Chapter 22 - Other Managed Products PDF

Other Managed Products 22 CHAPTER OVERVIEW In this chapter, you will learn about additional types of managed products, including their structure and characteristics, their regulatory issues and tax considerations....

Other Managed Products 22 CHAPTER OVERVIEW In this chapter, you will learn about additional types of managed products, including their structure and characteristics, their regulatory issues and tax considerations. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the features and structure of Segregated Funds segregated funds. 2 | Discuss the advantages and disadvantages Labour-Sponsored Venture Capital of Labour-Sponsored Venture Capital Corporations Corporations. 3 | Describe the features and structure of Closed-End Funds closed-end funds. 4 | Differentiate among the types of Income Trusts income trusts. 5 | Describe the advantages, disadvantages, and Listed Private Equity process for investing in private equity. © CANADIAN SECURITIES INSTITUTE 22 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. allocation insurable interest annuitant interval funds Assuris irrevocable designation beneficiary labour-sponsored venture capital corporations business trust maturity guarantees Canadian Life and Health Insurance notional units Association Inc. Office of the Superintendent of Financial closed-end discretionary funds Institutions closed-end funds private equity contract holder probate creditor protection real estate investment trusts death benefits reset income trust revocable designation individual variable insurance contracts segregated fund © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 3 INTRODUCTION In the last five chapters, we discussed mutual funds and exchange-traded funds, which are the most common types of managed products, along with alternative funds such as hedge funds and liquid alts. In this chapter, we look at other types of managed products that have been developed to meet specific investor needs. All managed products have some characteristics in common with mutual funds. For example, they all pool capital to purchase securities according to a specific investment mandate. They are all managed by either an active or passive manager who is paid a fee to carry out the mandate. And they all share certain features, such as economies of scale and low cost of diversification. However, given that the various types of managed products are designed to meet particular needs, each type also has unique characteristics. In this chapter, we discuss the characteristics of various managed products, including segregated funds and income trusts, among others. You will learn how the different products are structured, regulated, and taxed. SEGREGATED FUNDS 1 | Describe the features and structure of segregated funds. Segregated funds are a type of pooled investment much like a mutual fund, but with a difference: they are considered an insurance product. The proceeds received by the insurance company are used to purchase underlying assets, and then units of the segregated fund are sold to investors. Like mutual funds, segregated funds offer services such as professional investment management and advice, the ability to invest in small amounts, and regular client statements. However, segregated funds also have unique features that enable them to meet special client needs, such as maturity protection, death benefits, and creditor protection. REGULATION OF SEGREGATED FUNDS Segregated funds are insurance contracts, known as individual variable insurance contracts, between a contract holder and an insurance company. For that reason, they are regulated by provincial insurance regulators. There are three regulatory bodies that oversee the activities of segregated funds. Canadian Life and Each province and territory has accepted the Canadian Life and Health Insurance Health Insurance Association Inc. guidelines as the primary regulatory requirements. Federal insurance Association Inc. regulators do not regulate the sale of segregated funds. Office of the The Office of the Superintendent of Financial Institutions is responsible for ensuring Superintendent of that federally regulated insurance companies are adequately capitalized under the Financial Institutions requirements of the federal Insurance Companies Act. © CANADIAN SECURITIES INSTITUTE 22 4 CANADIAN SECURITIES COURSE      VOLUME 2 Assuris Assuris is the insurance industry’s self-financing provider of protection against the loss of policy benefits in the event of the insolvency of a member company. The Assuris guarantee covers only the death benefits and maturity guarantees in a segregated fund contract. The assets of the funds themselves are not eligible for Assuris protection because they are segregated from the general assets of the insurance company. Assuris’ role is to supplement any payments made by a liquidator to fulfill the insurance obligations under a segregated fund contract. The maximum compensation that can be awarded under an individual segregated fund policy is $60,000 or 85% of the promised guaranteed amounts, whichever is higher. These limits apply both to amounts held by individuals in registered plans and to contracts held outside registered plans. Registered plans include registered retirement savings plans (RRSP), registered educations savings plans (RESP), and registered retirement income funds (RRIF). DID YOU KNOW? Because segregated funds are regulated as insurance products, you cannot sell or advise on them without a proper licence. In Canada, you must complete a separate insurance licensing course that covers the curriculum prescribed by the Canadian Council of Insurance Regulators. For more information, visit the website of the Canadian Securities Institute at www.csi.ca and review the LLQP Insurance Course description. STRUCTURE OF SEGREGATED FUNDS Because of their legal structure, segregated funds do not issue actual units or shares to investors, because doing so would imply ownership. Instead, an investor is assigned notional units of the contract—a concept that measures a contract holder’s participation and benefits in a fund. This approach also makes it possible to compare the investment performance of segregated funds with those of mutual funds. Essentially, the contract covers the three different parties described below. The contract holder The contract holder is a person