Chapter 18 - CSC.pdf

Mutual Funds: Types and Features 18 CHAPTER OVERVIEW This chapter will discuss the features and risk characteristics of the various types of mutual funds. You will learn...

Mutual Funds: Types and Features 18 CHAPTER OVERVIEW This chapter will discuss the features and risk characteristics of the various types of mutual funds. You will learn about the different fund management styles and strategies, and the theories behind them. You will also learn how to make appropriate recommendations, including price calculation, the various types of withdrawal plans, and the tax consequences of redemption. Finally, you will learn how mutual fund performance is measured and how to assess the performance of one fund against that of another. LEARNING OBJECTIVES CONTENT AREAS 1 | Compare and contrast the features of the Types of Mutual Funds different types of mutual funds. 2 | Differentiate between the mutual fund Fund Management Styles management styles. 3 | Calculate the redemption price of a mutual Redemption of Mutual Fund Units or Shares fund. 4 | Explain the tax consequences of redemptions. 5 | Compare the features and benefits of the types of withdrawal plans. 6 | Explain the process for measuring and Measuring Mutual Fund Performance comparing mutual fund performance. © CANADIAN SECURITIES INSTITUTE 18 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. adjusted cost base index fund asset allocation funds life expectancy-adjusted withdrawal plan balanced funds Modified Dietz method bond funds peer group closet indexing ratio withdrawal plan daily valuation method right of redemption dividend funds systematic withdrawal plans equity funds T3 form fixed-dollar withdrawal plan T5 form fixed-period withdrawal plan target-date funds glide path time-weighted rate of return © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 3 INTRODUCTION When recommending a mutual fund investment to a client, there are many factors to consider before selecting from among the numerous types of funds available. Mutual funds can be categorized based on the types of investments held in the portfolio, the level of risk and reward, and the management style. You should be able to explain the various categories and the implications of choosing a particular fund. Two important factors to consider are the available methods of withdrawal and the tax implications. But before, and after, you recommend a mutual fund, you must assess its performance against a benchmark. There are several methods to choose from to assess performance, and several factors to consider when choosing a benchmark. Canada has regulations regarding performance measures that make it easier to compare similar mutual fund investments. In each mutual fund category, there are many individual funds to choose from. It is essential, therefore, that you be able to assess the risk and return characteristics of a particular fund so that you can make intelligent and well- informed recommendations. TYPES OF MUTUAL FUNDS 1 | Compare and contrast the features of the different types of mutual funds. Mutual funds are distinguished by either their basic investment policy or by the kind of assets they hold. The Canadian Investment Funds Standards Committee (CIFSC) groups Canadian-domiciled mutual funds into several categories, based on the types of assets under management: Money market funds Fixed-income funds Balanced funds Equity funds Commodity funds Specialty funds Target-date funds Alternative Funds The different types of funds offer different risks and rewards to investors. When recommending funds to clients, you have the duty to match the appropriate fund with the particular needs of each client. MONEY MARKET FUNDS As their name implies, money market funds invest in the securities that trade in the money market. All assets in a money market fund are invested in cash, cash-equivalent securities, and short-term debt securities of an approved credit rating. Investments might include Treasury bills, high quality corporate paper, and short-term bonds. Funds in this category include Canadian and U.S. funds. Money market funds add liquidity to a portfolio. They also provide a small stream of income and relative safety of principal. They are considered the least risky type of mutual fund. To comply with National Instrument 81-102, funds designated as money market funds must maintain a minimum weighting of 95% of their total net assets in cash or cash-equivalent securities. © CANADIAN SECURITIES INSTITUTE 18 4 CANADIAN SECURITIES COURSE      VOLUME 2 A feature of these funds is a constant share (or unit) value, often $10. To keep their net asset value per share (NAVPS) constant, the net income of the fund is calculated daily and credited to unitholders. The earned interest is paid out as cash or reinvested in additional shares on a monthly (or sometimes quarterly) basis. Although risk is low, money market funds, like all mutual funds, are not guaranteed. The main risk to these funds is interest rate risk. Fund managers try to maintain a stable NAVPS, but rapid increases in interest rates can reduce the value of the shares. Distributions received from a money market fund are taxable as interest income when they are held outside of a registered plan. Investors must add the interest to their income and pay tax on that portion at their marginal rate. FIXED-INCOME FUNDS Fixed-income funds are designed to provide a steady stream of income and safety of principal, rather than capital appreciation. Funds in this category must invest at least 95% of their non-cash assets in fixed-income securities. This category includes the following fund types: Canadian short-term fixed income Canadian long-term fixed income Canadian inflation-protected fixed income Global fixed income High-yield fixed income High-yield fixed-income funds invest in fixed-income securities with a non-investment-grade credit rating. Otherwise, all mutual funds in the fixed-income category invest primarily in high-quality government and corporate debt securities. Their degree of volatility is related to the degree of interest rate fluctuation. However, fund managers may attempt to change the duration of the portfolio and the mix of low- and high-coupon bonds to compensate for changes in interest rates. Interest rate volatility is the main risk associated with this type of fund. Funds that invest in corporate bonds are also exposed to default or credit risk. The primary source of returns from bond funds is interest income. The investor may also receive a capital gain if the fund sells some of its bonds at a profit. BALANCED FUNDS Balanced funds invest in both stocks and bonds to provide a balanced mix of income and capital growth. Some managers add value by shifting investment proportions in anticipation of market conditions. Otherwise, if diversification is the goal, investors can achieve the same effect by putting their money into more than one fund. This category includes the following fund types: Canadian equity balanced Canadian neutral balanced Canadian fixed income balanced Global equity balanced Global neutral balanced Global fixed income balanced Tactical balanced © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 5 The main investment objective of these funds is, as the name implies, to provide a balanced portfolio