Chapter 17 - CSC Mutual Funds PDF

SECTION 7 ANALYSIS OF MANAGED AND STRUCTURED PRODUCTS 17 Mutual Funds: Structure and Regulation 18 Mutual Funds: Types and Features 19 Exchange-Traded Funds 20 Alternative Investments: Benefits, Risks and Structure 21 Alternative...

SECTION 7 ANALYSIS OF MANAGED AND STRUCTURED PRODUCTS 17 Mutual Funds: Structure and Regulation 18 Mutual Funds: Types and Features 19 Exchange-Traded Funds 20 Alternative Investments: Benefits, Risks and Structure 21 Alternative Investments: Strategies and Performance 22 Other Managed Products 23 Structured Products © CANADIAN SECURITIES INSTITUTE  Mutual Funds: Structure and Regulation 17 CHAPTER OVERVIEW In this chapter, we provide a brief introduction to managed products. We then focus specifically on one of the most widely recognized managed products—mutual funds. We discuss various mutual fund structures and explain the rules and regulations of the industry. We then discuss the importance of Know Your Client and suitability requirements in the context of mutual funds. Finally, you will learn about the requirements around documentation and disclosure. LEARNING OBJECTIVES CONTENT AREAS 1 | List the advantages and disadvantages of Overview of Managed Products managed products. 2 | Describe the advantages and disadvantages of Overview of Mutual Funds mutual funds and the types of fund structures. 3 | Calculate a fund’s net asset value per share Pricing Mutual Fund Units and how mutual fund units or shares are priced. 4 | Analyze the impacts of charges associated with mutual funds. 5 | Describe the mutual fund regulatory Mutual Fund Regulation requirements. 6 | Describe mutual fund restrictions and Other Forms and Requirements prohibited selling practices. 7 | Describe the Know Your Client rule, Know Your The Know Your Client and Know Your Product Product requirements, and suitability. Rules 8 | Discuss the elements that must be included Requirements for Opening and Updating in the client disclosure document, and the an Account circumstances in which Know Your Client information requires an update. © CANADIAN SECURITIES INSTITUTE 17 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. active management no-load fund annual information form offering price custodian open-end trust early redemption fee passive management F-class fund pre-authorized contribution plan front-end load redemption price Fund Facts registrar Know Your Client relationship disclosure Know Your Product simplified prospectus managed product switching fees management expense ratio System for Electronic Document Analysis and Retrieval money market trading expense ratio mutual fund trailer fee National Instrument 81-101 transfer agent National Instrument 81-102 trust deed National Registration Database unsolicited orders net asset value per share © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 3 INTRODUCTION Managed products have been around since the first modern mutual fund was created in the 1920s. Over the past 35 years, there has been tremendous growth in the number of managed products on the market and in the amount of assets under management. In this chapter and the next, we focus exclusively on mutual funds. Although they may seem simple and are nearly universally available, mutual funds are, in fact, a complex investment vehicle. They are available in many forms and through many distribution channels. They may be one of the most visible vehicles for investors, from the smallest retail client to the largest institutional investor. The funds themselves are subject to a range of unique fee structures, provisions, and regulations. As such, they offer many opportunities and challenges. It is important, therefore, that you fully understand this investment vehicle, particularly if you choose mutual fund sales as a career path. OVERVIEW OF MANAGED PRODUCTS 1 | List the advantages and disadvantages of managed products. A managed product is a pool of capital gathered to buy securities according to a specific investment mandate. The fund is managed by an investment professional that is paid a management fee to carry out the mandate. The mandate of a fund can specify either active management or passive management. Active management Active fund managers make investment decisions based on their outlook for the markets and securities in which they invest, which should be clearly identified in the fund’s investment mandate. In almost all cases, active fund managers intend to outperform the return on a specific benchmark index. Passive management Managers of passively managed funds do not make security selections; they assume only the systematic risk associated with investing in a particular asset class. The most common type of passively managed fund is one that attempts to replicate the returns of a market index. Managed products are available in various types and formats, each with specific characteristics. The following types are some of the most common formats: Mutual funds Exchange-traded funds (ETFs) Segregated funds Liquid alternatives Hedge funds Listed private equity funds Closed-end funds Labour-sponsored venture capital corporations (LSVCC) © CANADIAN SECURITIES INSTITUTE 17 4 CANADIAN SECURITIES COURSE      VOLUME 2 ADVANTAGES AND DISADVANTAGES OF MANAGED PRODUCTS Managed products can have the following advantages for investors, which may differ depending on the product: Professional Investors benefit from the experience and specialized knowledge of investment management professionals. Economies of scale The asset size of the pooled investment funds allows for negotiation of lower fees and transaction costs. Low-cost Investors with relatively small sums to invest have access to diversification, which they diversification could not otherwise achieve. Liquidity and flexibility Some managed products, such as mutual funds, can be bought and sold at their net asset value at any time. Tax benefits Products such as LSVCCs can provide tax benefits, including provincial and federal tax credits. Low-cost investment Products such as exchange-traded funds have some of the lowest management costs in options the fund universe. However, managed products can also have various disadvantages, depending on the type of product. Lack of transparency Because of the largely unregulated and competitive nature of their business, products such as hedge funds rarely disclose their portfolio holdings on a timely basis. Liquidity constraints Some managed products prevent investors from accessing their funds until a specified time, or only when certain conditions are met. High fees Active fixed income and foreign equity mutual funds can charge 2% to 5% in management fees. Some private equity funds and hedge funds typically charge a 20% performance fee. Volatility of returns Some mutual funds and hedge funds can be subject to market instability, as well as volatility associated with their underlying securities. OVERVIEW OF MUTUAL FUNDS 2 | Describe the advantages and disadvantages of mutual funds and the types of fund structures. A mutual fund is a single investment vehicle sponsored by an investment management company on behalf of many investors. By selling shares or units to a pool of investors, the fund raises capital, which is then invested according to the fund’s investment policies and objectives. The fund makes money from the dividends and interest it receives on the securities it holds. It may also earn capital gains from trading its investment portfolio. Thousands of mutual funds exist in the Canadian market and globally that cater to many different investment objectives. Some funds take a passive approach by simply replicating a stock or bond index. Others offer moderate risk and moderate return by balancing investments between fixed income and equities. Still others may be very active by constantly trying to beat the market. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 5 Mutual funds’ investment objectives are stated in a document called the Fund Facts document. This document generally discloses the degree of risk the fund is exposed to, the main types of securities held in its portfolio, and the historical returns it earned, among other things. Investors in a mutual fund become unitholders or shareholders in the fund. As such, they share in the income, gains, losses, and expenses the fund incurs in proportion to the number of units or shares they own. Professional money managers manage the assets of the fund by investing the proceeds according to the fund’s policies and objectives and based on a particular investing style. Mutual funds are sold in units or shares, depending on the structure, which are redeemable on demand at the fund’s current offering price. In the financial press, the offering price is expressed as the net asset value per share (NAVPS) or net asset value per unit. The NAVPS depends on the market value of the fund’s portfolio of securities at the time of redemption. DID YOU KNOW? The mutual funds industry in Canada has experienced tremendous growth since 1980. In that year, mutual fund net assets totalled $3.6 billion in Canada. By February 2024, mutual fund net assets under management were more than $2 trillion. For more information, the Investment Funds Institute of Canada releases statistics and updates on a monthly basis (www.ific.ca). Individuals who are licensed to sell mutual funds must have a good understanding of the type and amount of risk associated with each type of fund. As is true with other financial services, you must carefully assess each client’s profile to ensure that the type of mutual fund you recommend properly reflects that client’s risk tolerance and investment goals. You must also keep in mind that your clients’ goals and objectives are not static, so the review process is ongoing, rather than transactional. Finally, proper diversification is important, which means that a client’s portfolio should contain an asset mix allocated among cash or near-cash investments, equity investments, and fixed income investments. DID YOU KNOW? For the purposes of this course, we use the term mutual fund sales representative to refer to investment advisors who have met the regulatory requirements to sell or advise on mutual funds. However, the term dealing representative is also used in the