who buys the segregated fund contract. The contract can be held within a registered plan belonging to the holder, such as an RRSP, RESP, RRIF, or TFSA. In such cases, the contract holder and the annuitant must be the same person. When the contract is held outside a registered plan, the contract holder can be someone other than the annuitant. The annuitant The annuitant is the person whose life is insured by the contract and on whose life the insurance benefits are based. There are restrictions on whose life a contract holder can base a contract. The general rule in most provinces is that the contract holder, at the time the contract is signed, must have an insurable interest in the life or health of the annuitant. Otherwise, the proposed annuitant must consent in writing to have his or her life insured. © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 5 The beneficiary The beneficiary is the person or persons who will receive the benefits payable under the contract upon the death of the annuitant. (A contract may have more than one beneficiary.) The contract holder may designate one or more beneficiaries or may designate his or her estate as the beneficiary. The beneficiary does not have to be a person. For example, a charitable organization can be a beneficiary. The designation of beneficiary can be revocable or irrevocable: A revocable designation allows the contract holder to alter or revoke the beneficiary’s status. An irrevocable designation does not allow the contract holder to change the rights of a beneficiary without the beneficiary’s consent. DID YOU KNOW? You have an insurable interest in the life or health of another person if you derive a financial or other kind of benefit from that person. For example, a person who depends for a living on the income of a spouse has an insurable interest in the spouse. SEGREGATED FUND FEATURES Segregated funds offer investors a variety of unique features, including maturity guarantees, death benefits, and creditor protection. MATURITY GUARANTEES One of the fundamental contractual rights associated with segregated funds is the promise that the contract holder or the beneficiary will receive at least a partial guarantee of the money invested. Provincial legislation requires that the maturity guarantee be at least 75% of the amount invested over a contract term of at least a 10-year holding period or upon the death of the annuitant. To offer greater capital protection, some insurers have increased the minimum statutory guarantee to 100%. The 100% guaranteed funds are often based on a longer term-to-maturity, such as 15 years. They also feature a higher management expense ratio (MER) than the 75% guaranteed funds, reflecting the higher risks of offering full maturity protection after 10 years. Some insurers offer flexible guarantee options. Protection may be provided as 75% maturity guarantee and 75% death benefit, 75% guarantee and 100% benefit, or 100% guarantee and 100% benefit, depending on the contract. One benefit of a maturity guarantee is that the client may participate in rising markets without setting a limit on potential returns. At the same time, subject to the 10-year holding period, the client’s invested capital is protected from loss. AGE RESTRICTIONS Insurance companies offering 10-year maturity guarantees that exceed the statutory requirement of 75% may impose restrictions on who qualifies for the enhanced guarantee. The restriction might be that the person on whose life the death benefits are based must be no older than 80 at the time the policy is issued. Alternatively, the contract holder might receive a reduced level of protection under the policy when the annuitant reaches a certain age. © CANADIAN SECURITIES INSTITUTE 22 6 CANADIAN SECURITIES COURSE      VOLUME 2 RESET DATES Although segregated fund contracts have at least a 10-year term, they may be renewable when the term expires, depending on the annuitant’s age. If renewed, the maturity guarantee on a 10-year contract resets for another 10 years. A reset allows contract holders to lock in the current market value of the fund and set a new 10-year maturity date. Reset dates can be anywhere from daily to once a year. A daily reset benefits clients in both rising or falling markets. In a rising market, when the net asset value of fund units is increasing, the daily reset enables contract holders to continually lock in accumulated gains. In a falling market, when net asset values are falling, contract holders are protected because the guarantee is based on the previous high. DEATH BENEFITS The death benefits associated with segregated funds meet the needs of clients who want exposure to long-term asset classes while ensuring that their investments are protected in the event of death. The principle behind the death benefits is that the contract holder’s beneficiary or estate is guaranteed to receive payouts amounting to at least the guaranteed amount, excluding sales commissions and certain other fees. The amount of the death benefit is equal to the difference, if any, between the guaranteed amount and the net asset value of the fund at death. Table 22.1 illustrates the death benefits when the market value of the units held in the segregated fund is below, the same as, and higher than the original purchase price. Table 22.1 | Death Benefits Total Amount Paid Guaranteed Amount Market Value at Death Death Benefit to Beneficiary $10,000 $8,000 $2,000 $10,000 $10,000 $9,000 $1,000 $10,000 $10,000 $10,000 None $10,000 $10,000 $11,000 None $11,000 EXAMPLE Keith purchases a segregated fund contract for $100,000. His wife, Patricia, is the beneficiary of the contract. The contract provides for a 75% guarantee at death; therefore, the death benefit guarantee is $75,000. Keith dies during the fifth year of the contract. At the time of his death, the market value of the segregated fund is $80,000. Patricia receives that amount because it is greater than the death benefit guarantee of $75,000. In a different example, Ayida also purchases a segregated fund contract for $100,000, with terms identical to Keith’s contract. She names her son, Antoine, as the beneficiary. Like Keith, Ayida dies during the fifth year of the contract. However, at the time of Ayida’s death, the market value of the segregated fund is $65,000, which is less than the guaranteed amount ($75,000). Antoine therefore receives the guaranteed