of safety, income, and capital appreciation. Fixed-income securities provide stability and income, and a broadly diversified group of common stock holdings provide diversification, dividend income, and growth potential. The balance between defensive and aggressive security holdings is rarely split evenly. Rather, managers of balanced funds adjust the percentage of each part of the total portfolio in accordance with current market conditions and future expectations. In most cases, the prospectus specifies the fund’s minimum and maximum weighting for each asset class. For example, a balanced fund may specify a weighting of 60% equity and 40% fixed income. According to the CIFSC, balanced funds can hold a range of 5% to 90% in equities and 10% to 95% in fixed-income securities. Investors in balanced funds are subject to market and interest rate risk in varying degrees, depending on the split between fixed-income and equity securities. They may receive a combination of interest, dividends, and capital gains, and are taxed accordingly. DID YOU KNOW? Asset allocation funds have similar objectives to those of balanced funds, but they differ in that they typically do not have to hold a specified minimum percentage of the fund in any class of investment. The portfolio manager has great freedom to shift the portfolio weighting among equity, money market, and fixed-income securities as the economy moves through the different stages of the business cycle. These types of funds are subject to the risks and tax implications of balanced funds. EQUITY FUNDS The CIFSC divides equity funds into as many as 24 different subcategories, including the following fund types: Canadian, U.S., and global equity Canadian dividend Canadian and U.S. small- and mid-cap equity International, European, and emerging markets equity Asia Pacific equity Greater China equity Health care, precious metal, natural resources, and real estate equity Funds in the equity category must invest a minimum of 90% of their non-cash assets in equity securities. The main investment objective of equity funds is long-term capital growth. The fund manager invests primarily in the common shares of publicly traded companies. They may purchase short-term notes or other fixed-income securities from time to time in limited amounts for liquidity and, occasionally, income. The bulk of assets, however, are in common shares in the pursuit of capital gains. Because common share prices are typically more volatile than other types of securities, prices of equity funds tend to fluctuate widely. These funds are therefore considered riskier than other fund types. As with common stocks, equity funds range greatly in degree of risk and growth potential. All equity funds are subject to market risk, and investments in markets outside of Canada are subject to foreign exchange rate risk. Some equity funds are broadly diversified holdings of blue chip, income-yielding common shares. This type is classified at the conservative end of the equity fund scale. Other equity funds adopt a slightly more aggressive investment stance. For example, they may invest in emerging growth companies with the objective of above- average growth of capital. © CANADIAN SECURITIES INSTITUTE 18 6 CANADIAN SECURITIES COURSE      VOLUME 2 Still other equity funds are more speculative; they aggressively seek capital gains at the sacrifice of safety and income. These funds invest in certain sectors of the market, such as precious metals, health care, and biotechnology, or in certain geographical locations, such as China, Latin America, and Japan. The tax implications are the same as for any fund that holds equity securities. Distributions are in the form of capital gains and dividends and are taxed accordingly. SMALL-CAP AND MID-CAP EQUITY FUNDS Some Canadian equity funds limit investments to companies with capitalization below those of the hundred largest Canadian companies. These funds are considered to be small- to mid-cap Canadian equity funds. Smaller companies are considered to have higher potential for growth than large, well-established ones. These funds, therefore, offer opportunities that theoretically differ from general Canadian equity funds. Because these young companies tend to reinvest profits into expansion, they do not usually pay dividends. Along with the potential for greater gains comes more volatility than is typically experienced with equity funds that invest in mature blue-chip equities. Distributions in this type of fund are usually in the form of capital gains. DIVIDEND FUNDS Canadian dividend funds provide tax-advantaged income with some possibility of capital appreciation. Dividend funds invest in preferred shares as well as high-quality common shares, with a history of consistently paying dividends. The income from these funds is in the form of dividends, which have the tax advantage of receiving the dividend tax credit. There may be capital gains as well. The price changes that lead to capital gains or losses on dividend funds are driven by changes in interest rates and general market trends. They are thus subject to both interest rate risk and market risk. Price changes in the preferred share component of these funds are driven by interest rate changes. General upward or downward movements in the stock market most heavily affect the common share component. As discussed earlier in this course, preferred shareholders rank ahead of common shareholders, but below bondholders, in the event of bankruptcy or insolvency. Consequently, dividend funds are considered riskier than bond funds, but less risky than equity funds. COMMODITY FUNDS The funds that fall under the commodity grouping must either invest in physical commodities or gain exposure to commodities through the use of derivatives. The exposure to commodities is primarily long and must not exceed 100% by way of leverage. SPECIALTY FUNDS Specialty funds are narrowly focused funds that do not fit easily into any of the broader categories defined above. They concentrate their assets into one main area, such as a specific industry or region. This category includes the following fund types: Retail venture capital Alternative strategies Miscellaneous, including: Income and real property Leveraged Geographic Sector Specialty funds seek capital gains and are willing to forgo broad market diversification in the hope of achieving above- average returns. Because of their narrower investment focus, these funds often carry substantial concentration risk. © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 7 Specialty funds offer some diversification when combined with other fund types in a portfolio. However, they are vulnerable to swings in the industry in which they specialize or, if they have a portfolio of foreign securities, in currency values. Many, but not all, specialty funds tend to be more speculative than most types of equity funds. TARGET-DATE FUNDS Target-date funds (also called target-based funds or life-cycle funds) are structured on the assumption that risk tolerance declines as investors grow older. These funds have two characteristics that distinguish them from other mutual funds—a target date and a glide path—which are described as follows: The target date (i.e., the maturity date) is a date set by the investor to match a certain