industry. ADVANTAGES OF MUTUAL FUNDS Mutual funds provide varying degrees of safety, income, and growth for investors. In addition to these basic provisions, mutual funds also offer investors more specific advantages. The most favourable characteristics are described below. LOW-COST PROFESSIONAL MANAGEMENT Mutual funds are continually managed by a fund manager who is an investment specialist, which is perhaps one of the main advantages that mutual funds offer. Fund managers analyze the financial markets and select securities that best match a particular fund’s investment objectives. They also play the important role of continuously monitoring fund performance and fine-tuning a fund’s asset mix as market conditions change. Professional management is an advantage for both small and wealthy investors who do not have the time, willingness, or expertise to monitor a portfolio of securities. The low cost of access to professional management is an additional advantage, especially for small investors. © CANADIAN SECURITIES INSTITUTE 17 6 CANADIAN SECURITIES COURSE      VOLUME 2 DIVERSIFICATION Fund ownership provides an inexpensive way for small investors to acquire a diversified portfolio. A typical large fund might have a portfolio consisting of 60 to 100 or more different securities in 15 to 20 industries. For individual investors in a portfolio of stocks, acquiring such a broad-ranging portfolio is likely not feasible. When individual accounts are pooled in a fund, however, the fund sponsor enjoys economies of scale that can be shared with the unitholders. Thus, fund investors have access to a wider range of securities that can trade more economically than they would as individual investors. VARIETY OF TYPES AND TRANSFERABILITY OF FUNDS The many types of mutual funds, ranging from fixed income funds through to aggressive equity funds, enables investors to meet a wide range of objectives. Many fund families also permit investors to transfer between two or more different funds managed by the same sponsor, usually at little or no added fee. Transfers are also usually permitted between different purchase plans under the same fund. FLEXIBLE PURCHASE AND REDEMPTION OPTIONS Investors can make a one-time, lump-sum investment in a mutual fund, or they can make regular purchases in small amounts under a pre-authorized contribution plan. This ability to make accumulative, low-cost contributions is one of the main advantages of mutual funds. For example, an investor can open an account through a pre- authorized contribution plan with as little as $100 and then continue to contribute the same amount monthly. At redemption, similarly flexible options are available. LIQUIDITY Mutual fund shareholders have a continuing right to redeem shares or units for cash at NAVPS. Payments must be made to investors within two business days after the NAVPS is calculated, in keeping with the securities industry requirements. EASE OF ESTATE PLANNING Shares or units in a deceased person’s mutual fund continue to be professionally managed during the probate period until estate assets are distributed. In contrast, other types of securities may not be readily traded during the probate period, even when market conditions are changing drastically. DID YOU KNOW? The term estate refers to all the assets owned by a person at the time of his or her death. Estate planning is the process of arranging ahead of time for the administration and disposal of such property when the time comes. Probate is the process of validating the person’s will after death before distributing the estate assets. LOAN COLLATERAL AND MARGIN ELIGIBILITY Fund shares or units are usually accepted as security for a bank loan. They are also acceptable for margin purposes, thus giving aggressive fund buyers the benefit of leverage in their financial planning. Note that the use of fund assets for this purpose also poses risk. VARIOUS SPECIAL OPTIONS Mutual funds consist of not only an underlying portfolio of securities, but also the following customer services: Reinvestment and Most mutual funds offer the opportunity to compound an investment through the contributions reinvestment of dividends. Other mutual funds allow investors to make monthly contributions in amounts as low as $50 per month. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 7 Regulatory filing Sponsors of mutual funds file a variety of reports annually to meet their regulatory disclosure requirements. These reports include the annual information form (AIF), audited annual and interim financial statements, and an annual report, among others. Reports must be provided to unitholders (or any person) on request. They are easily retrieved through the System for Electronic Document Analysis and Retrieval website. Increasingly, these reports contain useful educational features such as manager commentaries. Record-keeping Other benefits associated with managed products include record-keeping features that assist with income tax reporting and other accounting requirements. DISADVANTAGES OF MUTUAL FUNDS Mutual funds also have disadvantages. In the role of a sales representative, you should be able to explain to your clients the disadvantages of investing in mutual funds, as described below. COSTS There are various charges associated with investing in a mutual fund. Historically, most mutual funds charged a sales commission up front, called an initial sales charge or front-end load, along with a management fee that was typically higher than the cost to purchase individual securities from a broker. More recently, no-load funds have become commonplace as competition from lower cost index mutual funds and exchange-traded funds has intensified. Competition in the market has subsequently reduced both front-end loads and management fees. NOTE A commission paid when a fund is sold is called a deferred sales charge or back-end load. The Canadian Securities Administrators adopted rules to ban deferred sales charges on mutual funds. This ban applies to back-end loads and low loads (i.e., back-end loads with a shorter time frame and a lower fee structure payable upon redemption). The ban took effect in all provinces and territories on June 1, 2022. SHORT-TERM UNSUITABILITY Most funds emphasize a long-term investment horizon and thus are generally unsuitable for investors wanting short-term gains for an emergency reserve. Because sales charges are often deducted from a planholder’s contributions, purchasing funds on a short-term basis is generally not advised. The investor would have to recoup at least the sales charges on each trading transaction. Mutual fund companies charge an early redemption fee to discourage short-term trading. The prospectus as well as the cost section of the Fund Facts document will identify the fee for short-term trading. The cost could range as high as 2% of the purchase cost of the securities redeemed. EXAMPLE Murray was considering using Defy Global Equity Fund as a vehicle for short-term trading. However, he changed his mind once he read the following statement found in the mutual fund’s cost section of the Fund Facts document: Defy Mutual Funds monitors for short-term trading activity. You are charged a short-term trading fee of 2% of the value of the securities if you redeem or switch securities within 30 days of buying securities of the Global Equity Fund. © CANADIAN SECURITIES INSTITUTE 17 8 CANADIAN SECURITIES COURSE      VOLUME 2 However, these disadvantages typically do not apply to money market funds, which are designed with liquidity in mind given that these funds mainly invest in short-term fixed income securities. SYSTEMATIC RISK Like equities, mutual fund units can lose value in falling markets; in other words, they are subject to systematic risk. Volatility in the market is extremely difficult to predict and is therefore not controllable by the fund manager. TAX COMPLICATIONS Unless the investor’s holdings are in a registered account, purchases and sales made by the fund manager creates a series of taxable events that may not suit that unitholder’s time horizon. For example, the manager might consider it in the best interests of the fund to take a profit on a security holding. At the same time, the individual unitholder might have been better off if the fund had held on to the position and deferred the capital gains liability. MUTUAL FUND STRUCTURED AS A TRUST Although a mutual fund may be structured as either a trust or a corporation, the most common structure for mutual funds is the unincorporated open-end trust. The trust structure enables the fund itself to avoid taxation. Any interest, dividends, or capital gains income, net of fees and expenses, flows through directly to the unitholders. That income is taxed in the hands of the unitholder, based on the type of income the fund generates. The trust deed establishing the open-end fund covers such things as the fund’s principal investment objectives, its investment policy, and any restrictions on its investments, among other things. It also establishes who the fund’s manager, distributor, and custodian will be. Investors in an open-end mutual fund receive units. They have the right to redeem their units at a price that is the same as, or close to, the fund’s current NAVPS. They may or may not be given voting rights under the terms of the trust agreement. Investors should consult the fund’s prospectus before purchasing units, to better understand their rights. (Mutual funds prospectuses are discussed later in this chapter.) The governing policy for mutual funds, in most cases, requires that funds convene a meeting of security holders to consider and approve specific issues. These issues include such matters as a change in the fund’s fundamental investment objectives, a change in auditor or fund manager, or a decrease in the frequency of calculating NAVPS. MUTUAL FUND STRUCTURED AS A CORPORATION A mutual fund can also be set up as a federal or provincial corporation, provided that it meets the following conditions set out in the Income Tax Act: The corporation’s holdings must consist mainly of a diversified portfolio of securities. The income it earns must be derived primarily from the interest and dividends paid out by these securities and any capital gains realized from the sale of these securities for a profit. Investors in mutual fund corporations receive shares in the fund, rather than units. Investment funds established as corporations lack the flow-through status of investment fund trusts. However, the corporation can achieve a virtually tax-free status by declaring dividends throughout the year that are equivalent to the corporation’s net income after fees and expenses. These dividends are then taxed in the hands of the shareholder. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 9 ORGANIZATION OF A MUTUAL FUND The typical structure and organization of mutual funds, including its directors, manager, distributors, and custodian, are described below. Directors and trustees The directors of a mutual fund corporation, or the trustees of a mutual fund trust, hold the ultimate responsibility for ensuring that investments in the fund are consistent with the fund’s investment objectives. To assist in this task, they may contract out the business of running the fund to an independent fund manager, a distributor, and a custodial organization. Fund manager The fund manager provides day-to-day supervision of the fund’s investment portfolio. In trading the fund’s securities, the manager must observe the guidelines specified in the fund’s own charter and prospectus, as well as constraints imposed by provincial securities commissions. The manager must also maintain a portion of fund assets in cash and short-term highly liquid investments. The manager is thus able to redeem fund shares on demand, pay dividends, and make new portfolio purchases as opportunities arise. Managers must judge the amount of cash needed and still have fund assets productively invested as fully as possible. Their ability to do so has a direct bearing on the success of the fund. Managers also have the following responsibilities: Calculate the fund’s NAVPS Prepare the fund’s Fund Facts documents, simplified prospectus, and reports Supervise shareholder or unitholder record-keeping Provide the custodian with documentation for the release of cash or securities. The fund manager receives a management fee for these services, which accrues daily and is paid monthly. Fees are calculated as a percentage of the net asset value of the fund being managed. Distributors Mutual funds are sold by the following distributors: Investment advisors employed by securities firms A sales force employed by some organizations that control both management and distribution groups Independent direct sales organizations In-house distributors, including employees of trust companies, banks, or credit unions who have duties other than selling In selling mutual funds, the distributor’s representatives must explain the objectives and terms of various funds in language that is understandable to new, often unsophisticated investors. They also mail out confirmations of sales, handle client inquiries about features of the fund, and accept and transmit orders for fund share redemptions. In the process, they offer clients financial planning assistance that involves “know your client” and suitability standards. These standards are as important in mutual fund sales as they are in the general securities business. As compensation for these services, the distributor usually receives a sales fee. © CANADIAN SECURITIES INSTITUTE 17 10 CANADIAN SECURITIES COURSE      VOLUME 2 Custodian When a mutual fund is organized, an independent financial organization, usually a trust company, is appointed as the fund’s custodian. The custodian collects money received from the fund’s buyers and from portfolio income, and arranges for cash distributions through dividend payments, portfolio purchases, and share redemptions. Sometimes the custodian also serves as the fund’s registrar and transfer agent, maintaining records of who owns the fund’s shares. This duty is complicated by the fact that the number of outstanding shares is continually changing through sales and redemptions. Fractional share purchases and dividend reinvestment plans further complicate this task. MUTUAL FUNDS FUNDAMENTALS How are mutual funds structured? What are the advantages and disadvantages of investing in them? Complete the online learning activity to assess your knowledge. PRICING MUTUAL FUND UNITS 3 | Calculate a fund’s net asset value per share and how mutual fund units or shares are priced. 4 | Analyze the impacts of charges associated with mutual funds. Mutual fund shares or units are purchased directly from the fund (often through a distributor) and are sold back to the fund when the investor redeems his or her units. Because the fund’s units cannot be purchased from or sold to anyone other than the fund, mutual funds are said to be in a continuous state of primary distribution. Before purchasing any mutual fund units, the purchaser must receive a Fund Facts document. The price an investor pays for a share or unit is its offering price, which is based on the NAVPS at the close of business on the day the order was placed. The NAVPS is the theoretical amount that a fund’s shareholders would receive for each share if the fund were to sell all its portfolio of investments at market value, collect all receivables, pay all liabilities, and distribute what is left to its shareholders. It is also used to calculate the redemption price, which is the amount (subject to redemption fees, if any) that a shareholder receives when he or she redeems the shares. If a mutual fund does not charge a sales commission to purchase a share or unit, an investor would pay the fund’s current NAVPS. NAVPS is calculated as follows: Total Assets - Total Liabilities NAVPS = Total Number of Shares or Units Outstanding © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 11 EXAMPLE ABC fund has $13,000,000 in assets, $1,000,000 in liabilities, and 1,000,000 units outstanding. The offering price (the price paid by an investor for 1 unit) is calculated as follows: 13,000,000 - 1,000,000 NAVPS = = 12 1,000,000 Thus, the NAVPS of this fund is $12. This is also the redemption price, if the fund does not levy any sales charges or fees. Because most funds calculate an offering or redemption price at the close of the market each day, a specified deadline during the day is set. The generally accepted deadline to get the end of day price is 4:00 p.m. ET. Orders received after that deadline are processed at the price calculated at the end of the next business day. Mutual fund representatives are expected to transmit any order for purchase or redemption to the principal office of the mutual fund on the same day the order is received. As noted earlier in this chapter, payment for redeemed securities must be made within two business days after the NAVPS is determined. The frequency with which mutual funds calculate NAVPS varies. Regulation requires that new funds calculate NAVPS at least once a week. However, funds that were calculating NAVPS on a monthly basis when this regulation came into effect may continue to do so. In reality, most large funds calculate NAVPS each business day after the markets have closed. If a fund computes its NAVPS less frequently than daily, sales and redemptions are made at the next valuation date. If computed monthly, a fund may require that requests for redemption be submitted up to 10 days before the date of the NAVPS computation. One exception to these rules is real estate funds. They must compute the NAVPS at least once a year, although most funds make the calculation on a quarterly basis. CHARGES ASSOCIATED WITH MUTUAL FUNDS There are three basic mutual fund categories of charges, including sales charges, the management expense ratio, and the trading expense ratio. SALES CHARGES Mutual funds can be categorized by the type of sales commission that is levied. The actual level of the sales charge levied by load funds depends on the following factors: The type of fund Its sponsor and method of distribution The amount of money being invested The method of purchase (i.e., lump-sum purchases versus contractual purchases spread out over a period of time) Front-end sale charges, also referred to as front-end loads, vary from firm to firm. Because they are set by the distributor, they are often negotiable, especially if a large amount of money is involved. A no-load fund has no sale charges when the fund is purchased. Calculating the impact of the various types of fees on mutual funds can be a complicated process. The Ontario Securities Commission and the department of Innovation, Science and Economic Development Canada have developed an online tool to assist in this process. © CANADIAN SECURITIES INSTITUTE 17 12 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? The Mutual Fund Fee Impact Calculator allows investors to determine the impact that mutual fund fees have on investment returns over time. You can find this tool at www.getsmarteraboutmoney.ca. NO-LOAD FUNDS Many mutual funds, primarily those offered by direct distribution companies, banks, and trust companies, have no sale charges when investors purchase or redeem units and are referred to as no-load funds. However, some self- directed brokers levy modest administration fees to process the purchase and redemption of no-load funds. Also, like other funds, these funds charge some management fees and other administrative fees. FRONT-END LOADS A front-end load is payable to the distributor at the time units are purchased. It is usually a percentage of the purchase price. The percentage typically decreases as the amount of the purchase increases. Investors should be aware that the front-end load effectively reduces the actual amount invested, which makes the overall offering price higher than the NAVPS. Regulations require that front-end loads be disclosed in the prospectus, both as a percentage of the purchase amount and as a percentage of the net amount invested. EXAMPLE A $1,000 investment in a mutual fund has a 4% front-end load, which means that $40 (or 4% × $1,000) goes to the distributor by way of compensation. Therefore, only the remaining $960 is actually invested. The prospectus states that the front-end load charge is 4% of the amount purchased (calculated as [$40 ÷ $1,000] × 100) and 4.17% of the amount invested (calculated as [$40 ÷ $960] × 100). CALCULATING A FRONT-END LOAD To determine a fund’s