Riskier Mutual Fund Products PDF

Riskier Mutual Fund Products 12 CONTENT AREAS What Are Equity Mutual Funds? What Are Balanced Mutual Funds? What Are Global Mutual Funds? What Are Specialty Mutual Funds? LEARNING OBJECTIVES...

Riskier Mutual Fund Products 12 CONTENT AREAS What Are Equity Mutual Funds? What Are Balanced Mutual Funds? What Are Global Mutual Funds? What Are Specialty Mutual Funds? LEARNING OBJECTIVES 1 | Describe and compare and contrast the composition of the different types of equity mutual funds. 2 | List and describe the investment objectives, comparative returns and the volatility of the different types of equity mutual funds. 3 | Describe the features and key types of specialty mutual funds. © CANADIAN SECURITIES INSTITUTE 12 2 INVESTMENT FUNDS IN CANADA KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. balanced mutual funds global mutual funds currency forward contract international funds equity growth funds market risk equity index funds natural resource funds equity mutual funds portfolio allocation service foreign exchange risk precious metals funds fund of funds small cap funds fund wraps specialty mutual funds glide path standard equity funds global equity funds target-date funds © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 3 INTRODUCTION This chapter covers riskier mutual fund products ranging from equity and balanced mutual funds, which are toward the middle of the risk-return spectrum, to global and specialty mutual funds, which are at the higher end of the risk- return spectrum. Mutual fund sales representatives should not, however, rely on a fund’s name or categorization to determine its suitability for clients; instead, you must do your homework and take a close look at a mutual fund’s fund facts document, prospectus and annual report. A balanced fund may turn out to be a high-risk product if it is slanted aggressively towards equities, while a specialty fund may be lower risk because of its investment objective and portfolio composition. WHAT ARE EQUITY MUTUAL FUNDS? Equity mutual funds invest in the common and preferred shares of publicly-traded companies. Equity mutual funds as a group have the goal of earning capital gains, sometimes with a current dividend income component. They are the riskiest of the three basic mutual fund types—money market, fixed-income, and equity funds—and are suitable primarily for clients with longer investment time horizons. It is difficult to discuss equity mutual funds as one mutual fund category. The problem is that although all equity mutual funds share the objective of investing in equities, the particular equities they select give different funds very different risk and return characteristics. This chapter examines Canadian equity mutual funds in terms of three fairly distinct types: “standard” equity funds, equity growth funds and equity index funds. What are the investment objectives of these types of equity funds, what are their return characteristics in comparison to the S&P/TSX Composite Index, and what are some examples of equity funds? STANDARD EQUITY FUNDS There are no mutual funds that distributors refer to as “standard” equity funds. The term is used here to distinguish this type of fund from the two other types discussed. A standard equity fund seeks to earn some combination of dividend income and capital gains from investment in Canadian common stocks. This objective appears to be similar to that of a preferred dividend fund. The difference between the two is that an equity fund usually has a much stronger capital gains focus. Note as well that equity funds make no specific attempt to preserve capital; in other words, equity funds are willing to put capital at substantially greater risk than preferred dividend funds in the hope of earning higher returns. To earn both dividend income and capital gains, portfolio fund managers must seek out common shares that pay dividends generally but also have some potential for capital appreciation. The most conservative of these equity funds hold common shares of large capitalization firms with strong dividend records. That is, these firms almost always pay their quarterly dividend. The capital appreciation potential for this type of shares is, however, limited. EQUITY GROWTH FUNDS The investment objective of an equity growth fund is capital gains. Some dividend income may be earned, but probably not much. Equity growth funds seek out smaller firms that do not have the financial ability to pay dividends. They need all the funds they can obtain in order to grow. If these firms are successful, their share prices should increase to reflect the growing value of the firm. The key risk factor that equity growth funds present to you and your clients is that smaller, growing firms have a greater potential for failure than larger, well-established firms. In addition, these growth firms often trade at very high price/earnings ratios (recall that the P/E ratio is the price paid for a share relative to the profit earned per share). This tends to make a growth