life goal. The date of retirement is a common target date. The glide path refers to changes in the fund’s asset allocation mix over time. The fund pursues a growth strategy in its early years by holding more risky assets. It then gradually moves towards less risky assets as the target date approaches. The fund manager adjusts the fund over time, without any action required from the fund holder. Target-date funds have their own category under the CIFSC classification. Upon maturity, they are moved out of the target-date group and included in the appropriate fixed-income or balanced fund category. EXAMPLE Your client Angela plans to retire in 2032. In 2022, she bought a 2032 target-date fund. At the time of purchase, the fund’s asset allocation was 70% equity and 30% fixed income in the early years and will change over time to gradually lower its risk level. By the 2032 target date, Angela’s fund will have an allocation mix of 20% equity and 80% fixed income. ALTERNATIVE FUNDS Funds in the Alternative Funds category employ alternative strategies such as short selling or other forms of leverage that the typical mutual fund is not permitted to use. Funds in this category may use speculative as well as hedging strategies. Funds that do not issue a simplified prospectus will not be ranked with the funds in this category. Subcategories include Alternative Equity Focused, Alternative Credit Focused, Alternative Multi-Strategy, Alternative Market Neutral and Alternative Other. The Alternative Other category includes those funds that employ a unique strategy that does not fit into any of the other subcategories. More information on alternative funds can be found in Chapter 20 and 21. INDEX FUNDS An index fund sets out to match the performance of a broad market index, such as the S&P/TSX Composite Index (for an equity index fund) or the FTSE Canada Universe Bond Index (for a bond index fund). Index funds are not specifically listed in these categories; instead, they are categorized under the type of asset class they tend to replicate. EXAMPLE ABC Fund replicates the FTSE Canada Universe Bond Index. This fund is categorized as Fixed-Income Fund— Canadian Fixed Income. The index fund manager invests in the securities that make up the model index, in the same proportion that these securities are weighted in the index. EXAMPLE DEF Fund replicates the S&P/TSX Composite Index, and the Bank of Montreal represents 0.75% of that index. DEF Fund must therefore include 0.75% of Bank of Montreal stock. © CANADIAN SECURITIES INSTITUTE 18 8 CANADIAN SECURITIES COURSE      VOLUME 2 Overall, the management fees associated with index funds are usually lower than those of other equity or bond funds. Investing in an index fund is therefore a low-cost way for an investor to pursue a passive investment strategy. The investment objective of an equity index fund is to provide long-term growth of capital. These funds are subject to market risk because the portfolio is tied to the performance of the market. With a bond index fund, the main risk is interest rate risk. The distributions of an index fund depend on the type of index being matched. For example, the income of a fund matching a bond index will be primarily interest, with some capital gains. An index fund matching an equity index, on the other hand, may have dividend and capital gains distributions. DID YOU KNOW? The RI Marketplace, the Responsible Investment Association’s online directory of Canadian RI products, includes a comprehensive list of responsible investment products including mutual funds, segregated funds, and ETFs. The most common types of retail RI product in the RI Marketplace are mutual funds and exchange-traded funds. For more information on RI investment products, please visit https://www.riacanada.ca/ri-marketplace/ COMPARING FUND TYPES The variety of funds provided by the mutual fund industry are designed to meet the diverse needs of the Canadian investing public. Because each fund category holds different types of securities and pursues different investment objectives, the risk and return between the various funds also differ. Figure 18.1 illustrates the risk-return trade-off between the different categories of mutual funds. Note: Target-date funds are not included in the diagram because the risk profile of this type of fund changes over its lifetime, and commodity funds and alternative funds are not included because of the various investment methods employed. Figure 18.1 | Risk and Return Between Different Types of Mutual Funds High Specialty Funds Equity Funds Return Balanced Funds Fixed Income Funds Money Market Funds Low High Risk © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 9 DID YOU KNOW? There can be a large range of risk-return profiles within the same fund category. For example, consider two typical equity funds: a Canadian dividend fund and an emerging markets equity fund. The risk profile of the dividend fund may be significantly lower than that of the emerging markets fund. FUND MANAGEMENT STYLES 2 | Differentiate between the mutual fund management styles. The absolute and relative return of a portfolio can be attributed first to the choice of asset class, and second to the style in which it is managed. To measure fund performance, you must understand the investment style of its manager. Managers employing a particular strategy may outperform or underperform others using a different strategy over the same periods. Management style falls into either of two broad categories: passive and active. A passive investment strategy involves some form of indexing to a market or a customized benchmark. An active investment strategy, in contrast, is designed to outperform the market benchmarks. Overall, funds that follow a passive strategy report lower management expense ratios than funds that pursue an active strategy. Most equity styles of management are active. At any one time, several of many different active investment styles may be in favour or out of favour. Active management may involve individual company selection, over-weighting in favoured segments of industry sectors, or country selection for regional funds. The various equity and fixed-income manager styles that we discussed in previous chapters also apply to mutual funds. As an example, if you consider yourself an active investor, you might diversify your portfolio using a mix of growth and value investments. The same strategies hold true when investing in mutual funds. You could diversify your portfolio of mutual funds by holding both a value mutual fund and a growth mutual fund. You can then reduce volatility while maintaining an opportunity for higher returns than the returns of the market as a whole. INDEXING AND CLOSET INDEXING Indexing and closet indexing are two passive styles that some mutual fund managers apply to their investment strategy. There are advantages and disadvantages to both of these styles. Indexing is a passive style of investing in securities that constitute or closely replicate the performance of a market benchmark such as the S&P/TSX Composite Index or the S&P 500 Composite Index. The indexing style is a low- cost, long-term, buy-and-hold strategy, with no need to conduct individual securities analysis. Many index funds, particularly those that provide foreign exposure, rely