson you will be able to: describe the main types of financial statements that portfolio managers use to analyze securities: - Balance Sheet - Income Statement - Cash Flow Statement - Statement of Retained Earnings describe the common types of ratios that portfolio managers use in assessing the value of securities: - Profitability - Liquidity - Debt-equity - Valuation © 2021 IFSE Institute 241 Unit 7: Portfolio Management Financial Statements Companies that make their securities available to the public are required to publish audited financial statements on an annual basis. Annual financial statements must be reviewed by an independent auditor or auditing firm to ensure that they comply with accounting standards (Canada has adopted International Financial Reporting Standards (IFRS)). Interim reports are usually published quarterly or semi-annually but are not required to be audited. These statements are the primary source of information for a fundamental analyst. A company’s financial statements provide information about its past, current, and future business performance. Through the analysis of financial statements, portfolio managers can evaluate the value of a company and its securities. The primary financial statements used to evaluate a company include the following: balance sheet income statement cash flow statement statement of retained earnings Balance Sheet The balance sheet is often defined as a snapshot of a company's financial position at a specific point in time. Sometimes referred to as statement of financial position or statement of assets and liabilities, it provides valuable information about what a company owns and what it owes. There are three components to a balance sheet displayed as follows: Assets This is what a company owns and what it is owed. Assets include: current assets (e.g. cash, marketable securities, accounts receivables, inventories) fixed assets (e.g. buildings, properties, equipment) intangible assets (e.g. goodwill, patents) 242 Liabilities This is what a company owes its creditors. Liabilities include: = current liabilities (e.g. accounts payable, accrued expenses, short-term debt) long-term liabilities (e.g. long-term debt) Shareholder's equity This is the capital provided by the shareholders (common and preferred shareholders) plus retained earnings of the company. © 2021 IFSE Institute Canadian Investment Funds Course The balance sheet derives its name from the fact that both sides of the statement must be equal. NOTE: In most cases the assets and liabilities are recorded on the balance sheet at their historical value rather than market value. (An exception is a mutual fund where the assets or investments are recorded at market value.) Income Statement The income statement shows how much revenue a company earned and the expenses it incurred during a specific period. If revenues are greater than expenses, the company shows a profit. If revenues are less than expenses, the company shows a loss. There are six main sections on an income statement. Section Description Operating Income These figures show the revenue generated from sales of the company's products and services. The gross sales number is recorded minus any adjustments for returned merchandise, bad debts, rebates to customers, and other discounts. Operating Expenses These are the expenses incurred by the company in the process of conducting business. These include such costs as raw materials, employee salaries, rent, and marketing expenses. Operating Profit (or Loss) This figure is arrived at by subtracting operating expenses from operating income. This figure shows how much money was made (or lost) from the company's normal business operations. Other Income (or Losses) Aside from operations, a company may earn income from other sources, such as investments. These items are usually listed under other income. Income Taxes Corporate income taxes are based on the pre-tax profit of a company. The pre-tax profit is calculated by taking a company's operating profit, adding other income, and subtracting interest it pays on bonds. Taxes must be deducted before profits can be reinvested in the company or distributed to shareholders. Net Profit (or Loss) This figure, referred to as the bottom line, represents the overall success of the business. It is calculated by subtracting the income tax expense from pre-tax income. Any net profit (or loss) is then added to (or subtracted from) retained earnings on the retained earnings statement. © 2021 IFSE Institute 243 Unit 7: Portfolio Management Cash Flow Statement The cash flow statement shows where a company’s cash is coming from and how it is being spent. It helps creditors and investors assess whether the company: can generate cash when needed has the cash to meet its financial obligations has enough cash to pay dividends or to reinvest The cash flow statement is separated into three sections. Section Description Operating Activities Refers to cash inflows and outflows from the company’s daily activities, such as the net income from the sale of its products and services. Investing Activities Includes cash expenditures for the purchase of assets or cash receipts through the sale of assets as well as income from investments, such as interest or dividends. Financing Activities Includes cash raised by borrowing money or the issuance of shares and amounts repaid to shareholders and debt-holders. Statement of