offering price when it has a front-end load charge, you must first determine the NAVPS and then make an adjustment for the load charge, as in the following calculation: NAVPS Offering Price = 100% - Sales Charge EXAMPLE For a $1,000 investment in a mutual fund with a NAVPS of $12 and a 4% front-end load, the offering price is calculated as follows: 12 12 Offering Price = = = $12.50 100% - 4% 0.96 Note that the sales charge of 4% of the offering price is the equivalent of 4.17% of the net asset value (or net amount invested), which is calculated as follows: 4% of 12.50 = 0.50 0.50 = 4.17% 12 © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 13 MANAGEMENT EXPENSE RATIO The management expense ratio (MER) represents the total of all management fees and other expenses charged to a fund, expressed as a percentage of the fund’s average net asset value for the year. Trading or brokerage costs are excluded from the MER calculation because they are included in the cost of purchasing or selling portfolio assets. The MER is calculated as follows: Aggregate Fees and Expenses Payable During the Year MER = ´ 100 Average Net Asset Value for the Year Figure 17.1 provides a breakdown of the various components of the MER. Figure 17.1 | The Management Expense Ratio MER % = Management Fee % + Operating Expenses % Investment Trailing Management Commissions % % The MER consists of the management fee and the fund’s operating expenses. The management fee is divided between the fee paid to the investment manager and any trailer fees the fund manager pays to the mutual fund sales representative. These fees are described in more detail below. TRAILER FEES Mutual funds may incur a trailer fee, sometimes called a trailing commission or service fee. The mutual fund manager may pay an annual trailer fee to the mutual fund sales representative who sold the fund, as long as the client holds the funds. Trailer fees are paid out of the fund manager’s management fee. The justification for the fund manager paying a fee is that the representative provides ongoing services to investors, including investment advice, tax guidance, and financial statements. As of June 1, 2022, payments made by mutual funds to dealers who do not make a suitability determination, such as discount brokers, are prohibited. More information about suitability is covered later in this chapter. DID YOU KNOW? The value of trailer fees is an ongoing debate within the industry. Those in favour of such fees feel that ongoing services are a valuable benefit to investors, and that salespeople must be compensated for their work. Those who oppose trailer fees believe that they can produce a conflict of interest for sales representatives, who may be tempted to encourage investors to stay in the fund, even when market conditions indicate that they should redeem their shares. Critics of trailer fees also argue that investors who hold funds for the long term end up paying higher overall fees than they would if they had paid a one-time front-end load. © CANADIAN SECURITIES INSTITUTE 17 14 CANADIAN SECURITIES COURSE      VOLUME 2 MANAGEMENT FEES Management fees vary widely depending on the type of fund, particularly on the level of service required to manage the fund, as described below. Money market funds Management fees associated with money market funds are low; typically, they range from 0.50% to 1%. Equity funds The management of equity funds (with the exception of index funds) requires ongoing research. Therefore, management fees are higher; typically, ranging from 2% to 3% (or higher). Index funds Index funds try to mirror the market with occasional rebalancing. Because this strategy is largely a passive buy-and-hold strategy, management fees are usually lower than those of equity funds. In all cases, the management fees charged are outlined in the prospectus. Management fees are generally expressed as a straight percentage of the net assets under management. For example, the fee might be expressed as follows: “An annual fee of not more than 2% of the average daily net asset value computed and payable monthly on the last day of each month”. This method of compensation has been criticized because it rewards fund managers not on the performance of the fund, but on the level of assets managed. Of course, a fund that consistently underperforms will lose assets as investors redeem their holdings. OPERATING EXPENSES The management fee compensates the fund manager, but it does not cover the following operating expenses: Interest charges Taxes, audit, and legal fees Safekeeping and custodial fees Provision of information to share or unitholders These expenses are charged directly to the fund. EXAMPLE A fund with $500 million in assets has total annual expenses of $10 million. Its MER for the year is 2% (calculated as $10 ÷ $500). All expenses are deducted directly from the fund, as opposed to charged to the investor. As such, they decrease the ultimate returns to the investors. For example, if a fund reports a compound annual return of 8% and an MER of 2%, it has a gross return of roughly 10%. This means that the MER, expressed as a percentage of returns, is 20% of the return (calculated as [2% ÷ 10%] × 100). Published rates of return on mutual funds are calculated after deducting the MER. The NAVPS of the funds, on the other hand, are calculated after the management fee has been deducted. By law, funds must disclose in the fund prospectus both the management fee and the MER for the last five fiscal years. TRADING EXPENSE RATIO Unlike the MER, which represents the total of all management fees and other expenses, the trading expense ratio (TER), is an aggregate of all the trading commissions incurred to manage the portfolio, compared to the total assets of the fund. The TER is therefore expressed as a percentage of assets. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 15 EXAMPLE Defy Mutual Fund had an aggregate trading cost totalling $875,000 in the past year when the fund’s assets totalled $75 million in the same period. Defy Mutual Fund had an annual trading expense ratio of 1.17% (calculated as [$875,000 ÷ $75 million] × 100). Mutual funds that have high turnover rates, where the manager buys and sells securities more often, tend to have high TERs. Funds with low turnover rates tend to have lower TERs. Turnover rates are not the only contributing factor to a fund’s TER. For example, funds that invest in low liquidity securities may also tend to have higher TERs compared to funds that invest in high liquidity securities. Mutual fund performance is reported after the fund’s trading expenses have been deducted. OTHER FEES Other mutual fund fees may apply: A small number of funds charge a set-up fee on top of a front-end load. Another type of fee is the early redemption fee, which may be charged on some no-load funds. The prospectus for such funds states that a fee is charged when the fund is redeemed within 90 days of the initial purchase. It could be a flat fee of $100 or 2% of the original purchase cost. This fee is charged to discourage short-term trading, and to recover administrative and transaction costs. Switching fees may apply when an investor exchanges units of one fund for another in the same family or fund company. Some mutual fund companies allow unlimited free switches between funds; others permit a certain number of free switches in a calendar year before fees are applied. In many cases, the advisor may charge a negotiable fee to a maximum of 2% of the amount being transferred. Some advisors choose to waive this fee altogether. Switching fees generally do not apply if a fund merges with another or is being terminated for any other reason. In such cases, the investor is allowed to transfer to the existing fund or withdraw the cash value of the contract without incurring withdrawal fees. F-CLASS FUNDS An F-class fund is a type of fee-based fund with a lower MER. With a fee-based account, the client is charged a percentage of the assets under management, rather than a commission or fee for each transaction. In the past, on top of the asset-based fee, clients were charged an MER that included compensation to the sales representative. To accommodate fee-based financial advisors, many mutual fund companies began offering F-class mutual funds. These funds reduce or eliminate the double charge. As a result, many more financial advisors now provide fee-based, rather than commission-based, accounts. MUTUAL FUNDS FEES What are the costs and fees associated with purchasing, owning, and redeeming mutual fund units? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 17 16 CANADIAN SECURITIES COURSE      VOLUME 2 MUTUAL FUND REGULATION 5 | Describe the mutual fund regulatory requirements. The Canadian securities industry is a regulated industry in which each province and territory has its own securities act and its own regulator. Regulators are responsible for regulating the underwriting and distribution of securities designed to protect investors and the industry. Securities regulations related to mutual funds are based on three broad principles: personal trust, disclosure, and regulation. The success of these principles in promoting positive market activities relies largely on ethical conduct by industry registrants. MUTUAL FUND REGULATORY ORGANIZATIONS All securities industry participants are subject to the rules and regulations of the SRO and the securities law in their particular province, and in any other province where the relevant securities administrators may claim jurisdiction. The Canadian Investment Regulatory Organization (CIRO) is the SRO for the distribution side of the mutual fund industry. This function was formerly carried out by the Mutual Fund Dealers Association. CIRO does not regulate the funds themselves; that responsibility remains with the provincial securities commissions. However, they do regulate how the funds are sold. In Quebec, the mutual fund industry is under the responsibility of the Autorité des marchés financiers (AMF) and the Chambre de la sécurité financière. The Autorité is responsible for overseeing the operation of fund companies within the province, whereas the Chambre is responsible for setting and monitoring continuing education requirements and for enforcing a code of ethics. A