on a combination of stock index futures and Canadian Treasury bills. Closet indexing does not replicate the market exactly, but sticks fairly closely to the market weightings by industry sector, by country or region, or by average market capitalization. Some active managers are closet indexers. Their style can be determined by how closely their returns, volatility, and average market capitalization correspond to the index as a whole. The concept of index funds is generally simpler for investors to understand than other management styles: the funds simply buy the same stocks as the index. Because they do not need analysts for stock selection, management fees are lower than for actively managed funds. A final advantage is that indexing makes for low portfolio turnover, which is an advantage for taxable accounts. © CANADIAN SECURITIES INSTITUTE 18 10 CANADIAN SECURITIES COURSE      VOLUME 2 Because the indexing style is essentially a strategy that mirrors the market, the opportunity to outperform the market is lost. Another disadvantage is that, after the payment of fees and expenses, index mutual funds return somewhat less than the market benchmark in the long term. A further disadvantage of this style is that distributions in the form of derivative-based income are taxable as income rather than as capital gains. REDEMPTION OF MUTUAL FUND UNITS OR SHARES 3 | Calculate the redemption price of a mutual fund. 4 | Explain the tax consequences of redemptions. 5 | Compare the features and benefits of the types of withdrawal plans. After acquiring shares or units in a mutual fund, the investor may wish to dispose of them and use the proceeds. The mechanics of disposing of fund units are fairly straightforward. For example, to redeem your client’s mutual fund units would require the following three steps: 1. The client contacts you and asks to sell or redeem fund units. 2. You then place the trade request with the fund or the fund’s distributor through your dealer. 3. At the end of the valuation day, the fund calculates the net asset value, and the proceeds are sent to the investor. Most funds also allow investors to redeem shares or units over time using various systematic withdrawal methods, which we will discuss later in this chapter. However, there are several tax consequences of redemption that you need to consider first. TAX CONSEQUENCES OF REDEMPTION Mutual funds redeem their shares on request at a price that is equal to the fund’s NAVPS and the investor receives the NAVPS amount. Mutual funds can generate taxable income in one of two ways: Through the distribution of interest income, dividends, and capital gains realized by the fund Through any capital gains realized when the investor sells the fund DID YOU KNOW? Transactions that occur within a fund (such as the buying and selling of individual stocks or bonds) could result in income distributions to fund investors, such as a capital gain, in the year the distribution occurs. On the other hand, when mutual fund investors sell their shares of a fund, they simply receive the cash. Because such transactions do not occur within the fund, any capital gain realized results from the investor’s action, not a transaction within the fund itself. ANNUAL DISTRIBUTIONS When mutual funds are held outside a registered plan such as a registered retirement savings plan or a registered retirement income fund, the fund holder is sent either a T3 form (for unitholders) or a T5 form (for shareholders). Both tax forms report the types of income distributed that year: foreign income and Canadian interest, capital gains, and dividends, including dividends that have been reinvested. Each type of income is taxed at the fund holder’s personal rate in the year received. © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 11 EXAMPLE Lewis purchases an equity mutual fund for $11 per share. In each of the next five years, he receives $1 in annual distributions per share, composed of $0.50 in dividends and $0.50 in distributed capital gains. Each year, Lewis receives a T5 from the fund indicating that he must report to the Canada Revenue Agency an additional $1 per share in income. The T5 may indicate offsetting dividend tax credits (from dividends earned from taxable Canadian corporations). It is sometimes difficult for mutual fund clients to understand why they have to declare capital gains when they have not sold any of their funds. There is, however, a simple explanation: the fund manager buys and sells stocks throughout the year for the fund. If the manager sells a stock for more than it was bought, the capital gain that results is passed on to the fund holder. Capital losses, however, cannot be passed on. Instead, they are held in the fund and may be used to offset capital gains in subsequent years. CAPITAL GAINS When a fund holder redeems the shares or units of the fund itself, the transaction is considered a disposition for tax purposes. As such, it could give rise to either a capital gain or a capital loss. Only 50% of net capital gains is added to the investor’s income and taxed at their marginal rate. (Net capital gains is equal to total capital gains less total capital losses.) EXAMPLE Suppose a mutual fund shareholder buys shares in a fund at a NAVPS of $11 and later sells them at a NAVPS of $16. The sale generates a capital gain of $5 per share. The investor must therefore report an additional $2.50 per share in income for the year (calculated as 50% × $5 capital gain). This capital gain is not shown on the fund’s T5 form because the sale was not a fund transaction. DISTRIBUTIONS TRIGGERING UNEXPECTED TAXES Throughout the year, mutual funds generate capital gains and losses when they sell securities. Distribution of capital gains follows the same schedule as interest and dividends. If the distribution of capital gains is carried out only at year end, it can pose a problem for investors who purchase a fund close to the end of the year. EXAMPLE Consider an investor with a marginal tax rate of 40% who purchases an equity mutual fund through a non- registered account on December 1 at a NAVPS of $30. This fund had a very good year and earned capital gains of $6 per share. These capital gains are distributed to the investors at the end of December, either as reinvested shares or as cash. As is the case with all distributions, the NAVPS falls by the amount of the distribution, in this case to $24. The NAVPS of the investor’s portfolio after the distribution is calculated as follows: $30.00 − $6.00 = $24.00 At first glance, you might think that the investor is just as well off, given that the new NAVPS plus the $6 distribution equals the original NAVPS of $30. Unfortunately, the $6 distribution is taxable in the hands of the investor, even though it was earned over the course of the full year. Assuming that the $6 was a net capital gain, the tax consequences are calculated as follows: 50% × $6.00 × 40% (marginal tax rate) = $1.20 taxes payable per share Because of the tax implications, some investment advisors caution their clients against buying a mutual fund just before year end. They should first check with the fund sponsor to determine whether a capital gains distribution is pending. © CANADIAN SECURITIES INSTITUTE 18 12 CANADIAN SECURITIES COURSE      VOLUME 2 ADJUSTING THE COST BASE A