Retained Earnings and Notes Retained earnings is the amount remaining after a company's net income is distributed to shareholders in the form of dividends. The statement of retained earnings captures what is distributed to shareholders and what is retained by the company. It carries forward the previous retained earnings balance, adds the net profit from the income statement, and subtracts dividends distributed to shareholders to determine the retained earnings at the end of the period. Companies may use retained earnings to pay off existing debt or reinvest in the company, such as pay for machinery or building a new factory. Notes to Financial Statements Notes to financial statements are often included to clarify financial statements or to provide additional information. Because these notes contain information that may be important for an accurate comprehension of financial statements, they should be carefully studied. Here is a partial list of what topics might appear in notes to financial statements: consolidation of financial statements between parent company and its subsidiaries deferred income taxes 244 © 2021 IFSE Institute Canadian Investment Funds Course lease obligations the method of converting transactions in foreign currencies to Canadian dollars investment holdings legal actions in progress against the company Common Ratios Used in Financial Analysis Financial ratios are used to evaluate a company’s financial statements. Portfolio managers use financial ratios to compare a company's financial information to a benchmark or to other companies in the same industry. Since ratios are relative numbers, portfolio managers may directly compare two companies of very different sizes. Ratios are calculated over several years to look for trends and opportunities. They also provide information about the direction of the security’s future prices, as well as warning signals about companies in financial distress. There are four main types of financial ratios: profitability liquidity debt-equity valuation NOTE: Although you will not be tested on the formulas used to calculate the different ratios, you are expected to understand their significance. Profitability and Liquidity Ratios Profitability Ratios Profitability ratios measure a company’s ability to generate profits from its resources. The data used to calculate profitability ratios is found primarily on the income statement. One of the profitability ratios is the gross profit margin, which shows the percentage of revenue left over after a company pays for the cost of goods sold. Gross Profit Margin = (revenue – cost of goods sold) ÷ revenue © 2021 IFSE Institute 245 Unit 7: Portfolio Management Liquidity Ratios A company’s liquidity ratios tell us whether it has sufficient resources to meet current financial obligations. A commonly used liquidity ratio is the current ratio, which shows a company’s ability to pay its short-term debt. The higher the ratio, the greater the company’s ability to pay short-term debt. Current Ratio = current assets ÷ current liabilities Debt-Equity and Valuation Ratios Debt-Equity Ratios Debt-equity ratios gauge how heavily a company relies on borrowed money to conduct its business. Generally, a higher debt-equity ratio represents greater risk. A company with too much debt may have difficulty making interest payments, borrowing additional funds, or borrowing at a favourable interest rate. However, if used wisely, greater debt can increase productivity and profits. Debt-Equity Ratio = (total outstanding short-term and long-term debt) ÷ shareholders’ equity at book value Valuation Ratios Valuation ratios assess the investment value of a security in comparison to its share price. The price-toearnings (P/E) ratio is the most well-known valuation ratio. This ratio relates the current share price to its earnings per share and shows how much investors are willing to pay for $1 of earnings. Therefore, if a company’s shares are trading at a P/E of 20 that means investors are willing to pay $20 for $1 of current income. A higher P/E ratio means investors are expecting higher income in the future. This ratio allows portfolio managers to compare the earning potential of different companies. P/E Ratio = (market price per share) ÷ (earnings per share) 246 © 2021 IFSE Institute Canadian Investment Funds Course Lesson 3: Mutual Fund Performance and Risk Introduction Mutual fund performance, also called the return, is a measure of the income generated by the mutual fund combined with the fund’s capital appreciation over time. Mutual funds, like most investments, are affected by a variety of risks. As a Dealing Representative, your clients will expect you to be knowledgeable about the return that investors can expect from different mutual funds, as well as the risks associated with different fund types. This lesson takes approximately 35 minutes to complete. By the end of this lesson you will be able to: explain how mutual fund investments grow or decline in value explain how to calculate standard mutual fund performance describe how mutual fund distributions affect investors describe the effect of mutual fund distributions on a fund’s net asset value per unit (NAVPU) describe the types of investment risks that impact mutual fund holdings explain the various measures of investment risk explain the relationship between risk and performance © 2021 IFSE Institute 247 Unit 7: Portfolio