co-operative agreement currently in place between CIRO and the Quebec regulatory organizations will help to avoid regulatory duplication and to ensure that investor protection is maintained. DID YOU KNOW? Note that any reference to province or provincial encompasses not only Canada’s 10 provinces, but also its three territories. NATIONAL INSTRUMENTS 81-101 AND 81-102 Canadian funds fall under the jurisdiction of the securities act of each province. Securities administrators control the activities of these funds, their managers, and their distributors by means of a number of national and provincial policy statements dealing specifically with mutual funds. Provincial securities legislation governing all issuers and participants in securities markets also imposes requirements. Examples of applicable legislation include two national instruments: National Instrument 81-101 deals with mutual fund prospectus and Fund Facts disclosure. National Instrument 81-102 and its companion policy contain requirements and guidelines for the distribution and advertising of mutual funds. GENERAL MUTUAL FUND REQUIREMENTS Most mutual funds are qualified for sale in all provinces and are therefore registered for sale in each jurisdiction. With certain exceptions, the funds must annually file a full or simplified prospectus, which must be acceptable to the provincial securities administrator. Most funds, particularly the smaller ones, file a prospectus or a simplified prospectus only in provinces where sales prospects appear favourable. Selling a fund’s securities to residents of provinces in which the fund has not been qualified is prohibited. Therefore, mutual fund representatives must deal only in those funds registered in their own jurisdiction. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 17 Because mutual funds are considered to be in a continuous state of primary distribution, investors must receive a Fund Facts document before making any purchase. The actual requirements are set out in NI 81-101. Mutual funds require the following disclosure documents: A Fund Facts document A simplified prospectus The AIF The annual audited statements or interim unaudited financial statements Other information required by the province or territory where the fund is distributed, such as material change reports and information circulars NI 81-101 requires only that the Fund Facts document be delivered to investors before they purchase a mutual fund. However, an investor may also request delivery of the simplified prospectus, the AIF, or the financial statements. In such case, the distributor must provide all those documents as well. THE FUND FACTS DOCUMENT The Fund Facts document is designed to give investors key information about a mutual fund. It must be written in plain language and must consist of no more than two double-sided pages. It must be presented in an easily understood format that follows a universal standard so that investors can compare mutual fund data consistently. The purpose of the Fund Facts document is to provide timely information that may affect the investors’ decision. Pre-purchase delivery of the Fund Facts document to investors is mandatory for each class or series of mutual funds. It may be delivered in person, by email, or through other means, according to how the dealer typically interacts with its investors. The following disclosure of investor rights related to withdrawal and misrepresentation must appear in the Fund Facts document: Investors have the right to withdraw from the purchase within 48 hours after confirmation of the purchase is received. Depending on the province, they maintain their right of damages or to rescind the purchase if the Fund Facts document, simplified prospectus, AIF, or financial statements contain a misrepresentation. Each province specifies a time limit within which investors must act to claim the right to damages or rescission. Investors can request a copy of the simplified prospectus at no charge. DISCLOSURE COMPONENTS OF FUND FACTS As shown in Table 17.1, the Fund Facts document is divided into two major sections, each with subsections of related items. Table 17.1 | Components of the Fund Facts Document Section 1: Fund Information Introduction This subsection provides the document date, fund name, fund manager name, and name of class or series, if the mutual fund has more than one. Quick Facts This subsection provides key background points, including the date the fund was created, the total value of all units of the fund, the MER, the identity of the portfolio manager, the expected frequency and date of distributions, and the minimum investment needed for both the initial and repeat purchases. © CANADIAN SECURITIES INSTITUTE 17 18 CANADIAN SECURITIES COURSE      VOLUME 2 Table 17.1 | Components of the Fund Facts Document Section 1: Fund Information Investment This subsection describes the fundamental nature of the mutual fund under the heading of the Fund “What Does the Fund Invest In?” It provides a list of top the 10 investments and the percentage of net asset value for each investment, as well as the investment mix and a breakdown of the fund’s investment exposure. Risks This subsection reminds investors that the fund is subject to a certain degree of risk. It rates the extent of the fund’s risk on a scale that ranges from low, low-to-medium, medium, medium-to-high, and high. It also reminds investors that the fund does not guarantee a return and that they may not get back the amount of money invested. Past Performance This subsection asks, “How has the fund performed?” and provides the following three illustrations: A chart showing returns, after expenses have been deducted, over the previous 10 years on a year-by-year basis (or since the date of its inception, if under 10 years). A table showing both the best and worst returns for the fund in a three-month period over the previous 10 years (or since the date of its inception, if under 10 years). An average return calculation based on an investment of $1,000 into the fund 10 years ago (or since the date of its inception, if under 10 years) and its worth today, together with the percentage annual compound return during this period. Suitability This subsection asks, “Who is this fund for?” It describes the characteristics of the investor for whom the fund may or may not be appropriate, and the portfolios for which the fund is and is not suited. Impact of Income This item highlights the tax consequences of the fund under the heading of “A Word Taxes on Investor About Taxes”. Returns Section 2: Costs, Rights, and Other Information Cost of Buying, This subsection outlines the following three items: Owning, and Selling the Fund Sales charges—This item discloses whether the sales charge is structured as a front- end load or no load. Fund expenses—These expenses may include the MER and the TER. Both ratios are expressed as a percentage value and translated to a dollar figure relative to every $1,000 invested. Trailing commissions are also highlighted in this area. Other fees—Fees may include short-term trading fees, switch fees, change fees, or a combination. Statement of Rights This subsection asks, “What if I change my mind?” It advises the investor of their rights and options within a defined period, including the right to cancel a purchase within 48 hours after receiving confirmation of the purchase. More Information This subsection provides contact information for investors who may wish to obtain more About the Fund information, such as the simplified prospectus and other disclosure documents. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 19 THE SIMPLIFIED PROSPECTUS In addition to the Fund Facts document, the simplified prospectus of a mutual fund must be filed and mailed or otherwise delivered to mutual fund investors upon request. A mutual fund prospectus is normally shorter and simpler than a typical prospectus for a new issue of common shares. Under the simplified prospectus system, the issuer must abide by the same laws and deadlines that apply under the full prospectus system. As well, the buyer is entitled to the same rights and privileges. The simplified prospectus must be filed with the securities commission annually, but it need not be updated annually unless there is a change in the affairs of the mutual fund. Like the Fund Facts document, the simplified prospectus must be written in plain language and presented in an easy-to-understand format. For further purchases of the same fund, it is not necessary to provide the Fund Facts document or simplified prospectus again unless it has been amended or renewed. The simplified prospectus has the following two sections: Part A provides introductory information about the mutual fund, information about mutual funds in general, and information applicable to funds managed by the mutual fund. Part B contains detailed information about the specific mutual fund. The simplified prospectus may be used to qualify more than one mutual fund. However, Part A of each prospectus must be substantially similar, and the funds must belong to the same mutual fund family, administered by the same entities, and operated in the same manner. The simplified prospectus must contain the following information: Introductory statement describing the purpose of the prospectus and identifying the other information documents that the fund must make available to investors Name and basic information about the issuer, including a description of the issuer’s business Risk factors and description of the securities being offered Method used to set the price of the securities being sold or redeemed, and disclosure of any sales charges Method of distribution Statement of who has the responsibility for management, distribution, and portfolio management Fees paid to dealers Statement of management fees and other expenses, including the annual MER for the past five years The fund’s investment objectives and practices Information on the amount of dividends or other distributions paid by the issuer In general terms, the income tax consequences to individuals holding an investment in the fund Notice of any legal proceedings material to the issuer Identity of the auditors, transfer agent, and registrar Statement of the purchaser’s statutory rights Summary