firm’s share price particularly volatile, causing equity growth funds to have a lot of volatility. As with standard equity funds, equity growth funds can be conservative or aggressive for their class. An aggressive growth fund invests exclusively in smaller, lesser-known firms. Sometimes these types of funds are called small cap funds. © CANADIAN SECURITIES INSTITUTE 12 4 INVESTMENT FUNDS IN CANADA “Small cap” stands for small capitalization, which means that the market value of the equity of the firm is relatively low, probably because the firm itself is small. In this chapter, small cap funds are treated as specialty mutual funds. Recall that you can calculate the market value of a firm’s equity in the following way: Market Capitalization = Number of shares outstanding × Current Market Share Price In contrast to aggressive growth funds, more conservative equity growth funds seek out small, growth-oriented firms that have higher market capitalizations than small cap funds. EQUITY INDEX FUNDS An equity index fund has the goal of replicating the movements of a market index. In Canada, that particular index is often the S&P/TSX Composite Index. Equity index funds intend to do this by constructing an investment portfolio that has similar weightings to the index it tries to replicate. For example, if Company ABC represents 4% of the chosen index, the equity index fund would include 4% of Company ABC shares. And so on for most of the stocks represented in the index. Index funds generally do not hold all of the stocks represented in the index they try to replicate. Some very illiquid stocks, or those that have a very small weighting in the index may not be included in the index fund. Equity index funds typically generate capital gains, and are also likely to earn a certain amount of dividend income simply because some of the stocks in the index will pay dividends. This is not always the case, however. Some equity index funds do not own equities at all. Instead, they hold risk-free investments like T-bills and purchase derivatives that closely replicate the index return. EXAMPLE An index fund can construct its portfolio by buying Canadian T-bills and S&P/TSX 60 Index Futures. The return from that combination of T-bills and futures will mimic the return on the Index, but the returns will be made up of interest income from the T-bills and the futures contracts, not from dividends and capital gains on the stocks underlying the Index. Equity index funds appeal to clients who believe strongly in market efficiency and think that portfolio managers generally lack the skills to beat the markets consistently. There is the added benefit of lower management fees, due to the fact that equity index funds are easier to construct and manage than other types of equity funds. As a result, investing in an index fund is a lower-cost way for your clients to pursue a passive investment strategy. An alternative to index funds are exchange-traded funds (ETFs). These are discussed in greater detail in Chapter 13. In Canada, ETFs are traded on the Toronto Stock Exchange and are bought and sold through appropriately licensed investment advisors or discount brokers. A WORD ABOUT DERIVATIVES Within specified guidelines, mutual funds are permitted to use derivative securities. Recall from Chapter 7 that derivatives are financial instruments, such as futures and options that derive their value from the value of underlying securities such as bonds, stocks and indexes. This means, for example, that equity mutual funds are allowed to use futures contracts on stock market indexes to hedge the value of their portfolios. Equity funds also are allowed to take speculative positions on stock market indexes within certain limits defined under National Instrument 81-102. Speculative positions may have an underlying value of not more than 10% of the value of the mutual fund’s portfolio. The difference between a hedger and a speculator is that a hedger uses derivatives as a kind of insurance policy against the decline of the portfolio. A speculator is simply taking a bet on the future movement of the market. Most mutual funds do not permit their managers to take speculative positions in derivatives, but they do permit them to hedge the value of the portfolio by using them. What a manager is permitted to do is specified in the fund’s simplified prospectus. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 5 RESPONSIBLE INVESTMENT Responsible investment (RI) refers to the incorporation of environmental, social and governance (ESG) factors into the selection and management of investments. There is growing evidence that incorporating ESG factors into investment decisions can reduce risk and improve long-term financial returns. ESG issues are also some of the most important drivers of change in the world today. In Canada, RI gained prominence during the 1970s and 1980s. At that time, it was commonly known as ethical or socially responsible investing. Since then, shareholder activism or corporate engagement has subsequently become commonplace. Today, there is no one-size-fits-all strategy or approach. Responsible investors practice both values-driven approaches, which incorporate the investors’ moral or ethical beliefs, and valuation-driven approaches, which consider the materiality of ESG issues. There are numerous different strategies available to serve the diversity of responsible investors, including ESG integration, shareholder engagement, screening, thematic, and impact investing. On the more technical side, there are even more sub-strategies, including carbon efficiency, ESG momentum, tilting, smart beta, and others. ESG ISSUES ESG issues are some of the most important drivers of change in the world today. They are also critical economic issues with significant implications for businesses and investors. Environmental, or “E”, issues generally include the conservation of our natural resources, climate change, water and waste management, and more. Social issues are those that relate to people and society and they include human capital management, diversity and inclusion, human rights, and Indigenous and community relations. Governance issues relate to the controls, standards, and processes for running a company and overseeing its operations. Examples of ESG issues include: Climate Change Water Scarcity Supply Chain Indigenous and Community Relations Executive Compensation Diversity and Inclusion There are many sources of ESG information, including corporate ESG ratings and rankings, corporate sustainability reports, in-house research, ESG information disclosure in securities filings, and media coverage. DID YOU KNOW? Equity funds are not the only RI choices available to investors. Responsible investments are found in all major asset classes and investment vehicles, including: Equities Fixed income (corporate bonds, green bonds, sustainability bonds, community bonds, etc.) Money market Alternative investments such as impact investments Real estate Mutual funds Exchange-traded funds Guaranteed investment certificates Segregated funds © CANADIAN SECURITIES INSTITUTE 12 6 INVESTMENT FUNDS IN CANADA RETURNS ON EQUITY MUTUAL FUNDS Figure 12.1 presents the hypothetical 15-year return performance of equity mutual funds and equity growth mutual funds in comparison to Toronto Stock Exchange returns and money market funds. The growth funds are represented by returns from the small or mid cap equity funds category. Figure 12.1 | Simple Annual Returns: Equity Mutual Funds 40 30 20 10 Annual Return (%) 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 -10 -20 Year -30 Legend: Canadian Money Market S&P/TSX Index -40 Equity Funds Growth Funds Source: Bloomberg © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 7 The average return performance of both types of equity funds parallels that of the S&P/TSX Index, and both are much more volatile than the returns on money market funds. In addition, the data indicate that the average return on the S&P/TSX Index was 3.9% and the average return of equity funds was 6.2%. The average return on money market funds over the same period was 3.2%. The average performance of equity growth funds was 6.6%. Because of the global downturn in Year 13, where markets around the world experienced losses ranging from 30% to 40% of their value, the extreme volatility had a strong negative impact on the reported 15-year returns by equity funds. HYPOTHETICAL EXAMPLES OF EQUITY FUNDS The following examples compare three different types of equity mutual funds—blue chip, growth, and index funds— in terms of their investment objectives, portfolios, and investment strategies. CRYSTAL CANADIAN BLUE-CHIP FUND The investment objective of the Crystal Canadian Blue-Chip Fund is: “…to seek the greatest potential returns while accepting the greater volatility. Crystal Canadian Blue-Chip Fund maintains a diverse portfolio of equity securities of Canadian companies listed on Canadian stock exchanges that are considered likely to benefit from prevailing and anticipated economic conditions.” This investment objective is entirely consistent with that of a standard equity fund. Note that the Fund will only invest in exchange-traded stocks, as opposed to OTC (over-the-counter) stocks. This suggests a conservative approach, since stocks traded OTC may be less liquid and their prices also may not reflect the most current information. The portfolio of this Fund is summarized below and presented in Figure 12.2. Note that Canadian equities account for 96% of the portfolio. Short-term notes account for the rest. For a typical breakdown of equities within the various industries, see the example of the growth company fund that follows this one. Crystal Canadian Blue-Chip Fund Asset Allocation Equities $323,061,694 Short term Notes $13,839,150 Total $336,900,844 © CANADIAN SECURITIES INSTITUTE 12 8 INVESTMENT FUNDS IN CANADA Figure 12.2 | Crystal Canadian Blue-Chip Fund Portfolio Short Term Notes 4% Equities 96% Canadian equity funds may also have two features that differ from the Crystal Blue Chip Fund example. First, many are