amount of $75,000, which represents the market value of $65,000 plus the death benefit of $10,000 (the difference between the guaranteed amount and the market value). © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 7 CREDITOR PROTECTION Segregated funds are unique among managed products by offering protection from creditors in the event of bankruptcy. Creditor protection is available because a segregated fund’s assets are owned by the insurance company, rather than the contract holder. Insurance proceeds generally fall outside the provisions of bankruptcy legislation. Creditor protection can be a valuable feature for clients whose personal or business circumstances make them vulnerable to court-ordered seizure of assets to recover debt. Clients who might benefit from this feature include business owners, entrepreneurs, professionals, and other clients who have concerns about their personal liability. However, creditor protection does not apply under all circumstances (see the Bankruptcy and Family Law section below). For the assets held in the contract to be eligible for protection, the purchase must be made in good faith. In other words, it must not be made with the intention of avoiding potential creditor action. Additionally, the contract holder must name a beneficiary. BYPASSING PROBATE One of the key estate-planning advantages of segregated funds is the opportunity to avoid probate (the legal process of administering the estate of a deceased person). Segregated fund contracts are not regarded as part of the deceased’s estate; the proceeds of the funds pass directly into the hands of the beneficiaries. The beneficiary need not wait for probate to be completed, nor can payment be delayed by a dispute over the settlement of the estate. Moreover, by passing assets directly to beneficiaries through a segregated fund, contract holders can ensure that their beneficiaries save on fees paid to executors, lawyers, and accountants. COST OF THE GUARANTEES In addition to the costs incurred by mutual funds, such as sales fees, switching fees, trailer fees, and management expense ratios, segregated funds have added costs related to death benefits and maturity guarantees. Assessing the true value of the insurance in segregated funds is not easy. Certainly, the management expense ratios for segregated funds are higher than those of comparable mutual funds. BANKRUPTCY AND FAMILY LAW Under federal bankruptcy law, segregated funds are not normally included in the property divided among creditors. For example, a bankruptcy trustee cannot change a beneficiary designation to make the proceeds of the contract payable to the contract holder’s creditors. However, under the federal Bankruptcy and Insolvency Act, the proceeds of a segregated fund may be subject to seizure under certain conditions. If it can be proven that the purchase was made within a certain period before the bankruptcy, normally within one year, the proceeds may not be protected. If the contract holder was legally insolvent at the time of purchase, the purchase could be challenged as far as five years back. TAXATION OF SEGREGATED FUNDS Segregated funds are taxed as if they were trusts. The insurance company itself, which is the legal owner of the assets of the segregated fund, does not pay taxes on income earned by the fund. ALLOCATION A segregated fund’s net income, whether in the form of dividends, capital gains, or interest, is deemed to be the contract holder’s income. In non-registered accounts, this income is taxable in the current year. The amount of income deemed to have been earned by each contract holder is calculated using a procedure known as allocation. A percentage of the fund’s total income is allocated to each unit, according to the terms of the segregated fund contract. © CANADIAN SECURITIES INSTITUTE 22 8 CANADIAN SECURITIES COURSE      VOLUME 2 Most funds allocate income to a contract holder based on two factors: the number of units held and the proportion of the calendar year during which those units are held. For example, a segregated fund contract held for six months of the year would receive half the per-unit allocations accorded to a contract held for the full year. IMPACT OF ALLOCATIONS ON NET ASSET VALUES Mutual funds and segregated funds flow income through to unit holders in different ways. Unlike a mutual fund, a segregated fund does not suffer a decline in the net asset value per share (NAVPS) of the fund after an allocation of income. Instead, the fund contract receives additional income, which is allocated to existing units. In most cases, these allocations are held in the policy, though they may also be redeemed by the contract holder and received as cash. The allocation increases the investor’s adjusted cost base and is reported for tax purposes. One of the advantages of segregated fund contracts over mutual funds is that both capital losses and capital gains can be passed on to the contract holder. The same is not true of mutual funds, where capital losses cannot flow through to unit holders. They must be kept in the fund and used in future years to offset capital gains. TAX TREATMENT OF GUARANTEES Payments from a segregated fund contract’s maturity guarantees are taxable. If the proceeds of the contract (after commissions) are less than the adjusted cost base, income tax is payable on the guaranteed amount. However, the contract holder can use the difference between the market value of the segregated fund and the adjusted cost base as a capital loss. The net tax effect is zero. If the proceeds exceed the adjusted cost base, the contract holder is taxed on the capital gain. TAX TREATMENT OF DEATH BENEFITS When the annuitant dies, the contract is terminated. The beneficiaries receive the market value of the segregated fund plus death benefits, if any, tax free. If the contract holder is not the same person as the annuitant, the contract remains in force when the contract holder dies. However, the deceased owner is deemed to have disposed of the contract at fair market value. This deemed disposition normally triggers a capital gain or loss. If the contract holder took advantage of the provision allowing his or her spouse to be named as the successor owner, the contract can be transferred to the spouse. It is transferred at its adjusted cost base, thereby deferring any capital gains liability. If no successor owner has been