Management Sources of a Mutual Fund's Return How does a mutual fund investment grow in value? Quite simply, mutual funds make money in three ways: they earn income in the form of interest, dividends, or other income (e.g. foreign income) they realize capital gains (when securities are sold at a price higher than the initial purchase price) the price of the securities in the portfolio appreciates in value (i.e. capital appreciation) How does a mutual fund lose money? They either: realize capital losses (when securities are sold at a price below the initial purchase price) the price of the securities in the portfolio declines in value Each individual holding in the mutual fund has its own characteristics and makes a contribution to the portfolio according to those characteristics. The following illustrates how a bond or an equity holding contributes to a mutual fund portfolio. For simplicity, assume the portfolio consists of only one investment. Example Assume you purchase a $1,000 bond at par value that pays 5% per annum. In other words, you pay $1,000 for the bond and you receive $50 in interest each year. The value of your portfolio at the beginning of the period is $1,000. We can look at several different scenarios to see how it impacts your end value at the end of one year. Scenario Beginning Value Interest Income Price (based on $100 par value) Value of Portfolio at the end (one year later) 1 $1,000 $50 $100 – no change in price $1,050, calculated as ($1,000 x $100 ÷ $100) + $50 2 $1,000 $50 $98 – drops in value $1,030, calculated as ($1,000 x $98 ÷ $100) + $50 3 $1,000 $50 $101 – increases in value $1,060, calculated as ($1,000 x $101 ÷ $100) + $50 In scenario 1, you earn $50 in interest and the price of your bond does not change. So your end value is $1,050. Basically, your portfolio is up because of the interest payment. 248 © 2021 IFSE Institute Canadian Investment Funds Course In scenario 2, you earn the same interest, but your bond drops in value. Your end value is $1,030, which consists of the value of the bond based on the current market price ($980) and the interest payment ($50). Overall, your portfolio increases but your return is tempered by the drop in bond prices. If you sell the bond, you realize a capital loss of $20, calculated as $980 - $1,000. If you keep the bond, the $20 loss is an unrealized capital loss. In scenario 3, you actually benefit from an increase in bond prices. The market value of your bond is $1,010 and along with your interest payment of $50, your end value is $1,060. So the increase is a combination of interest and price appreciation. If you sell the bond, you realize a capital gain of $10, calculated as $1,010 - $1,000. By keeping the bond, the $10 capital gain remains unrealized. Example Assume you purchase 100 common shares of a Canadian public company which may pay an annual dividend of $40. The price of the common shares is $10 per share so the value of your portfolio at the beginning of the period is $1,000, calculated as $10 X 100 common shares. There is no guarantee the dividend will be paid. Let's review the impact on the end value of the portfolio based on several different scenarios. Scenario Beginning Value Dividend Income Price (based on 100 common shares) Value of Portfolio at the end (one year later) 1 $1,000 $40 $10 – no change in price $1,040, calculated as ($10 x 100) + $40 2 $1,000 $0 $10 – no change in price $1,000, calculated as ($10 x $100) 3 $1,000 $40 $7 – drops in value $740, calculated as (7 x 100) + $40 4 $1,000 $0 $7 – drops in value $700, calculated as ($7 x 100) 5 $1,000 $40 $15 – increases in value $1,540, calculated as ($15 x 100) + $40 6 $1,000 $0 $15 – increases in value $1,500, calculated as ($15 x 100) In scenarios 1 and 2, the price of the common shares does not change. With scenario 2, your end value is the same as the beginning value. You have not made or lost money. But the dividend payment in scenario 1 increases the end value by the $40 dividend. © 2021 IFSE Institute 249 Unit 7: Portfolio Management In scenarios 3 and 4, the price drops the value of your common shares to $700. You have an unrealized capital loss of $300, calculated as $700 - $1,000. So your portfolio is down in both these scenarios. However, the dividend payment in scenario 3 recovers some of this loss. In scenarios 5 and 6, your portfolio is up substantially. The dividend payment pushes the end value of scenario 5 higher than scenario 6. It is important to note that the prices of securities will fluctuate when the markets are open for trading. However, the gains or losses are not realized until the securities are sold. They are considered unrealized until that time. Calculating Mutual Fund Standard Performance Mutual fund investors are extremely interested in performance, both as a measure of their current investment values and as a yardstick in comparing potential new investments. A mutual fund's performance over any time period is the result of a number of factors including: the performance of the financial markets in which the mutual fund invests the investment skill of the portfolio manager the flow of cash in and out of the mutual fund as a result of net sales and net redemptions Standard Performance Data The total return of a mutual fund incorporates the income generated from the fund, which includes interest, dividends, realized capital gains and other income, and the capital