of the fees, charges, and expenses payable by the security holder The prospectus must be amended concurrently with the Fund Facts document when material changes occur, and investors must receive a copy of the amendment. Funds that invest in real property may not use the simplified prospectus system under NI 81-101. As part of the simplified prospectus system, a fund must provide its investors with financial statements on request. Annual audited financial statements must be made available to the securities commission (or commissions) where the fund is registered on or before the deadline set by the commission. These statements must be made available to new investors. © CANADIAN SECURITIES INSTITUTE 17 20 CANADIAN SECURITIES COURSE      VOLUME 2 Financial statements that are unaudited at the end of six months after the fund year-end must also be submitted to the securities commissions, usually within 60 days after the reporting date. These statements must also be made available to new investors. THE ANNUAL INFORMATION FORM The AIF must be delivered to investors on request. Much of the disclosure required in the AIF is similar to that provided in the simplified prospectus. In addition to that information, the AIF contains the following details: Significant holdings in other issuers The tax status of the issuer Directors, officers, and trustees of the fund and their indebtedness and remuneration Associated persons, the principal holders of securities, and the interests of management and others in material transactions The particulars of any material contracts entered into by the issuer OTHER FORMS AND REQUIREMENTS 6 | Describe mutual fund restrictions and prohibited selling practices. Under securities legislation, mutual fund dealers must abide by several other requirements. Those additional requirements are described below. REGISTRATION REQUIREMENTS FOR THE MUTUAL FUND INDUSTRY Mutual fund managers, distributors, and sales representatives must be registered with the securities administrators in all provinces in which they operate. The commissions also insist that they be informed within five business days of any important change in personal circumstances, such as a change of address or a bankruptcy. EDUCATION QUALIFICATIONS Mutual fund sales representatives must have successfully passed a mutual funds course such as the Canadian Securities Institute’s Canadian Securities Course (this two-volume course), the Investment Funds in Canada course, or another qualifying education program. REGISTRATION REQUIREMENTS An application for registration must be filed electronically with the National Registration Database (Form NRD 33-109F4), with the appropriate fee. Provincial securities acts set the requirements for initial and continuing registration. In Quebec, the representative must register with the Autorité des marchés financiers. As noted in the first volume of this course, the government of Quebec and the AMF announced their approval of a delegation of powers to CIRO. CIRO will have the power to act as the organization that registers dealing representatives of a mutual fund dealer. They were also delegated the power to conduct compliance examinations for mutual fund dealers who operate in Quebec, which represents a further step in the harmonization of the regulatory framework across Canada. At the time of this writing, CIRO and the AMF were working together to form an implementation timeline for the delegation of powers. During this period of planning and transition, CIRO’s regulatory requirements for the most part will not apply to the dealer’s activities in the province of Quebec. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 21 To work as a mutual fund sales representative, you must also meet the following requirements, among others: Generally, you must be employed by the distribution company. You are not permitted to carry on other forms of employment without the prior approval of the appropriate securities administrators and any industry associations of which your firm is a member. However, many provinces have issued policy statements permitting persons to be dually registered as mutual fund representatives and life agents. You must complete a detailed report about your past businesses, employment, and conduct and submit it to a police review. The report must include the following information: Any companies with which you have been associated in certain capacities Any action against you regarding any government licence to deal in securities Any action against you regarding any government licence to deal with the public in any other capacity requiring registration Any disciplinary action regarding an approval by any securities commission or similar professional body Any past criminal convictions or current charges or indictments Any bankruptcies or proposals to creditors Any civil judgment or garnishment NOTICE OF CHANGES As a mutual fund representative, you must notify the provincial securities administrator within five business days (or 10 days in Quebec) of any of the following changes in your provincial application: Change of address Disciplinary action of a professional body Personal bankruptcy (Ontario and Quebec) Criminal charges or civil judgments TRANSFER OF REGISTRATION As soon as a mutual fund sales representative ceases to work for a registered dealer, registration is automatically suspended. The employer must notify the provincial securities administrator of the termination of employment and, in most provinces, the reason for termination. Before a representative’s registration can be reinstated, notice in writing must be received by the securities administrator from another registered dealer of the employment of the representative by that other dealer. The reinstatement of the registration must be approved by the securities administrator. If the securities administrator does not receive a request for reinstatement and transfer to a new company within the permitted period, the registration lapses and the representative must reapply for registration. The permitted period is 30 days in most provinces and six months in Quebec. MUTUAL FUND RESTRICTIONS A mutual fund’s manager provides day-to-day supervision of the fund’s investment portfolio. In trading the fund’s securities, the manager must observe a number of guidelines specified in the fund’s charter and prospectus, as well as constraints imposed by provincial securities commissions. © CANADIAN SECURITIES INSTITUTE 17 22 CANADIAN SECURITIES COURSE      VOLUME 2 RESTRICTIONS ON MUTUAL FUND MANAGEMENT PRACTICES When managing a portfolio of securities, mutual fund managers are restricted on what they can or cannot do. Some funds have more restrictions than others. A mutual fund manager may have any or all of the following restrictions: Purchases of no more than 10% of the total securities of a single issuer or more than 10% of a company’s voting stock No purchases of shares in the manager’s own company (e.g., a fund owned by a bank cannot buy shares in that bank) Purchases of no more than 10% of the net assets in the securities of a single issuer or 20% of net assets in companies engaged in the same industry (except specialty funds) No purchases of the shares of other mutual funds, except in certain cases where no duplication of management fees occurs No borrowing for leverage purposes No margin buying or short selling No commodity or commodity futures purchases Limitations on the percentage of holdings in illiquid securities, such as those sold through private placement and unlisted stocks USE OF DERIVATIVES Mutual fund managers are subject to strict regulatory controls regarding the use of derivatives—contracts whose value is based on the performance of an underlying asset, such as a commodity, a stock, a bond, a foreign currency, or an index. However, mutual fund managers are allowed to incorporate specific permitted derivatives as part of their portfolios. For example, options (such as puts or calls), futures, forwards, rights, warrants, and combination products are among the permitted derivatives that mutual fund managers can include. Derivatives are most commonly used by mutual fund managers for two purposes: to hedge against risk and to facilitate market entry and exit. It is often cheaper and quicker to enter the market using derivatives rather than by purchasing the underlying securities directly. EXAMPLE A fund manager has experienced rapid growth in the value of her portfolio, but she is concerned that the market may fall. To protect herself against a fall in value, she purchases put options on the iUnits S&P/TSX 60 Index Fund (i60s). If the market declines, any loss in the portfolio’s value will be offset by an increase in the value of the put options. Other managers may sell call options on shares they already own in order to enhance the fund’s income. When fund managers deal internationally, they may use futures contracts as protection against changes in currency values. One focus of NI 81-102 is to allow the use of derivatives to benefit investors by minimizing overall portfolio risk. At the same time, regulations seek to ensure that portfolio managers do not use derivatives to speculate with investors’ money. Derivatives regulation covers the following requirements: The total amount that can be invested in derivatives (10% maximum as a percentage of the net assets of a fund) How derivative positions must be hedged by the assets of the fund (based on daily portfolio valuations) Expiry dates on different option products © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 23 Permitted terms The qualifications required by portfolio advisors to trade these instruments Hedge funds are exempted from these rules. Another exception is alternative mutual funds, which are permitted to use derivatives in a leveraged manner for speculation. These products will be covered in a later chapter. The use of permitted derivatives must be disclosed in a mutual fund’s simplified prospectus. The disclosure must explain how they will be used to achieve the mutual fund’s investment and risk objectives. It must also describe the limits of and risks involved with the planned use of derivatives. PROHIBITED SELLING PRACTICES As a mutual fund sales representative, or one considering that role, you