named, the contract will pass to the deceased owner’s estate. If the contract owner and annuitant are the same person, the gain or loss will be reflected on the owner’s terminal tax return for the year of death. SEGREGATED FUNDS COMPARED TO MUTUAL FUNDS Table 22.2 highlights some of the key similarities and differences between segregated funds and mutual funds. Table 22.2 | Comparing Segregated Funds to Mutual Funds Segregated Funds Mutual Funds Legal status Insurance contract Security Owner of the fund’s The insurance company The fund itself, which is a separate assets legal entity Nature of fund units No legal status; serving only to determine the Legal property; carrying voting value of benefits payable rights and rights to receive distributions © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 9 Table 22.2 | Comparing Segregated Funds to Mutual Funds Segregated Funds Mutual Funds Regulator Provincial insurance regulators Provincial securities regulators Issuers Mainly insurance companies Mutual fund companies Main disclosure Information folder Fund Facts document (simplified document for investor prospectus available upon request) Frequency of valuation Usually daily, and at least monthly Usually daily, and at least weekly Redemption rights Redeemed upon request Redeemed upon request Required financial Audited annual financial statement Audited annual financial statements statement and semi-annual statement, for which no audit is required Sellers’ qualifications Licensed life insurance agents; successful Licensed mutual fund completion of a recognized investment course, representatives or such as those offered by the Canadian Securities registered brokers Institute, the Investment Funds Institute of Canada, or Advocis also required by British Columbia, Saskatchewan, and Prince Edward Island Maturity guarantees Minimum of 75% of deposits after 10 years; None companies may offer guarantees up to 100% Government None None guarantees Protection against Assuris, a not-for-profit organization, providing The Canadian Investor Protection issuer insolvency limited protection to Canadian life insurance Fund, a not-for-profit corporation, policy holders; maximum compensation up to providing limited protection to $60,000 or 85% of the promised guaranteed eligible customers of its members amounts, whichever is higher; protection only needed if the guaranteed amount is higher than the market value of the investment Death benefits Yes; may be subject to age or other restrictions None Creditor protection Yes; under certain circumstances None Probate bypass Yes; proceeds of contract held by deceased None contract holder may be passed directly to beneficiaries, avoiding probate process © CANADIAN SECURITIES INSTITUTE 22 10 CANADIAN SECURITIES COURSE      VOLUME 2 SEGREGATED FUNDS SCENARIOS AND TRUE AND FALSE Test your understanding of segregated funds features. Complete the online learning activity to assess your knowledge. LABOUR-SPONSORED VENTURE CAPITAL CORPORATIONS 2 | Discuss the advantages and disadvantages of Labour-Sponsored Venture Capital Corporations. Labour-sponsored venture capital corporations (LSVCC), also called labour-sponsored investment funds, are managed investment funds sponsored by labour organizations to provide capital for small to medium-sized and emerging companies. LSVCCs vary greatly in terms of size, risks, and management style. ADVANTAGES OF LABOUR-SPONSORED FUNDS The main attractions of LSVCCs are the federal tax credits that investors receive and the provincial tax credits that some provinces offer. Tax credits included a 15% federal credit on an annual investment up to a maximum amount, as well as an additional 15% provincial tax credit in some provinces (17.5% in Saskatchewan). Therefore, depending on the type of fund and place of residence, LSVCCs generate a tax credit ranging from 15% to 32.5%. In some provinces, only the federal credit of 15% is available. DID YOU KNOW? The federal LSVCC tax credit was to be phased out by 2017. However, the 2016 federal budget reinstated the federal tax credit for provincially registered funds and it currently remains at 15%. The federal tax credit for federally registered LSVCCs was eliminated effective 2017 and remains unavailable. EXAMPLE Pierre invests $5,000 in an LSVCC in Quebec, his province of residence. The fund is eligible for a federal tax credit of 15% and a provincial tax credit of 15%. Pierre therefore receives a $750 federal tax credit (15% × $5,000) and a $750 provincial tax credit (15% × $5,000), for a combined tax credit of $1,500. Though there is no maximum amount an investor may invest in an LSVCC, both the provincial and the federal tax credits are subject to annual maximum limits. The federal tax credit is available on a maximum of $5,000 invested in any one year. Some provinces have a lifetime limit on the amount eligible for a tax credit. The unused portion of the federal tax credits is not refundable and cannot be carried forward or back for application in subsequent or prior taxation years. An investor purchasing an LSVCC in the first 60 days of the calendar year can apply the tax credits either to the previous year’s taxes or to those of the current year. Most LSVCC shares are eligible for RRSPs and RRIFs (see Chapter 24 for more on tax deferral plans). In fact, buying an LSVCC investment within an RRSP, as most investors do, offers further tax savings. Shares can be purchased directly by an RRSP trust, or they may be purchased and then transferred to an RRSP or RRIF. When LSVCC shares are purchased with money contributed to an RRSP, the contributor to the RRSP receives the RRSP tax deduction, as well as any available LSVCC tax credits. In the case of a direct purchase, a deduction of a sum equal to the purchase price is permitted. With a transfer, a sum equal to the fair market value of the shares at the time of transfer is permitted. Both transactions must be within the limits prescribed for contributions to an RRSP. © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 11 EXAMPLE Pierre invests $5,000 in an LSVCC for his RRSP in Quebec. Assuming a 50% marginal tax rate, Pierre realizes tax savings of $2,500 (calculated as $5,000 × 50%) in addition to the $1,500 in LSVCC tax credits received on the purchase of the fund. Therefore, the effective after-tax cost of his investment is reduced to $1,000 (calculated as $5,000 − [$2,500 + $1,500]). LSVCC shares are also eligible investments for other registered accounts, including tax-free savings account. DISADVANTAGES OF LABOUR-SPONSORED FUNDS Because of the nature of the companies in which they invest, LSVCCs are considered a high-risk, speculative investment suitable only for investors who have a high risk tolerance and risk capacity. DID YOU KNOW? It is estimated that 80% of all new companies dissolve within five years of start-up. Another disadvantage is that the redemption of LSVCC shares is more complicated than that of conventional mutual fund shares. Rules governing LSVCC redemptions differ from province to province, as well as between provinces and the federal government. The Income Tax Act requires that the shares be held for eight years to avoid the recapture of federal tax credits. If redeemed before this minimum holding time, the investor must repay the tax credits received on the LSVCC when the fund was originally purchased. EXAMPLE If Pierre decides to redeem his LSVCC shares after holding the investment for only five years, he will have to repay the $750 federal tax credit and the $750 provincial credit he received. Some provinces allow investors to redeem the shares immediately after purchase; others place restrictions until a mandatory holding period has elapsed; and some others ban redemptions altogether. Another disadvantage of LSVCCs is higher costs. Because venture capital investing is more labour intensive than investing in liquid stocks, the costs of administering these funds tends to be much higher than for conventional equity funds. The extra cost is reflected in the MER. These funds must also maintain a large cash reserve to finance redemptions, which can drag down fund performance in rising markets. CLOSED-END FUNDS 3 | Describe the features and structure of closed-end funds. Closed-end funds are pooled investment funds that initially raise capital by selling a limited or fixed number of shares to investors. The manager of the fund uses the fixed pool of capital to purchase and manage a basket of securities according to a specific investment mandate, for which the manager is paid a management fee. In general, the management fee charged by a closed-end fund is lower than the management fee of a mutual fund with a similar investment objective. © CANADIAN SECURITIES INSTITUTE 22 12 CANADIAN SECURITIES COURSE      VOLUME 2 STRUCTURE OF CLOSED-END FUNDS Once issued, closed-end fund units are listed for trading on a stock exchange. Investors who wish to buy or sell units of the fund must do so through the stock exchange. They pay a commission on the transaction, rather than a front- end load. The prices of closed-end funds are based on market supply and demand, as well as underlying asset value. Closed-end funds can trade at a discount, at par, or at a premium relative to the combined net asset value of their underlying holdings. Historically, most closed-end funds trade at a discount to their NAVPS. An increase or decrease in the discount can indicate market sentiment. The greater the relative discount, all other things being equal, the more attractively priced the fund. However, it is important to find out whether the discount at which a fund is trading is below historical norms. A widening discount could indicate underlying problems in the fund, such as disappointing results from an investment strategy, a change in managers, poor performance by the existing managers, increased management fees or expenses, or extraordinary costs such as a lawsuit. The underlying assets in a closed-end fund may include the following examples, among others: Preferred shares of Canadian financial institutions Diversified holdings of a basket of foreign-based manufacturing companies A portfolio of income-producing securities, including business trusts, real estate investment trusts (REIT), and utility income trusts Funds that have the flexibility to buy back their outstanding shares periodically are known as interval funds or closed-end discretionary funds. They are more popular in the United States. In Canada, closed-end funds may also be structured with buyback or termination provisions. For example, a fund could be structured to terminate on June 30, 2028, at which time the proceeds will be distributed to unitholders. However, the fund manager could propose to continue the fund after this date, subject to unitholder approval. CLOSED-END FUNDS AS AN ALTERNATIVE INVESTMENT STRATEGY Historically, after hedge funds, closed-end funds have been the next most-popular investment product structure utilized by investors seeking exposure to alternative investment strategies. The closed-end fund product structure is ideally suited to alternative investment strategies since the alternative investment manager does not have to concern herself with managing fund liquidity over the life of the fund (at least as it pertains to investor redemption requests). Accordingly, this type of product structure is well-suited for illiquid alternative investment strategies, such as equity real estate and private equity. Of course, closed-end funds that incorporate an alternative investment strategy have to pay particular attention to the possibility that the fund will trade at discounts and premiums to the fund’s NAV over time. The 2018 mutual fund modernization amendments to NI 81-102 made closed-end funds subject to generally the same investment restrictions as alternative mutual funds, including with respect to leverage, short selling, use of derivatives and portfolio concentration. An exception is that, given their structure as described above, they will be afforded a higher limit on illiquid assets relative to alternative funds. This limit will be set at 20% of NAV for closed- end funds (rather than 10% for alternative mutual funds), with a hard-cap of 25% of NAV (rather than 15% for alternative mutual funds) for up to a maximum of 90 days. With the investment strategies of closed-end funds now capable of being delivered through an alternative mutual fund it will be interesting to see how the closed-end market pertaining to the use of alternative strategies develops going forward. It should be noted that existing closed-end funds are grandfathered from these changes provided they do not make another public offering. © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 13 ADVANTAGES OF CLOSED-END FUNDS