permitted to hold foreign equities. Second, other portfolios may contain greater amounts of short-term notes, T-bills and cash. There are two reasons for holding cash or cash-equivalents. One reason relates to transactions. Fund managers like to have some cash reserved to meet redemption demands of unitholders and be able to buy attractively priced securities should they become available. Another reason for holding cash is that managers may want to take a defensive position in relation to the equity markets in general. In other words, they are concerned about the performance of equity markets over the short run and do not want to put all the fund’s assets at risk in that market. When they feel that market conditions have improved, fund managers will likely decrease their cash holdings by buying equities. CRYSTAL CANADIAN GROWTH COMPANY FUND The fund objectives of the Crystal Canadian Growth Company Fund are to achieve long-term capital growth. Fund investments Primarily equity securities of Canadian companies judged to have the potential for above-average growth. Fund focus The Fund tends to focus on small- and medium-sized companies, but may also invest in larger companies. Special risks The share prices of smaller or less well-known companies tend to fluctuate more than the share prices of larger companies because of the greater uncertainty of investing in less established businesses. Smaller companies may have limited product lines, markets, management expertise or financial resources, making them more vulnerable to setbacks. According to the following information, also shown in Figure 12.3, the foreign stock component is about 11% of the value of the portfolio. The Canadian equity portion of the portfolio is made up of stocks from many sectors. The single largest sector is “Industrial Products” representing about 20% of the portfolio’s value. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 9 Crystal Canadian Growth Company Fund Asset Allocation Domestic Equities Communication & Media $281,302,000 Conglomerates $113,208,000 Consumer Products $123,555,000 Financial Services $67,700,000 Industrial Products $411,104,000 Merchandising $117,869,000 Oil and Gas $164,940,000 Paper and Forest Products $114,139,000 Real Estate $31,778,000 Transportation $122,979,000 Utilities $41,936,000 Sub-total $1,590,510,000 (77%) Foreign Equities $228,875,000 (11%) Total Equities $1,819,385,000 (88%) Canadian Govt. T-Bills $245,089,000 (12%) Total Investment Portfolio $2,064,474,000 Figure 12.3 Canadian Gov’t T-bills Foreign Equities 12% 11% Domestic Equities 77% © CANADIAN SECURITIES INSTITUTE 12 10 INVESTMENT FUNDS IN CANADA CRYSTAL CANADIAN INDEX FUND The investment objective of the Crystal Canadian Index Fund is: “… to provide long-term growth of capital primarily by purchasing Canadian equity securities to track the performance of a Canadian equity market index.” The Fund seeks to achieve its investment objective by tracking the performance of a generally recognized index of Canadian equity market performance (the “Recognized Canadian Index”), currently the S&P/TSX Composite Index. The number of securities comprising the Recognized Canadian Index in which the Fund actually invests from time to time will depend on the size and value of the Fund’s assets. The Fund will therefore be rebalanced with a frequency and degree of precision that seeks to track the Recognized Canadian Index as closely as possible, consistent with minimizing trading costs. This index fund is designed to mimic the S&P/TSX Composite Index while at the same time keeping trading costs low. This is entirely consistent with the objectives of Index funds. The portfolio of this Fund would be consistent with its objectives. Its holdings would consist of S&P/TSX Composite Index stocks with possibly a small percentage of the stocks not belonging to the Index. Portfolio managers for the Fund would construct a portfolio with essentially the same stocks and weightings as the Index. WHAT ARE BALANCED MUTUAL FUNDS? Balanced mutual funds invest a percentage of their assets in fixed-income securities and a percentage in equities. They are often referred to as “hybrid” products, because they are part fixed-income fund and part equity fund. Balanced mutual funds have the objective of earning some amount of both current income and capital gains while at the same time preserving capital. Balanced funds ideally provide a “balanced” mix of safety, income and capital appreciation. These objectives are sought through a portfolio of fixed-income securities for stability and income, plus a broadly diversified group of common stock holdings for diversification, dividend income and growth potential. The balance between defensive and aggressive security holdings is rarely 50‑50. Rather, managers of balanced funds adjust the percentage of each part of the total portfolio according to current market conditions and future expectations. INVESTMENT OBJECTIVES OF BALANCED MUTUAL FUNDS As noted above, balanced mutual funds have the objective of earning some