appreciation of the mutual fund over time. There are many ways of calculating performance. Without a common methodology, comparing the performance of different funds can be very misleading. Standard performance data was developed so investors can make meaningful comparisons between funds. For non-money market funds, standard performance data is calculated using the formula for annual compounded rate of return. The calculation assumes that any distributions from the mutual fund are immediately reinvested back into the mutual fund. For money market funds, current yield and effective yield are used to show performance. It is important to understand that a fund's past performance is no guarantee of future performance. NOTE: You are not expected to calculate the returns for non-money market funds or money market funds. The formulas are provided to help you understand how mutual fund returns are calculated. 250 © 2021 IFSE Institute Canadian Investment Funds Course Non-money Market Mutual Funds Total Return This formula allows you to calculate the standard return for non-money market mutual funds, including reinvestment and compounding of distributions. Where: n = the length of the performance measurement period in years, with a minimum value of 1 initial value = the beginning net asset value of one unit or share of a mutual fund redeemable value = the end net asset value of one unit or share of a mutual fund, incorporating all distributions Example Leilani bought Mammoth Mutual Funds three years ago. At the time, her initial value was $10. Now, she has decided to sell the mutual fund. Her redeemable value is $13. Leilani's total return is 9.13933%, calculated as [($13 ÷ $10) (1÷3) -1] x 100. Money Market Mutual Funds Total Return Money market returns are calculated using two different formulas: current yield and effective yield. Current Yield Current yield reflects the income earned on a money market fund for the most recent seven days expressed as a simple annualized percentage. Where: seven day return = income generated divided by the beginning value of the money market fund Example Gargantuan Money Market Fund has assets of $10,000,000. In the last seven days the fund earned $9,595 of interest. The current yield is 5.0031%, calculated as [($9,595 ÷ $10,000,000) x 365 ÷ 7] x 100. © 2021 IFSE Institute 251 Unit 7: Portfolio Management Effective Yield Effective yield also calculates the return of a money market mutual fund, but this calculation includes the effect of compounding, the concept of interest added onto the principal and then itself also earning interest. Example Again looking at Gargantuan Money Market Fund, the effective yield is 5.1279%, calculated as [(($9,595 ÷ $10,000,000) + 1)(365÷7) - 1] x 100. Note that due to compounding, the effective yield is higher than the current yield. Effect of Mutual Fund Distributions In the course of a year, securities held in a mutual fund will generate income; this income increases the mutual fund’s net asset value which in turn raises the net asset value per unit (NAVPU). When this income is eventually distributed to unitholders it lowers the net asset value of the mutual fund, which results in a drop of the NAVPU. How distributions lower NAVPU The NAVPU is calculated by dividing the mutual fund’s net assets (total assets – total liabilities) by the number of units outstanding, in other words the number of units held by all the mutual fund’s unitholders. Example The Extraordinary Mutual Fund is calculating the effect of a dividend distribution on the NAVPU of their fund. Before distribution Before distribution, the mutual fund’s net asset value (total assets – total liabilities) is $1,000,000, and the number of units outstanding is 100,000. The beginning NAVPU is $10, calculated as $1,000,000 ÷ 100,000. Dividend income for the fund is $50,000, making the new net asset value $1,050,000, which increases the NAVPU to $10.50, calculated as $1,050,000 ÷ 100,000. 252 © 2021 IFSE Institute Canadian Investment Funds Course After distribution When the dividend income is distributed to unitholders, they receive distributions of $0.50 per unit, calculated as $50,000 ÷ 100,000. This results in the fund’s total asset value dropping from $1,050,000 back to $1,000,000. The new NAVPU is $10, calculated as $1,000,000 ÷ 100,000. How does this affect unitholders? Candace owns 100 units of the mutual fund. Prior to the distribution, her total fund holding is $1,050, calculated as $10.50 x 100. After the distribution, she receives a total distribution of $50, calculated as $0.50 x 100 and her mutual fund is worth $1,000, calculated as $10 x 100. Mutual Fund Distribution Options When a mutual fund distributes income, unitholders can do one of two things with the distributions: receive a cash payment reinvest the distribution If the investor chooses to receive a cash distribution, his or her number of units remains the same as before the distribution. If on the other hand, an investor reinvests the distribution, he or she will receive additional units of the mutual fund. The number of units the investor will receive is calculated as follows: Example Continuing from the previous example, if Candace decides to take the cash option, she receives $50 in cash and continues to own the 100 existing units of the mutual fund. However, the new value of her mutual fund holdings is lower due to the reduction in NAVPU. It is $1,000, calculated as $10 x 100. Overall, the total value is $1,050, calculated as $50 cash and $1,000 mutual fund holdings. If she reinvests the $50 distribution, at the NAVPU of $10, she receives 5 additional units, calculated as $50 ÷ $10. Her total number of units after distribution increases to 105. The value of her mutual fund is now $1,050, calculated as $10 x 105. © 2021 IFSE Institute 253 Unit 7: Portfolio Management The table below summarizes the options. Investment Number of Units Owned NAVPU Value of Mutual Fund Cash Received Total Value of Mutual Fund and Cash Before Distribution After Distribution Reinvestment After Cash Distribution 100 105 100 $10.50 $10.00 $10.00 $1,050.00 $1,050.00 $1,000.00 Not applicable $0 $50.00 $1,050.00 $1,050.00 $1,000.00 Mutual Fund Risks Mutual fund returns like most investments are affected by a variety of risks that can be separated into three categories. We will discuss the three main categories and look at examples of those types of risks. Systemic risk This is the risk that a single event, such as the failure of an institution, can trigger a domino effect and harm other interconnected financial institutions. Eventually, a systemic risk can harm the whole economy. A prime example of systemic risk is the collapse of Lehman Brothers in 2008. The failure of this large investment bank reduced the stability of the entire U.S. financial system. Systematic risk This type of risk is also referred to as market risk because it affects everyone and cannot be avoided. Systematic risk includes events such as interest rate changes, recession, and wars. Systematic risk can be compared to the risk of bad weather. In the event of an earthquake, everyone is vulnerable. 254 © 2021 IFSE Institute Canadian Investment Funds Course Systematic Risks Interest rate changes Interest rate changes affect bond and stock prices. A rise in interest rates hurts existing bond investors because it lowers the price of their bonds. It also introduces reinvestment risk, in other words, the risk that interest payments will be reinvested at a lower rate. Also, an interest rate increase typically leads to a drop in security prices, as higher rates lower consumer spending and subsequently reduce business revenue. Inflation Inflation reduces the real return of investments, which in turn lowers the purchasing power of money. Recession During periods of prolonged economic slowdown, unemployment rates increase. Subsequently, consumer spending and businesses earnings fall. Interest rate changes Interest rate changes affect bond and stock prices. A rise in interest rates hurts existing bond investors because it lowers the price of their bonds. It also introduces reinvestment risk, in other words, the risk that interest payments will be reinvested at a lower rate. Also, an interest rate increase typically leads to a drop in security prices, as higher rates lower consumer spending and subsequently reduce business revenue. Mutual Fund Unsystematic Risks This is risk specific to a given company or industry. This type of risk includes business risk and liquidity risk. For instance, poor management can lead to a decrease in a company’s security prices. Diversification can reduce the amount of unsystematic risk in a portfolio. Unsystematic Risks Business Risks The risk of a loss in the company's profits due to factors related to its business such a management quality, operational inefficiency, or competitor activities. Liquidity Risks The risk that you will not be able to sell your assets when you want because there are few buyers or there are restrictions preventing you from selling it. Real estate is an example of an asset with great liquidity risk. When the housing market is slow, home-sellers may not be able to find a buyer for months. © 2021 IFSE Institute 255 Unit 7: Portfolio Management Unsystematic Risks Currency Risks A form of financial risk that occurs when investors or businesses have assets in foreign countries, and as a result require foreign currency. This risk arises from exchange rates of one currency in relation to another. If you have investments in the U.S., and the Canadian dollar appreciates relative to the U.S. dollar, the return of your U.S. investments will be reduced after the assets in the U.S. funds are converted into Canadian dollars. Measures of Investment Risks The various types of risk affect the value of the securities in a mutual fund. When looking at how to measure the impact of these risks, we refer to volatility. Volatility is a measure of changes of a security's value over a period of time. Highly volatile securities experience dramatic price fluctuations in a short time period, thereby forcing a higher risk that the actual performance of a mutual fund may differ from the expected performance. Investments with lower volatility levels are those that experience a steady price change over time. As a result, these investments have a lower risk of failing to meet the expected return. Knowing the types of risk to which securities are exposed is important in assessing the volatility level and therefore the total return of a fund. Volatility measurements include: standard deviation beta duration 256 © 2021 IFSE Institute Canadian Investment Funds Course Standard Deviation Standard deviation indicates how much a mutual fund's performance fluctuates around its average historical return over a specified period of time. Returns