Closed-end funds have the following advantages for investors: Diversification can reduce the risks associated with the varying discounts of closed-end funds. A portfolio of closed-end funds that have a low degree of correlation with each other will smooth out the adverse effects of closed-end discounts. Closed-end funds offer certain opportunities for investment returns, such as short selling, that are not available to investors in open-end investment funds. Typically, a closed-end fund is more fully invested than an open-end fund. Open-end funds must keep a certain percentage of their funds liquid to allow for redemptions. Closed-end funds do not have this constraint. In working with a closed-end structure, money managers have the flexibility to concentrate on long-term investment strategies without having to reserve liquid assets to cover redemptions. Because the number of units of a closed-end fund is generally fixed, capital gains, dividends, and interest distributions are paid directly to investors, rather than reinvested in additional units. Therefore, tracking the adjusted cost base of these funds may be easier than for open-end mutual funds. Also, because there is only a fixed number of units to be administered, investors in closed-end funds may benefit from lower MERs than open-end funds with similar objectives. DISADVANTAGES OF CLOSED-END FUNDS Closed-end funds have disadvantages as well, particularly in comparison to open-end funds: Like stocks, and unlike open-end funds, closed-end funds do not necessarily trade at NAVPS. In bear markets, as the value of the underlying assets declines, the gap between the discount and the net asset value widens. In such markets, therefore, closed-end unitholders or shareholders may suffer. Also, because closed-end funds are not widely used in Canada, they may trade for extended periods at prices that do not reflect their intrinsic or true value. Partly because of the divergence of trading prices from net asset value, closed-end funds are less liquid than open-end funds. Buyers and sellers must be found in the open market. The fund itself does not usually issue or redeem units. Commissions are paid at the time of purchase and at the time of sale. Because many closed-end funds do not provide for automatic reinvestment of distributions (a feature of most open-end funds), unitholders are responsible for reinvesting cash that may build up in their accounts. For closed-end funds that trade on foreign exchanges, any dividend income earned is considered foreign income and is therefore not eligible for the federal dividend tax credit. INCOME TRUSTS 4 | Differentiate among the types of income trusts. An income trust is similar in some ways to a closed-end fund. Investors purchase ownership interests in the trust, which in turn holds interests in the operating assets of a company. These securities are exchange-traded and trade on the Toronto Stock Exchange. Generally, income trusts are divided into the following two major categories: REITs purchase real estate properties and pass the rental incomes through to investors. They are usually specialized in one real estate sector, such as shopping centres, senior housings, office or industrial rentals, and residential rentals. © CANADIAN SECURITIES INSTITUTE 22 14 CANADIAN SECURITIES COURSE      VOLUME 2 Business trusts purchase the assets of an underlying company, usually in the manufacturing, retail, or service industry. The companies may operate in such diverse areas as peat moss extraction, restaurants, industrial appliances, canning, and distribution. DID YOU KNOW? Different types of business may operate within the same income trust category; therefore, they cannot be compared for evaluation. For example, one REIT may be invested in shopping centres, whereas another may own senior housing—both are REITs, but a comparison between the two is not useful. When evaluating an income trust, you must compare it against other income trusts that operate in a relatively similar market niche. Income trusts are similar to fixed-income securities in the way they react to changing interest rates; however, like equities, they trade on an exchange. Because they are backed by the specific revenue-generating properties or assets held in the trust, they face the same risks as common equities. The underlying business is affected by market conditions and economic cycles, as well as management performance. Depending on their structure, the priority and security of trusts typically rank below those of subordinated debentures. REAL ESTATE INVESTMENT TRUSTS REITs consolidate the capital of a large number of investors to invest in and manage a diversified real estate portfolio. Investors participate by buying units in the trust. Small investors are thus able to invest in commercial real estate that was previously available only to corporate or more affluent and sophisticated investors. REITs generally pay out a high percentage of their income—typically 95%—to their unitholders. They are publicly traded companies that may be structured as either open-end or closed-end funds. If they meet the stringent standards set out under the Income Tax Act, REITs may qualify as registered investments for RRSPs and RRIFs. REITs face many of the risks that are typical to real estate investments, as follows: Quality of the properties State of the rental markets and tenant leases Costs of debt financing Natural disasters and access to liquidity REIT managers generally minimize risk by avoiding real estate development, investing instead primarily in established income-producing properties. Liquidity is a major benefit of REIT ownership. REIT units are much more liquid than real estate. However, investors should determine the liquidity of any particular REIT before investing. Some REITs, especially the more specialized ones, have thin trading volumes, despite being exchange traded. As publicly traded instruments, REITs are also subject to full disclosure rules, which allow investors to base their decisions on more complete information. When interest rates rise, higher borrowing costs make the purchase of new properties less profitable, and REIT trading values may therefore fall. On the other hand, REITs represent a good hedge against inflation. In an inflationary environment, the value of the underlying real estate owned by REITs may appreciate. © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 