problem may arise when an investor chooses to reinvest fund income automatically in additional, non-registered fund units. When the fund is sold, the capital gain must be calculated on the difference between the original purchase price and the sale price. The total sale price of the fund includes the original units purchased plus those units purchased over time through periodic reinvestment of fund income. This mix of original and subsequent units can make it difficult to calculate the adjusted cost base of the investment in the fund. The adjusted cost base refers to the total cost of purchase plus commission expenses. If careful records have not been kept, the investor could be taxed twice on the same income. Many investment funds provide this information on quarterly or annual statements. If these statements are not kept, it can be very time consuming to attempt to reconstruct the adjusted cost base of the investment. EXAMPLE Maryam buys $10,000 of fund units. Over time, annual income is distributed and Maryam pays tax on it, but she chooses to reinvest the income in additional fund units. Several years later, the total value of her portfolio rises to $18,000 and Maryam decides to sell the fund. An uninformed observer might assume that Maryam has incurred a capital gain of $8,000. However, the $8,000 increase is actually made up of two parts: a capital gain and the reinvestment of income on which she has already paid tax. To arrive at the adjusted cost base, the portion of the increase from reinvestment must be added to the original investment of $10,000. The capital gain is calculated on this adjusted cost base. Suppose, for example, that Maryam had received a total of $3,500 in reinvested dividends over the course of the holding period. The adjusted cost base would then be $13,500 (the original $10,000 plus the $3,500 in dividends that have already been taxed). The capital gain is then $4,500, rather than $8,000. TAX CONSEQUENCES What are the tax consequences when distributions from a mutual fund are automatically reinvested? Complete the three online learning activities to assess your knowledge. REINVESTING DISTRIBUTIONS Many funds, unless otherwise advised, automatically reinvest distributions into new shares at the prevailing net asset value, without a sales charge on the shares purchased. Most funds also have provisions for shareholders to switch from cash dividends to dividend reinvestment, and vice versa. The reaction of the NAVPS to a distribution of funds is similar to that of a stock the day it begins to trade ex- dividend. The NAVPS falls by an amount proportionate to the dividend. Because most investors receive their dividends in the form of more units rather than cash, the net result of the distribution is that the investor owns more units, but the units are each worth less. For example, assume that on the day before a dividend distribution, a fund of $9,000,000 has 1,000,000 units outstanding. The NAVPS of the fund is therefore $9.00 (calculated as $9,000,000 ÷ 1,000,000 = $9.00). The fund decides to pay a dividend of $0.90 per unit (for $900,000 in total), bringing the value of the fund to $8,100,000. The NAVPS after the distribution is therefore $8.10 (calculated as $8,100,000 ÷ 1,000,000 = $8.10). © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 13 Table 18.1 shows the impact of the distribution on the total net assets of the fund. Table 18.1 | Impact of a Distribution on Total Net Assets After Distributions Before Distribution After Distribution Are Reinvested Assets Portfolio $8,075,000 $8,075,000 $8,075,000 Cash 950,000 50,000* 950,000 Liabilities Expenses (25,000) (25,000) (25,000) Total Net Assets $9,000,000 $8,100,000 $9,000,000 * Distributions payable: $950,000 cash − ($0.90 dividend × 1,000,000 units outstanding). Because the investors receive their distribution in new units, the fund now has 1,111,111.11 units worth $8.10 each (calculated as $900,000 ÷ $8.10 = 111,111.11, plus the original 1,000,000 units). Total fund assets are still $9,000,000. These assets never actually leave the company; they are reinvested in the fund. As a result, the investor ends up with more units worth less each. As Table 18.2 illustrates, the net effect is that the investor’s portfolio is worth the same amount. An investor who owns 1,000 units of the fund would receive a distribution worth $900.00 (calculated as 1,000 units × $0.90), which is invested into new units. These new units now have a NAVPS of $8.10. The investor would receive $900 ÷ $8.10 = 111.11 units. The investor now has a total of 1,111.11 units (calculated as 1,000 + 111.11). Table 18.2 | Impact of a Distribution on Value of Investment Before Distribution After Distribution 1,000 units × $9.00 $9,000 1,111.11 × $8.10 $9,000 Those who are new to mutual funds often wonder if there is value in reinvesting distributions into an investment that doesn’t seem to change much over time. The following example demonstrates that value, and the power of reinvested distributions. © CANADIAN SECURITIES INSTITUTE 18 14 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Assume that Martha purchases a no-load mutual fund with $10,000 when the mutual fund units trade at $10. At the end of the year, any distribution is used to purchase additional units at the year-end price. Table 18.3 demonstrates how Martha’s investment grows (excluding taxes), even though the unit price of the mutual fund seems to change very little over time. Table 18.3 | Investment Growth Despite Little Change in Price Year-End Year-End Beginning Unit Price Before Price After New Units Price Units Owned Distribution Distribution Distribution Purchased Year 1 $10.00 1,000 $11.50 $1.00 per unit $10.50 95.24* Year 2 $10.50 1,095.24 $12.00 $1.00 per unit $11.00 99.57 Year 3 $11.00 1,194.81 $11.50 $1.00 per unit $10.50 113.79 Year 4 $10.50 1,308.60 At the end of Year 3, after the $1.00 per unit distribution was reinvested at a price of $10.50, she would be left with a total of 1,308.60 units. Her investment value would be $13,740.26 (calculated as $10.50 per unit × 1,308.60 = $13,740.26). So even though the price per unit doesn’t appear to have changed much in the past three years, Martha’s investment in the fund has grown considerably. * With the $1,000 distribution, Martha purchases 95.24 units at $10.50 per unit (calculated as $1,000 ÷ $10.50 per unit = 95.24 units). WITHDRAWAL PLANS A mutual fund’s shareholders have a continual right to withdraw their investment in the fund simply by making the request to the fund itself. In return, they receive the dollar amount of their net asset value. This characteristic is known as the right of redemption and it is the hallmark of mutual funds. Withdrawal plans have evolved to meet the needs of investors who require regular income and tax efficiency, and who do not want to withdraw their entire investment in a lump sum. Retiring and retired investors most commonly fit this profile. To meet their needs, many funds offer one or more systematic withdrawal plans. In simple terms, rather than withdrawing the entire amount at once, the investor instructs the fund to pay out part of the capital invested, plus distributions, over time. Withdrawals may be arranged monthly or quarterly, or at other predetermined intervals. If the fund invests its assets