amount of both current income and capital gains while at the same time preserving capital. Thus, balanced mutual funds have characteristics of both fixed-income funds (that earn current income) and equity funds (that earn capital gains). The distinguishing feature of balanced mutual funds is the way they go about meeting their investment objectives. Portfolio managers frequently attempt to shift the proportions of investments in fixed-income and equity securities in keeping with changing market conditions. When interest rates have peaked, managers want to be in fixed-income securities. When the stock market is set for an increase, they want to be in stocks. When both bond and stock markets are volatile, they will hold large amounts of money market securities. In other words, balanced mutual fund managers attempt to time the market to get the best returns depending on market conditions. A common misconception is that a balanced fund’s objective is to hold a “balance” between stocks and bonds. This is not the case. Nevertheless, balanced mutual funds typically hold both debt and equity securities in the portfolio at all times. While fund managers might shift the portfolio toward debt or equity, they do not as a rule go to 100% in either direction, as that would be inconsistent with their “middle-of-the-road” investment objectives. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 11 While most balanced mutual funds attempt to time the market to some extent, some do not. Instead, they hold fixed proportions of debt and equity securities over the longer term. RETURNS ON BALANCED MUTUAL FUNDS Since balanced mutual funds are part bond fund and part equity fund, you might expect them to perform mid-way between the performances of the two funds. If the efforts at market timing succeed, however, balanced mutual funds should earn returns on bond funds in periods when bonds outperform equities, and returns on equity funds when equities outperform bonds. Figure 12.4 compares the performance of equity funds, bond funds and balanced mutual funds during a hypothetical 15-year period. Figure 12.4 | Simple Annual Returns: Balanced Mutual Funds Compared with Bond Funds and Equity Funds 40 35 30 25 20 15 10 Annual Return (%) 5 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 -5 -10 -15 Year -20 -25 Legend: CDN Bond Funds -30 CDN Equity Funds Balanced Funds -35 Source: Bloomberg Since balanced mutual funds are composed of both bonds and equities, their returns generally fall somewhere between bond fund returns and equity fund returns. As you can notice in figure 12.4, balanced funds returns were more volatile than bond funds returns and less volatile than equity funds returns over the 15-year period. © CANADIAN SECURITIES INSTITUTE 12 12 INVESTMENT FUNDS IN CANADA HYPOTHETICAL EXAMPLES OF BALANCED FUNDS The fundamental nature or features of the Crystal Balanced Fund is stated in the fund facts document and prospectus as follows: “This Fund invests primarily in Canadian equities, bonds and short-term debt securities, but may also invest in foreign securities. The objective of the Fund is to provide a combination of capital growth and modest income at a competitive rate of return for a balanced-oriented client. The percentage of the Fund invested in each asset class is adjusted in response to changes in the market outlook for each asset class.” The Summary of Investments and Other Net Assets presented in Figure 12.5 indicates that the portfolio of the Crystal Balanced Fund consists of 37% Canadian equities, 17% foreign equities and 46% bonds. Figure 12.5 | Summary of Investments in a Balanced Fund Bonds Canadian 46% Equities 37% International US Equities Equities 12% 5% TARGET-DATE FUNDS Target-date funds (also referred to as target-based funds or life-cycle funds) have two characteristics that distinguish them from other mutual funds: a maturity date and a glide path. Investors who buy this product generally select maturity dates that match a certain life goal or target date in the future (e.g., date of retirement). The glide path refers to changes in the fund’s asset allocation mix over time which allows the fund to pursue a growth strategy by holding more risky assets in the early years of the fund’s life and then gradually reduce the risk of the fund as the target date approaches. The adjustment is made automatically by the fund manager without any action from fund holder. Target-date funds are structured on the assumption that risk tolerance and risk capacity declines as investors grow older. These funds have their own category under the CIFSC classification. Upon maturity, target-date funds are moved out of the target-date group and included in the appropriate fixed income or balanced fund category. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 13 EXAMPLE An investor who plans to retire in 2030 could buy a 2030 target-date fund. The asset allocation may gradually move from 80% equity and 20% fixed income in the early years to an asset allocation of 20% equity and 80% fixed-income by the target date. The increase in popularity of target-date funds is driven by demographics—baby boomers in Canada will retire in significant numbers over the next 15 to 20 years. Case Study | Targeting Education: Saving for Emma (for information purposes only) Ryan is meeting with his clients, Carol and Kevin. The couple has a two-year-old daughter, Emma. With the rising cost of education, Carol and Kevin want to begin saving for Emma’s post-secondary education as soon as possible. They anticipate she will begin her post-secondary education around age 17. Ryan establishes that Carol and Kevin’s risk profile is such that they have a high-risk tolerance and a relatively high- risk capacity and that their investment time horizon is long enough to allow them the ability to take a reasonable amount of risk to achieve their long-term goal of growth. Given their investment profile, Ryan recommends a Target Education Fund to meet the couple’s education funding needs for Emma. With 15 years until Emma will begin drawing down the portfolio to fund her education, Ryan recommends the Crystal Target Education 2035 Fund (the fund). Ryan explains to Carol and Kevin that the fund has a target maturity date of 2035, meaning that the fund’s glide path works to grow the fund in the early years and to gradually reduce risk as the target date of 2035 approaches. The fund is more heavily-weighted in equities in the early, growth-orientated years. Over time, the fund manager will gradually reduce the equity portion of the fund’s holdings and increase its bond weighting, reducing risk as the target date approaches. In its final few years, the majority of the fund’s holdings will be short-term bonds and money market funds to ensure that its volatility and risk are very low. In the last year before its maturity date, it will hold 100% money market funds, securing the savings of investors as their draw down period begins in 2035. For Carol and Kevin, this means that they only need to focus on saving and can leave the investment management to the fund manager, comfortable in the knowledge that the fund will be managed appropriately to achieve their goal of funding Emma’s education. WHAT ARE GLOBAL MUTUAL FUNDS? Global mutual funds, as the name suggests, hold assets from many countries in their portfolios. Technically, a global mutual fund can hold securities from any country, including Canada. The term international fund is sometimes used to describe a fund that invests anywhere except Canada. Some mutual funds specialize in a particular country or region. For example, many distributors offer “Asia” funds, “Europe” funds, “Japan” funds and “U.S.” funds. Global funds can be bond funds, equity funds or virtually any of the fund types discussed in this chapter. The most common type of global mutual fund is, however, the global equity fund. INVESTMENT OBJECTIVES OF GLOBAL MUTUAL FUNDS The investment objectives of global mutual funds depend first on the class of security they are designed to hold in their portfolios. For example, the primary objective of a global equity fund is to earn capital gains over the long term. The objective of an international bond fund, on the other hand, will be to earn interest income with some capital gains over a somewhat shorter horizon. © CANADIAN SECURITIES INSTITUTE 12 14 INVESTMENT FUNDS IN CANADA Investment objectives of a global mutual fund do not explain why investors may be attracted to a global mutual fund rather than a domestic equivalent. Investors are attracted to global mutual funds for two main reasons. The first is that at any one time, different countries are at different stages of an economic cycle. EXAMPLE It may be the case that the Canadian equity market is in a slump when the equity markets of other countries are performing well. Clients then can benefit from the higher returns available in non-Canadian markets. What this really means is that clients can benefit from additional diversification. Also, the Canadian securities market is relatively small, comprising only around 3% of the world’s market capitalization. Investing exclusively in a Canadian basket could leave a client unduly exposed to geographic concentration risk. Another reason global mutual funds are attractive is that they can provide a hedge against a decline in the relative value of the Canadian dollar. EXAMPLE If investors buy a Japan fund, and then the value of the Canadian dollar falls relative to the yen, the Canadian dollar value of that investment will increase whether the value of the fund’s units in yen has remained unchanged. A global mutual fund subjects the client to at least two types of risk: market risk of the country (or countries) in which the fund invests; and foreign exchange risk, because the value of the Canadian dollar can rise or fall in relation to the currency of another country. Not all global mutual funds expose clients to foreign exchange risk, however. Portfolio managers can undertake hedging transactions in the foreign exchange market to remove or greatly reduce the foreign