15 Because rental income is fairly stable, REITs generally yield high levels of income, but they usually lack the potential for the large capital gains or losses that are possible with equities. As with any investment, it may be necessary to accept lower yields to ensure a high-quality portfolio underlying the yield. Buying REITs gives investors access to professional management. REITs, however, are just as susceptible to ineptitude on the part of management as any other company. The key to minimizing risk lies in sound research before purchase and in diversification. BUSINESS TRUSTS Business trusts are as varied as the types of companies listed on a stock exchange. This category includes many examples of companies with strong, stable earnings, but little growth potential. Management uses the income trust structure to make investment in such companies more attractive than it would be if the companies traded as common share initial public offerings. Income trusts work best in markets where new competitors are unlikely to spring up. The ideal company is a monopoly, a quasi-monopoly, or a company operating in a protected niche. The following types of businesses are examples of the diverse holdings of business trusts: Forest products Storage facilities Natural gas processing Restaurants and food distributors Fish processing and sardine canning Aircraft parts, industrial washing machines, and biotechnology It is difficult to generalize the risks of business trusts because of the diversity of the underlying businesses. They are subject to the same interest rate risk as fixed-income securities and the same risks as equity securities. They tend to be more stable than the equity market because the underlying business assets provide regular, stable income. However, they are still subject to market and economic risk. INCOME TRUST TAXATION The tax treatment of income trusts is like that of taxable Canadian corporations. The income trust pays tax, and the distributions from the trust are taxed in the hands of the investor, as are dividends received from a corporation. However, it is important to note that Canadian REITs have different taxation rules. REITs can avoid paying tax by distributing the income generated by the trust directly to unitholders. The revenue generated by the REIT is therefore taxed in the hands of investors. LISTED PRIVATE EQUITY 5 | Describe the advantages, disadvantages, and process for investing in private equity. Private equity is the financing of firms unwilling or unable to find capital using public means, such as through the stock or bond markets, for example. The term private equity is a bit of a misnomer—the asset class encompasses investment from private debt, as well as private equity. Long-term returns on private equity typically exceed most other asset classes. In exchange for those returns, private equity exposes investors to far higher risks. © CANADIAN SECURITIES INSTITUTE 22 16 CANADIAN SECURITIES COURSE      VOLUME 2 Private equity plays a specific role in financial markets, both in Canada and worldwide. It complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets is difficult or impossible to do. A good example of private equity is venture capital. Businesses in the start-up phase often produce little or no cash flows and have few or no assets to offer as collateral. They also invest most, or all, of their revenue in more or less unproven technologies or production processes. In such situations, firms must typically turn to venture capital. These investors are ready to take substantially more risk against significantly higher profit prospects, if the venture is successful. Private equity investors can use various methods to provide finance to firms. Leveraged buyout A leveraged buyout is the acquisition of companies financed with equity and debt. Buyouts are one of the most commonly used forms of private equity. LBO firms represent some of the wealthiest finance organizations anywhere, with the ability to raise funds above $10 billion and conduct multi-billion-dollar deals. LBO funds are structured as limited partnerships, with the general partners (the promoters of the funds) receiving ongoing compensation, and the limited partners receiving returns contingent on investment performance. Growth capital Growth capital is the financing of expanding firms for their acquisitions or high growth rates. Turnaround Turnaround investments provide financing to underperforming or out-of-favour industries that are either in financial need or undergoing operating restructuring. Early-stage venture Early-stage venture capital invests in firms that are in the infancy stages of developing capital products or services in high-growth industries such as health care or technology. These firms usually have a limited number of customers. Late-stage venture Late-stage financing focuses on firms that are more established but still not profitable capital enough to be self-sufficient. Revenue growth is still very high. Distressed debt Distressed debt is the purchase of debt securities of private or public companies that are trading below par, due to financial trouble at the firm. Mezzanine financing A firm may wish to finance by floating high-yielding, unsecured preferred equity or subordinated loans. This mezzanine capital is typically just above common stocks in seniority. As such, it is a comparatively costly way to finance. From a private equity investor’s point of view, the risk of default is about the highest in the debt spectrum, but the investment pays high returns given the increased credit risk. LISTED PRIVATE EQUITY A listed private equity company is an investment company that uses its capital to purchase or invest in a wide range of other companies. The shares of a listed private equity company are publicly traded on a stock exchange. Investment holdings could include companies that are publicly traded on a stock exchange or that are privately held. (A privately held company does not trade on a stock exchange.) © CANADIAN SECURITIES INSTITUTE  CHAPTER 22      OTHER MANAGED PRODUCTS 22 17 EXAMPLE ABC Corp. is a private equity firm that trades on the Toronto Stock Exchange. The company is highly diversified and conducts business through various autonomous subsidiaries operating in multiple industries. Its holdings are in the real estate, financial, and health care sectors. ABC