successfully, the increased worth of its shares helps offset the reduction of principal that results from withdrawals. However, if the investment decreases in value, the investor’s entire investment may be extinguished earlier than expected. This is a real risk that must be explained to investors contemplating withdrawal plans. RATIO WITHDRAWAL PLAN With a ratio withdrawal plan, the investor receives an annual income from the fund by redeeming a specified percentage of fund holdings each year. The percentage chosen for redemption usually falls between 4% and 10% per year, depending on the amount of income the investor requires. Obviously, the higher the percentage, the more rapid the rate of depletion of the investor’s original investment. And, because the payout is a set percentage of the value of the fund, the amounts may vary each time. © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 15 Table 18.4 shows an example of a ratio withdrawal plan. We have assumed in this scenario, and each of the examples that follow, that the portfolio will grow by a steady 8% per year. In this example, we have also assumed that the investor wishes to withdraw 10% at the beginning of each year. Table 18.4 | Ratio Withdrawal Plan The value of each withdrawal will vary from year to year. Value at Value of Value at End Beginning of Year Withdrawal of Year Year 1 $100,000 × 10% = $10,000 ($90,000 × 1.08 = 97,200) Year 2 $97,200 × 10% = $9,720 ($87,480 × 1.08 = 94,478) Year 3 $94,478 × 10% = $9,448 ($85,030 × 1.08 = 91,833) Year 4 $91,833 × 10% = $9,183 ($82,650 × 1.08 = 89,262) Year 5 $89,262 × 10% = $8,926 ($80,336 × 1.08 = 86,763) FIXED-DOLLAR WITHDRAWAL PLAN A fixed-dollar withdrawal plan is similar to a ratio withdrawal plan except that the fund holder chooses a specified dollar amount to be withdrawn on a monthly or quarterly basis. Funds offering this type of plan often require that withdrawals be in round amounts (e.g., $50 or $100). If the investor’s fixed withdrawals are greater than the growth of the fund, the withdrawals will encroach upon the principal. Table 18.5 shows an example of a fixed-dollar withdrawal plan. In this case, a fixed amount of $10,000 is withdrawn at the beginning of each year. Table 18.5 | Fixed-Dollar Withdrawal Plan Value at Value of Value at End Beginning of Year Withdrawal of Year Year 1 $100,000 − $10,000 ($90,000 × 1.08 = $97,200) Year 2 $97,200 − $10,000 ($87,200 × 1.08 = $94,176) Year 3 $94,176 − $10,000 ($84,176 × 1.08 = $90,910) Year 4 $90,910 − $10,000 ($80,910 × 1.08 = $87,383) Year 5 $87,383 − $10,000 ($77,383 × 1.08 = $83,574) FIXED-PERIOD WITHDRAWAL PLAN With a fixed-period withdrawal plan, a specified amount is withdrawn over a pre-determined period with the intent that all capital will be exhausted when the plan ends. Table 18.6 shows an example of a fixed-period withdrawal plan where the investor has decided to collapse the plan over five years. In this case, a specific fraction is withdrawn at the beginning of each year. © CANADIAN SECURITIES INSTITUTE 18 16 CANADIAN SECURITIES COURSE      VOLUME 2 Table 18.6 | Fixed-Period Withdrawal Plan Value at Percentage Beginning of Capital Value of Value at End of Year Withdrawn Withdrawal of Year Year 1 $100,000 × 20% = $20,000 ($80,000 × 1.08 = 86,400) Year 2 $86,400 × 25% = $21,600 ($64,800 × 1.08 = 69,984) Year 3 $69,984 × 33.3333% = $23,328 ($46,656 × 1.08 = 50,388) Year 4 $50,388 × 50% = $25,194 ($25,194 × 1.08 = 27,209) Year 5 $27,209 × 100% = $27,209 $0 LIFE EXPECTANCY-ADJUSTED WITHDRAWAL PLAN A life expectancy-adjusted withdrawal plan is a variation of a fixed-period withdrawal plan. Withdrawals are designed to deplete the entire investment by the end of the plan, while providing as high an income as possible during the plan holder’s expected lifetime. The amount withdrawn on each date is based on periods that are continually readjusted to the changing life expectancy of the plan holder. Readjustments are based on mortality tables. Therefore, the amounts withdrawn vary in relation to the amount of capital remaining in the plan and the plan holder’s revised life expectancy. Table 18.7 shows an example of a life expectancy-adjusted withdrawal plan. Based on actuarial tables, it is assumed in this scenario that the client is currently age 75 and is expected to live to age 85. Table 18.7 | Life Expectancy-Adjusted Withdrawal Plan Value of the Portfolio Life Expectancy − Current Age Value at Value of Value at End Beginning of Year Withdrawal of Year $100,000 Year 1 $100,000 = $10,000 ($90,000 × 1.08 = $97,200) 85 − 75 $97,200 Year 2 $97,200 = $10,800 ($86,400 × 1.08 = $93,312) 85 − 76 $93,312 Year 3 $93,312 = $11,664 ($81,648 × 1.08 = $88,180) 85 − 77 Etc. SUSPENSION OF REDEMPTIONS As with all rules, there are exceptions. Securities commissions require all Canadian mutual funds to make payment on redemptions within a specified time; however, redemption suspensions are permitted in rare cases. Almost all funds reserve the right to suspend or defer a shareholder’s privilege to redeem shares, if necessary. For example, a suspension might be invoked if normal trading is suspended on securities that represent more than 50% of securities owned by the fund. Obviously, if the fund cannot determine the NAVPS, it cannot determine the redemption price of a unit or share. © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 17 MEASURING MUTUAL FUND PERFORMANCE 6 | Explain the process for measuring and comparing mutual fund performance. Mutual fund investors must be able to measure the performance of their fund over specific evaluation periods. Only by doing so can they tell how well the fund’s manager has done over that period relative to the cost of management. The tools and techniques used to measure performance judge their historical performance, either in isolation or in comparison to other mutual funds. Although past performance is never a guarantee of future performance, it can reveal certain historical trends or attributes that offer some insight into future performance. Performance data is freely available from several sources: the mutual fund companies themselves, independent research firms such as Morningstar and Globe Investor, and monthly reports in national newspapers. Morningstar, Globe Investor, and other publications and firms also offer more in-depth research and analysis for a fee. READING MUTUAL FUND QUOTES Many financial sources report the current net asset values of mutual funds on either a daily or weekly basis. The financial press sometimes includes simple and compound rates of return, the volatility of each fund, the expense ratio, and the maximum sales or redemption charge of each fund. Table 18.8 shows a typical quotation for a mutual fund that traded in the last 52-week period. Table 18.8 | Reading Mutual Fund Quotations Friday Data Rate of Return Weekly Data High Low Fund Vty Cls $chg %chg 1mo 1yr 3yr 5yr High Low Cls $chg %chg ABC 16.73 14.50 4 16.62 −.06 −.36 4.0 6.3 10.0 7.9 16.73 16.62 16.62.01.06 Growth The quotation shown in Table 18.8 may vary in format among financial sources. Though complex, it is very useful. It shows the following information: The NAVPS of the fund ABC Growth has traded as high as $16.73 per share and as low as $14.50 during the last 52 weeks. Vty is a measure of fund volatility (i.e., the variability