closer to the average historical return, indicate a lower standard deviation. This means there is a lower risk that the fund will fail to meet its average return. A higher standard deviation, on the other hand, indicates that returns are farther away from the historical average return, and denotes a higher risk that the fund will not meet its average return. A graphical representation of this measure is the familiar bell curve. The height and width of this curve reflects the amount of variation in an investment's return. Example Both the Lowell Equity Fund and the Darwin Equity Fund have an average annual return of 10%. Lowell has a standard deviation of 5 (percentage points). This means that this mutual fund's rates of return typically fluctuate within five percentage points around its average of 10%. So, its rates of return typically range between 5% and 15%, calculated as 10% - 5% and 10% + 5% respectively. Darwin has a standard deviation of 2. You could expect its rates of return to range from 8% to 12%, calculated as 10% - 2% and 10% + 2% respectively. Although both mutual funds have the same average annual returns, Lowell is a higher risk mutual fund since it has a higher standard deviation while Darwin's lower standard deviation means its returns fluctuate within a narrower range around its average. Beta Beta measures the systematic risk of an investment relative to a benchmark index. With beta, investors can compare the volatility level of an investment to its peer group. As the basis of comparison, the benchmark index is assigned the value of one. The table below summarizes the relationship between the investment’s beta and volatility. © 2021 IFSE Institute 257 Unit 7: Portfolio Management Investment Beta Volatility Level Investment Performance Less than one Lower volatility than the market Lower risk and return than the market Equal to one Volatility level similar to the market Return and risk similar to the market Greater than one Higher volatility than the market Potential for higher return with higher risk than the market Example Ingram Mutual Fund has a beta of 1.2. Its return is expected to be 20% more volatile than the underlying benchmark index. If the benchmark returns 10%, Ingram is expected to return 12%. If the benchmark returns -10%, Ingram is expected to return -12%. Duration Duration is commonly used to measure the volatility of fixed income investments such as bonds. Duration refers to the number of years, calculated as the weighted average time, it will take for the bondholder to receive the present value of the interest and principal payments. The longer the duration, the longer bondholders will have to wait to get their interest and principal payment. As there is greater uncertainty in the future, for instance, the bond issuer can go bankrupt or interest rates may rise, longer durations mean higher risk. For instance, if two bonds have the same coupon rate, but different terms, the bond with the longer term will have a longer duration and will be more volatile. Example Justine is considering two bonds with the same coupon rate. Bond A matures in five years and its duration is 4.33 years while Bond B matures in ten years and its duration is 8.70 years. Bond B's duration is greater because of the longer term making it riskier than Bond A. A bond's coupon rate will also have an effect on duration. For example, if two bonds have the same term, but different coupon rates, the bond with the lower coupon rate will have a longer duration and will be more volatile. 258 © 2021 IFSE Institute Canadian Investment Funds Course Example Olaf is considering two bonds that both mature on the same day. However, Bond C offers a coupon rate of 4% and duration of 5.25 years while Bond D pays 5% interest and duration of 4.80 years. Since its coupon rate is lower, Bond C has a greater duration, and therefore is riskier than Bond D. Since a zero-coupon bond only pays at maturity, its duration is equal to the bond's time to maturity. Example Daniella buys a zero-coupon bond that matures in 10 years. The duration for this bond is the same as the time to maturity, which is 10 years. The Relationship Between Risk and Return Investments that experience higher volatility generally have the potential for higher returns due to the dramatic changes in the price of the investment. However, price volatility includes both upward and downward price movements. Therefore, while higher volatility provides potential for larger return, it also comes with the risk of steeper losses. Another reason riskier investments provide higher return is that issuers offer compensation to investors as an incentive for holding higher risk investments. To compensate investors, issuers of higher risk investments typically provide a risk premium. Mutual Fund Risk Ratings The simplified prospectus and the Fund Facts list the types of risks that affect the mutual fund. The documents also classify the risk level of the mutual fund. In addition, some Fund Facts also indicate the mutual fund’s beta and standard deviation. © 2021 IFSE Institute 259 Unit 7: Portfolio Management Summary Congratulations, you have reached the end of Unit 7: Portfolio Management. In this unit you covered: Lesson 1: The Portfolio Manager Lesson 2: Financial Analysis Lesson 3: Mutual Fund Performance and Risk 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 7 Quiz button. 260 © 2021 IFSE Institute