should be aware of various sales practices that are prohibited by the regulators. Engaging in these and other types of unethical behaviour could lead to a loss of registration. Some sales practices that are prohibited are described below. Quoting a future price When an investor places an order to buy or sell a mutual fund, the price per unit or share the investor will pay or receive is not known. The purchase or sale price is based on the NAVPS on the next regular valuation date. Depending on the time of day on which the order is entered, the NAVPS may be priced at the end of the current business day or the end of the next business day. Mutual fund companies specify the time by which a trade must be entered to receive the closing price for the current business day. The general practice is to price orders entered before 4:00 p.m. ET at the end of the current business day. Orders received after 4:00 p.m. ET are priced at the end of the next business day. Consequently, it is unlawful for a representative to backdate an order in an attempt to buy or sell shares or units at a previous day’s price. Offer to repurchase As a sales representative, you may not make offers to repurchase securities in an attempt to insulate your clients from downturns in price. Of course, investors have the normal right of redemption, should they wish to sell their mutual fund investments. Selling without You must be licensed in each province where you intend to sell mutual funds, which a licence requires registration with each provincial regulatory authority under which you intend to work. You must inform authorities of material changes in your personal circumstances that could affect your registration status. Furthermore, it is against the law to sell products you are not registered to sell. For example, as a mutual fund representative, you cannot sell stocks, bonds, or insurance in any province unless you are licensed to do so in that province. Advertising You may not advertise or promote the fact that you are registered with a securities the registration authority. Doing so could imply that regulatory authorities sanction your conduct or the quality of the funds you offer, which is not relevant. Promising a future price You may not make promises that a fund will achieve a known price in the future. © CANADIAN SECURITIES INSTITUTE 17 24 CANADIAN SECURITIES COURSE      VOLUME 2 Sales made from one Despite ease of electronic access to out-of-province investors, you may not fill orders, province into another even unsolicited orders, unless you are registered in the investor’s province. If you province or country sell mutual funds to clients in a province in which you are not registered, or to a non- Canadian resident, your registration may be cancelled. Sale of unqualified Likewise, any mutual funds you sell must be approved in the province in which you securities are registered. It is forbidden to sell mutual funds that have not been approved by the provincial regulator. Fortunately, most mutual funds available on the market are approved in every Canadian jurisdiction. GUIDELINES AND RESTRICTIONS Distributor firms and fund managers are also subject to guidelines and restrictions. Those guidelines indicate what the firms and managers are permitted to do. As a mutual fund sales representative, you need to consider the impact of the following prohibitions on your role: Fund managers may not provide money or goods to a distributor firm or its representatives in support of client appreciation. The commission rate on a fund cannot be changed unless the simplified prospectus for that fund is renewed. (However, the commission rate for a new fund may differ from commission rates set for already established funds.) Fund managers may not provide co-operative funds for practices that are considered general marketing expenses, such as general client mailings. Fund managers may not financially subsidize skill enhancement courses such as courses in effective communication or improving presentation skills development. Fund managers may not provide non-monetary benefits of any significant value to a distributor firm or its representatives. Occasional rewards of minimal value may be permitted if they are unlikely to influence the behaviour of the recipient (e.g., pens, t-shirts, or golf balls). This list is not exhaustive. It is your responsibility as a mutual fund sales representative to be aware of what is and what is not allowed. The Investment Funds Institute of Canada publishes Sales Practices Bulletins, which interpret the rules and give examples of acceptable and unacceptable sales practices. SALES COMMUNICATIONS NI 81-102 and NI 81-105 outline specific guidelines with respect to sales communications. The following summary briefly describes these policies, but, as a mutual fund representative, you should be familiar with the entirety of both instruments. These rules apply commonly, whether the communication comes from the representative, the representative’s firm, the fund’s promoter, manager or distributor, or anyone who provides a service to the client with respect to the mutual fund. When in doubt, you should always consult with your branch manager or compliance officer. Their approval is needed before you send out any sales communications. These guidelines apply to any type of sales communication, including advertising or any oral or written statements you make to a client. Sales communications can include any of the following information: A description of the fund’s characteristics A comparison between funds under common management or funds with similar investment objectives A comparison of the fund to an index © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 25 Performance information (which must follow very specific rules with respect to how performance is calculated and presented) Advertising that the fund is a no-load fund Any information or comparisons must include all facts that, if disclosed, would likely lead clients to certain conclusions or affect their decisions. Information must never be communicated in a way that is misleading. The communication cannot make an untrue statement, nor can it omit any information that, if omitted, would make it misleading. Additionally, it cannot present information in a way that distorts that information. All information must agree with the information found in the simplified prospectus. COMMUNICATING RATES OF RETURN TO CLIENTS As with any communication delivered to the client, the expectation is that the client will be provided with “full, true, and plain disclosure.” This obligation extends to any communication that provides an annualized rate regarding a specific account or group of accounts. Such client communications must include a clear explanation of the method by which the rate of return was calculated. That method must be in accordance with standard industry practices. DID YOU KNOW? Standard industry practice with regard to calculating a rate or return includes a time-weighted or dollar- weighted return, daily valuation, or any method approved under the Global Investment Performance Standards, as endorsed by the Chartered Financial Analyst Institute. For those client accounts that have been opened for less than 12 months, the rate of return shown must be the total rate of return since the account was opened at the mutual fund dealer. It is also expected that any client communication that contains or refers to a rate of return has been reviewed and approved by appropriate supervisory staff at the mutual fund dealer. CLIENT ACCOUNT PERFORMANCE REPORTING Along with rates of return, clients must be provided with information regarding the performance of their investments. As described under rule 5.3.4 of CIRO’s Mutual Fund Dealer Rules, the mutual fund representative must provide clients with an annual performance report that covers, at a minimum, a 12-month period. Performance reports provided to clients must include the following information: The market value of the assets held in the client account at the beginning and end of the 12-month period covered by the report The total assets deposited and withdrawn during the 12-month period and since opening the account The annual change in the market value of the client’s account for the 12-month period The cumulative change in the market value of the account since the account was opened Annualized total percentage return using a money-weighted methodology for periods of one, three, five and 10 years, as well as since inception Client communication that contains an annualized rate of return must be calculated according to standard industry practices. It must also provide a clear explanation of the method used to calculate the return. The minimum threshold for account performance reporting is no less than yearly, and the report must cover, at a minimum, a 12-month period. Some mutual fund dealers elect to report on performance more frequently than the required minimum. © CANADIAN SECURITIES INSTITUTE 17 26 CANADIAN SECURITIES COURSE      VOLUME 2 THE KNOW YOUR CLIENT AND KNOW YOUR PRODUCT RULES 7 | Describe the Know Your Client rule, Know Your Product requirements, and suitability. The Canadian Securities Administrators (CSA) launched amendments to NI 31-103 and its Companion Policy in 2021 as part of the Client Focused Reforms initiative (the CFRs). The amendments cover the Know Your Client (KYC) and Know Your Product (KYP) rules, conflicts of interests, suitability, and relationship disclosure. The CSA developed the CFRs based on the concept that the interests of the client must come first in the client-registrant relationship. SUMMARY OF REGULATORY CHANGE AND CLIENT FOCUSED REFORMS Applying due diligence to ensure that each recommendation is suitable for a client has become a fundamental industry obligation of all registrants. It is critical that mutual fund representatives apply, and thoroughly document the components of suitability, a requirement that is at the intersection of the KYP and KYC rules. At this point, it is worthwhile restating key elements of the CFR requirements: 1. The KYC and KYP obligations are foundational pre-conditions to suitability. All representatives must meet their KYC, KYP, and suitability obligations carefully and completely. 