in returns over the previous three-year period compared with other funds in this asset class). The scale is from 1 to 10. Funds with a Vty of 1 have the lowest variability in returns; funds with a Vty of 10 have the highest variability in returns. During the day under review, ABC Growth closed at a NAVPS of $16.62. The fund closed down $0.06 from the previous trading day, representing a −0.36% fall over the previous day. ABC Growth had a one-month rate of return of 4%, a one-year rate of return of 6.3%, a three-year rate of return of 10% and a five-year rate of return of 7.9%. The rate of return assumes that all dividends have been reinvested in the fund. Over the previous week, ABC Growth traded at a high of $16.73 and at a low of $16.62, finally closing at a NAVPS of $16.62, for a dollar increase of $0.01 and a percentage increase of 0.06% from the previous week. The performance of money market funds is presented somewhat differently. Because of the relatively fixed NAVPS that these funds maintain, financial sources generally do not report the NAVPS. Instead, they report each fund’s current and effective yield. The current yield reports the rate of return on the fund over the most recent seven-day © CANADIAN SECURITIES INSTITUTE 18 18 CANADIAN SECURITIES COURSE      VOLUME 2 period expressed as an annualized percentage. The effective yield is the rate of return that would result if the current yield were compounded over a year, thereby allowing comparison with other types of compounding investments. In following the performance of a fund in the financial media, you should be aware that dividends and interest earned by the fund’s investments are distributed periodically. Many investors use these distributions to automatically purchase additional units in the fund. When distributions are made, the NAVPS is decreased by the amount of the distribution, which can be disconcerting for investors. You should explain to your clients that, under automatic reinvestment plans, the distributions are used to purchase additional shares. Therefore, your clients are just as well off as they were before the distribution decreased the NAVPS. MEASURING MUTUAL FUND PERFORMANCE Performance is measured by calculating the return realized by a portfolio manager over a specified time interval called the evaluation period. The most frequently used method to measure mutual fund performance is to compare NAVPS at the beginning and at the end of the period. Usually, this method is based on several assumptions, including the assumption that all dividends are reinvested. The increase or decrease at the end of the period is then expressed as a percentage of the initial value. EXAMPLE Beginning NAVPS = $19.50 Ending NAVPS = $21.50 Gain = 10.26%, calculated as [($21.50 − $19.50) ÷ $19.50] × 100 = 10.26% This calculation assumes that the investor made no additions to, or withdrawals from, the portfolio during the evaluation period. If funds were added or withdrawn, then the result may be inaccurate. TIME-WEIGHTED RATE OF RETURN When you are measuring the return on a mutual fund, it is important to minimize the effect of investor contributions and withdrawals because they are beyond the control of the portfolio manager. You can do this by using a time-weighted rate of return (TWRR), which measures the actual rate of return earned by the portfolio manager. The TWRR is calculated by averaging the return for each sub-period in which a cash flow occurs to create a return for the reporting period. Therefore, unlike a total return, it does account for cash flows such as deposits, withdrawals, and reinvestments. Methods of calculating a time-weighted return include the daily valuation method and the Modified Dietz method. Daily valuation With this method, the incremental change in value from day to day is expressed as an method index from which the return can be calculated. This method is beneficial for mutual funds, which generally calculate NAVPS daily. It greatly simplifies their return calculation at the end of the month. The main drawback is the need to value the portfolio every day. It can be difficult to price the daily market value of such assets as real estate, mortgage- backed securities, and illiquid issues. © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 19 Modified Dietz method This method reduces the extensive calculations of the daily valuation method by providing a good approximation. It assumes a constant rate of return through the period, eliminating the need to value the portfolio on the date of each cash flow. The Modified Dietz method weights each cash flow by the length of time it is held in the portfolio. STANDARD PERFORMANCE DATA Canadian regulators have instituted standard performance data that specify the minimum return measures that mutual fund companies must include, and how they are to be calculated. These measures ensure that mutual fund returns are comparable across different funds and fund companies. When they are presented in sales communications, they must be printed as prominently as any other performance data that the mutual fund company provides. For mutual funds other than money market funds, standard performance data include compounded annual return periods of one, three, five, and 10 years, as well as the total period since inception of the fund. For money market funds, the standard performance data include the current yield and the effective yield. In the role of a mutual fund advisor, you should look at periods of three to five years or more, as well as individual years. Nevertheless, it is reasonable to ask questions if the fund is significantly different from the average in its category. Always keep in mind, however, that past performance is not indicative of future performance. DID YOU KNOW? There is no single appropriate investment time horizon for rating risks and returns, and the practices of industry analysts vary considerably. For long-term funds, a three-year period is generally regarded as a bare minimum. More weight can be attached to longer periods of five to 10 years, or at least two market cycles. COMPARATIVE PERFORMANCE Return data is useful in telling us how much a particular fund earned over a given period. However, its usefulness is limited because it does not indicate whether the fund was performing well or poorly, especially relative to other funds in its group. To determine the quality of fund performance, you must compare the return against some standard. For mutual funds, there are two general standards of comparison: the return on a fund’s benchmark index and the average return on the fund’s peer group of funds. BENCHMARK COMPARISON All mutual funds have a benchmark index against which their return can be measured. Examples include the S&P/TSX Composite Index for broad-based Canadian equity funds and the FTSE Canada Universe Bond Index for bond funds. If a fund reports a return that is higher than the return on the index, we can say that the fund has outperformed its benchmark. If it reports a return that was lower than the return on the index, it has underperformed its benchmark. Morningstar Canada has developed a series of mutual fund benchmarks that summarize average rates of return for Canadian bond, Canadian equity, U.S. equity, global bond, and international equity funds. These