Corp. is led by a team of 30 partners who manage corporate investments, private equity portfolios, and various other assets. ABC uses its investment capital to purchase companies that appear to offer the potential for long-term capital gains. The company focuses on a wide range of small to mid-size privately held investment opportunities. Traditionally, investment in private equity occurred through companies that were not listed on a stock exchange. The companies were privately held and used their own invested capital to purchase and invest in other businesses. Over the past decade, an increasing number of private equity companies have started listing on stock exchanges. Reasons for this transformation include better access to capital, improved liquidity, and transparency. These listed companies trade like common shares and are subject to the same regulatory and reporting requirements as other publicly traded companies. The allure for the investor is the opportunity to invest in a diversified company whose investment holdings would not typically be available for investment by the average retail investor. DID YOU KNOW? For investors, purchasing shares in a listed private equity company is straightforward. You can buy and sell the shares in the same way you would purchase the shares of any other publicly traded company. ADVANTAGES AND DISADVANTAGES OF LISTED PRIVATE EQUITY As with any type of investment, there are advantages and disadvantages to investing in a listed private equity company. Two key advantages are described below. Access to legitimate Because private equity managers often buy majority ownership in a company, they have inside information access to a much greater depth of information on possible investments. This information helps them more accurately assess the likely success of a company’s business plan. It also helps investors follow a proper post-investment strategy. The greater level of disclosure significantly reduces uncertainty and risk in private equity investment. Equivalent information in the public markets would be considered inside information. Influence over To improve the odds of realizing superior returns on their investments, private equity management managers generally seek active participation in a company’s strategic direction. and flexibility of Such participation could include development of a business plan, selection of senior implementation executives, and identification of eventual acquirers of the firm. Because they are owners, private equity managers can also implement their business plan without answering to other shareholders or regulators. © CANADIAN SECURITIES INSTITUTE 22 18 CANADIAN SECURITIES COURSE      VOLUME 2 Two key disadvantages of private equity investment are described below. Illiquid investments Lack of liquidity is one of the key disadvantages that private equity investors face. For example, when a venture capital firm purchases shares in a private company, the holding period averages three to seven years. Venture capital fund investors are locked into their investment during this period. It is possible to sell partnership shares to a third party, but at a significantly discounted price. Dependence on key Private equity funds usually depend on the general partners and a relatively small staff personnel for all key investment decisions. Also, private equity managers often take an active role in the management of companies in which they invest, including participation on the company’s board of directors. Therefore, the inability of one or more key people to carry out their duties could have significant adverse effects on a partnership, and thus on the return on investment. 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  CHAPTER 22      OTHER MANAGED PRODUCTS 22 19 SUMMARY In this chapter, you learned about the following key features of several additional managed products: Segregated funds are like mutual funds because they are a type of pooled investment. However, unlike mutual funds, they are also a type of insurance contract. Accordingly, they have features such as maturity protection, death benefits, and creditor protection. Rather than receiving shares, investors are assigned notional units that measure their level of participation and benefits. Because they are insurance products, they are regulated by the provincial insurance regulators, and they are generally protected from creditors in a bankruptcy. Segregated funds are taxed as if they were trusts. LSVCCs are managed investment funds sponsored by labour organizations to provide capital for small to medium-sized and emerging companies. The main attractions of LSVCCs are the federal tax credits that investors receive and the provincial tax credits that some provinces offer. They are considered a high-risk, speculative investment suitable only for investors who have a high risk tolerance and risk capacity. Closed-end funds are pooled investment funds that initially raise capital by selling a fixed number of shares that are listed for trading on a stock exchange. Closed-end funds offer certain opportunities for investment returns, such as short selling, that are not available to investors in open-end investment funds. Capital gains, dividends, and interest distributions are paid directly to investors, rather than reinvested in additional units. An income trust is similar in some ways to a closed-end fund. Investors purchase ownership interests in the trust, which in turn holds interests in the operating assets of a company. These securities are traded on an exchange. The two broad categories of income trusts are REITs and business trusts. The tax treatment of income trusts is like that of taxable Canadian corporations. Private equity is the financing of firms unwilling or unable to find capital through the stock or bond markets. A listed private equity company is an investment company that uses its capital to purchase or invest in a wide range of other companies. The shares of a listed private equity company are publicly traded on a stock exchange. Private equity investment has two key advantages: access to legitimate inside information and influence over management. Lack of liquidity is one of the key disadvantages faced by private equity investors. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 22 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 22 FAQs. © CANADIAN SECURITIES INSTITUTE