2. If representatives don’t meet KYC and KYP requirements and lack knowledge of either a client or a product, it will be difficult to establish that the representative met the appropriate standard of care when determining suitability of an investment product. 3. All KYC, KYP, and suitability elements must be substantively in place with respect to each client and each investment. Furthermore, it is not enough simply to know the client and believe that a particular trade is suitable or to have a fundamental grasp of the mechanics and workings of a particular complex investment. For the protection of the client, the representative, and the representative’s firm, it is also critically important that all these aspects be clearly documented. 4. Individual representatives are responsible for understanding the products in a client’s account and any products the representative recommends after determining whether a particular product is suitable for a particular client. 5. The KYC, KYP, and suitability obligations are among the most fundamental obligations owed by representatives to their clients and are cornerstones of the industry’s investor protection regime. KNOW YOUR CLIENT RULE Before accepting a client account, securities regulations require that mutual fund dealers and their sales representatives gather enough information about their client to ensure that the purchase of mutual funds is suitable. This requirement is embedded in the Know Your Client rule. The CFRs have added to the existing KYC requirements by clarifying the KYC information that must be gathered to meet the enhanced suitability obligations. Required KYC information includes a customer’s: Personal circumstances (not limited to financial circumstances) Financial circumstances Investment knowledge Investment objectives Risk profile (guidance clarifies that this includes both the customer’s risk tolerance and their risk capacity) Investment time horizon Any other information that helps you meet your suitability obligations © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 27 Clients purchasing mutual funds must provide KYC information, whether or not they are acting on your recommendation. This information must be obtained for all persons who have trading authority for the account and any other person with a financial interest in the account. To make sure all orders are suitable for the client, order forms may contain a KYC section. In some cases, the KYC form is a separate document that must be completed by the purchaser. For clients with multiple accounts, you should obtain separate KYC information for each account. The investment objectives, risk profile, and investment horizon of each account may differ. Clients who refuse to provide the necessary information should be informed that its collection is required by law, and by all other mutual fund dealers. You should let your clients know that the KYC rule requirements are intended to benefit the client. You collect the information because it helps you choose an appropriate mutual fund to meet their investment needs and objectives. If the client still refuses to provide KYC data, then you cannot process the transaction. KNOW YOUR PRODUCT In addition to meeting KYC obligations, mutual fund representatives must fully understand the structure, features, and risks of the products they recommend to clients and how it can be used to help a client achieve their investment objectives. The Know Your Product provision of the CFRs make it clear that firms are required to establish a product due diligence process to ensure that investments made available to clients are assessed, approved, and monitored on an ongoing basis for significant changes. Rather than relying on third-party reports of investment products, firms should do their own analysis of the report to determine that it is reliable, fair, and balanced. The KYP provisions clarify that the KYP rules apply to the following actions: Purchasing or selling a product for a client Recommending a product to a client Placing a product on the firm’s product shelf Advertising or promoting a product in any medium, including marketing materials distributed to the client When assessing a new product, a firm should consider whether it may not be suitable for certain clients and should not be offered to those clients. For example, some products may generally not be suitable for elderly and other vulnerable clients, or for clients with a certain minimum risk tolerance, net worth, or time horizon. The client’s investment objectives are another relevant factor when considering suitability of a product. KYP AND YOUR RESPONSIBILITY Mere approval of an investment product by the firm is not enough in itself to discharge the representative’s obligation to take reasonable steps to understand the product and its suitability for a client. It is important to keep in mind that KYP is a distinct obligation of individual representatives, separate from the product due diligence responsibilities of the firm. Similar to the product due diligence requirements, individual representatives should both understand and be able to explain the following aspects of a product, among other things: Features, including potential returns, use of leverage, conflicts of interest, liquidity, time horizon, and overall complexity of the product Risks, including the risk that clients may lose some or all of their principal investment Costs, including fees paid to the representative and other parties in any combination of commissions, sales charges, trailer fees, management fees, incentive fees, referral fees, or embedded fees, including bid-ask spreads © CANADIAN SECURITIES INSTITUTE 17 28 CANADIAN SECURITIES COURSE      VOLUME 2 More complex investment products and others that carry higher risk might require a more detailed and robust review by the individual representative. An understanding of all products that representatives purchase, sell, or recommend to clients is an essential component of the regulatory requirement to determine suitability. SUITABILITY As set out under the KYC rule, among other responsibilities, mutual fund sales representatives must use due diligence in assessing the suitability of investments within each client’s account. Suitability means ensuring that all client interactions, including account opening, making recommendations, and receiving orders, take the client’s unique situation into account. This responsibility extends to any of the following situations: The client transfers assets into an account at the dealer. The dealer or mutual fund representative becomes aware of a material change in the KYC information. A different mutual fund representative has taken over the client’s account. CIRO’s Mutual Fund Dealer Rules require that mutual fund dealers and their sales representatives maintain an adequate record of each order and of all instructions, given or received, for the purchase or sale of mutual funds. This requirement holds whether or not the transaction is executed. Furthermore, the review must be completed within a reasonable period. In addition to the initial suitability assessment, mutual fund representatives also have an ongoing responsibility to assess that the investments in the client account continue to be suitable. As such, you must maintain documented evidence of all suitability reviews and any follow-up action taken as a result of a review. It is also expected, under Rule 200, Minimum Standards for Account Supervision, that a supervisor, branch manager, or branch compliance officer also perform a suitability review of the investments in a client’s account. They must maintain evidence of that review and any follow-up action taken as a result of their review. The suitability requirement applies to recommendations you make to a client, as well as to unsolicited orders. Unsolicited orders are orders for mutual funds that have not been recommended by the representative; the request comes from the clients. Before accepting an unsolicited order, you must verify that the purchase is reasonable given the client’s personal and financial circumstances, investment objectives, risk profile, investment horizon, and investment knowledge. If you determine that the order is unsuitable for the client, you must advise the client of its unsuitability. If the client wishes to go against your advice, you must maintain the following details in the record of the order: Evidence that the transaction was unsolicited Proof that you performed a suitability review Clear indication that you advised the client that the proposed transaction was unsuitable Before proceeding with an unsuitable, unsolicited trade, you should consult with your branch manager or compliance officer. Mutual fund dealers must have written procedures for dealing with unsuitable, unsolicited orders, and there should be no obligation to accept an unsuitable purchase order from a client. The KYC rule provides a service to the client, the dealer, and the mutual fund dealer’s representative. Having complete details of your client’s financial positions, investment objectives, and risk profile allows you to determine whether your clients’ investments are appropriate for them. INTERPLAY BETWEEN KYC, KYP, AND SUITABILITY The suitability rule requires that you exercise due diligence to ensure that you’re giving your clients advice and recommendations that are suitable for their circumstances. You must also understand the structure, features, risks, and costs of the customer’s investments when making a recommendation. This requirement relates to your obligations under the KYP rule. © CANADIAN SECURITIES INSTITUTE  CHAPTER 17      MUTUAL FUNDS: STRUCTURE AND REGULATION 17 29 Typically, to determine suitability, you’ll match the characteristics and risks of a particular investment to the customer’s investment objectives as set out in their KYC information. Where a product seems unsuitable with a customer’s KYC information, the account should be reviewed or rebalanced. Unless the client’s circumstances have changed, you should not amend the KYC information to match what the client holds. You should also not base a suitability determination solely on investment performance. An investment that loses value is not necessarily unsuitable, and positive investment returns do not make an investment suita