indexes, which are available on the firm’s website, provide a benchmark that investors can use to measure the relative performance of various funds. © CANADIAN SECURITIES INSTITUTE 18 20 CANADIAN SECURITIES COURSE      VOLUME 2 PEER GROUP COMPARISONS A peer group is made up of mutual funds with a similar investment mandate. To measure the performance of a fund, its return is compared to the average return of the peer group. Therefore, if a fund posted a one-year return of 12% while the average return of its peer group over the same period was 9%, we can say that the fund outperformed its peer group over the evaluation period. ISSUES THAT COMPLICATE MUTUAL FUND PERFORMANCE When comparing mutual fund performance, one must avoid comparing the performance of two funds that are dissimilar (e.g., a fixed-income fund versus a growth equity fund) or comparing funds that have differing investment objectives or degrees of risk acceptance. One complicating factor occurs when the name or class of fund does not accurately reflect the actual asset base of the fund. Investors should be aware, for example, that funds classified as Canadian equity funds may at times have significant portions of their assets invested in equities other than Canadian stocks. This is not to suggest that the fund manager is doing something wrong. Each manager must consider market trends and adjust the timing of the fund’s investments. It does, however, suggest that the published results are often comparing apples with oranges. This discrepancy between a fund’s formal classification and its actual asset composition can impair attempts to create a portfolio. For example, an investor who wished to allocate 10% of a portfolio to gold stocks might be surprised to find that, at some points, gold mutual funds are holding 50% of their assets in cash. The result is an actual asset allocation of 5% in gold, rather than the desired 10%. Another factor that complicates comparisons between funds is that there is often no attempt to consider the relative risk of funds of the same type. One equity fund may be conservatively managed, whereas another is willing to invest in much riskier stocks in an attempt to achieve higher returns. Any assessment of fund performance should consider the volatility of a fund’s returns. The measures of volatility attempt to quantify the extent to which returns will fluctuate. From an investor’s standpoint, a fund that exhibits significant volatility in returns is riskier than those with less volatility. The following measures are used to quantify mutual fund volatility: The standard deviation of the fund’s returns, which, if high, might indicate future volatility Beta, which relates the change in the price of a security to the change of the market as a whole The number of calendar years it has lost money The fund’s best and worst 12-month periods The fund’s worst annual, quarterly, or monthly losses Other methods, which look at different time periods, can be used to calculate best-case and worst-case scenarios. Ratings systems based on multiple periods avoid placing too much emphasis on how well or poorly the fund did during a particular short-term period. When dealing with mutual funds in the role of an advisor, you should be aware of a fund’s performance relative to the stock market cycle. Some funds will outperform others in rising markets, but do worse than average in declining markets. The beta, available on most fund performance software, measures the extent to which a fund is more or less volatile than the underlying market in which it invests. The greater the variation in the fund’s returns, the riskier it tends to be. Particular attention should be paid to periods during which a fund has lost money. DID YOU KNOW? Software products that permit advisors to review performance and sort funds according to various criteria include Globe HySales and Morningstar PALTrak. © CANADIAN SECURITIES INSTITUTE  CHAPTER 18      MUTUAL FUNDS: TYPES AND FEATURES 18 21 PITFALLS TO AVOID IN JUDGING MUTUAL FUND PERFORMANCE When judging a mutual fund’s performance, there are various issues to consider that may lead to flawed conclusions. The following considerations are some of the common issues to avoid: Past performance is not indicative of future performance. Especially in a general market downturn, there is no guarantee that any fund will be able to maintain or improve on its past performance. Nevertheless, mutual fund advisors often scrutinize the past in an attempt to predict future performances. Historical performance may be especially irrelevant when there has been a change in portfolio manager. Some observers argue that the performance of a fund is a direct reflection of the skill of the portfolio manager. Although average returns for a peer group of funds are useful measures, they can reflect survivorship bias. This term describes a tendency for poorly performing funds to be discontinued or merged. Therefore, average returns of surviving funds may be artificially high because they do not fully reflect past performance of the entire spectrum of funds. Mutual fund performance evaluations should consider both the type of fund and its investment objectives. Bond funds cannot be compared with equity funds, nor should you compare equity funds with different investment objectives. Finally, beware of selective reporting of performance periods, especially when there are no comparable numbers for the performance of a market benchmark or a peer group of competing funds. MEASURING MUTUAL FUND PERFORMANCE Can you evaluate the performance of various types of mutual funds? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 18 22 CANADIAN SECURITIES COURSE      VOLUME 2 SUMMARY In this chapter, we discussed the following key aspects of mutual funds: The CIFSC groups Canadian-domiciled mutual funds into several categories: money-market, fixed income, balanced, equity, commodity, specialty, alternative and target-date funds. Passive management involves indexing to a market or a customized benchmark. Active managers try to outperform market benchmarks by using active asset allocation and selection. Mutual funds held in registered accounts have no immediate tax consequences on redemption. Those held in non-registered accounts are subject to tax on capital gains when the fund is sold, as well as on annual distributions of income and capital gains earned within the fund. Mutual funds offer several types of systematic withdrawal plans: ratio withdrawal, fixed-dollar withdrawal, fixed-period withdrawal, and life expectancy-adjusted withdrawal. Performance is measured by calculating the return realized by a portfolio manager over a specified period. A TWRR minimizes the effect of contributions and withdrawal by investors. The daily valuation method measures the incremental change in fund value from day to day. The Modified Dietz method reduces the extensive calculations of the daily valuation method by providing a good approximation. The quality of a fund’s performance is determined by comparing it against a relevant standard, which is either a fund’s benchmark index or the average return on the fund’s peer group of funds. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 18 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 18 FAQs. © CANADIAN SECURITIES INSTITUTE