exchange risk of their fund. They can do this by selling foreign currency for future settlement, either through currency futures contracts or another similar type of contract called a currency forward contract. EXAMPLE Assume that a portfolio manager sells yen for delivery in six months at today’s exchange rate. If the value of the yen rises relative to the Canadian dollar, the fund will make a profit on the contract. If the value of the yen falls, the fund will take a loss. What the manager is doing through the currency forward market is fixing the price at which the mutual fund company will convert the yen it eventually receives into dollars. A global mutual fund’s prospectus will indicate if the fund hedges the foreign currency risk by using these currency derivatives. It is important for mutual fund sales representatives to know whether their global mutual funds hedge foreign exchange risk, because some clients will want to bear that risk themselves, while others will not. In addition to the market and foreign exchange risk, there are other risk factors for global mutual funds. First, accounting practices differ from country to country to a certain extent. While some countries follow practices similar to those used in Canada, others do not. Portfolio managers need reliable accounting data to assess the risks and potential profitability of companies. If the accounting data are not reliable or comparable, then investment results can suffer. Likewise, the level of compliance and the regulatory environment differ widely from country to country, especially in the emerging markets of Asia and Eastern Europe. The second additional risk factor for global mutual funds has to do with the liquidity and efficiency of foreign stock markets. Canadian markets are liquid for most stocks, and the prices at which stocks trade generally reflect the information investors have about them. This is the idea of market efficiency. Foreign stock markets (and bond markets for that matter) might not offer as much liquidity as Canadian markets, and stock prices might not reflect information as rapidly. For established markets, such as the U.S., these problems do not exist. For much smaller stock markets, however, such as those in developing countries, inefficient stock markets can make it difficult for portfolio managers to make changes to their portfolios. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 15 RETURNS ON GLOBAL EQUITY FUNDS Global equity funds are the most common type of global mutual funds. This section compares the performance of global equity funds to Canadian equity funds during a hypothetical 15‑year period. In Figure 12.6, the average performance of Canadian equity funds is similar to the performance of the S&P/TSX Composite Index. Figure 12.6 | Simple Annual Returns: Global Equity Funds 35 30 25 20 15 10 Annual Return (%) 5 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 -5 -10 -15 Year -20 -25 Legend: Canadian Equity Funds -30 Global Equity Funds -35 Source: Bloomberg Figure 12.6 illustrates that the average performance of global equity funds can diverge significantly from Canadian equity funds. For instance, in Year 1 Canadian equity funds posted returns of 26.4%, while global equity funds lagged behind at 14.8%. In Year 3 the tables were turned: Canadian equity funds fell by 2.7%, while global equity funds rose by 17%. During this 15-year period, both experienced two major downturns: one in Year 7, where the Canadian equity fund fell by 13.2%, while the global equity fund lost 19.7%, and in Year 13, where the Canadian equity funds lost between 34.6% and the global equity fund lost 31.4%. The average annual performance of global equity funds has been lower over the 15-year period (2.84%) compared to Canadian equity funds (6.17%). Global equity funds earn two types of return: dividends and capital gains. Capital gains are probably more significant. Dividends from global funds do not come from Canadian corporations and therefore are not eligible for the dividend tax credit. As a result, foreign-source dividends are taxed at the same rate as interest income. © CANADIAN SECURITIES INSTITUTE 12 16 INVESTMENT FUNDS IN CANADA HYPOTHETICAL EXAMPLES OF GLOBAL FUNDS The following examples compare two different types of global mutual funds—government bond funds and emerging market funds—in terms of their investment objectives, portfolios, investment strategies, and risks and returns. CRYSTAL GLOBAL GOVERNMENT BOND FUND The investment objective of the Crystal Global Government Bond Fund is: “…to seek, over the long term, as high a level of total return as is consistent with investments in debt instruments issued or guaranteed by governments and other governmental agencies. The Fund seeks to achieve its investment objective by investing in bonds, debentures and other evidences of indebtedness issued or guaranteed by governments, semi-governmental entities, governmental agencies, supranational entities (such as International Bank for Reconstruction and Development), and other governmental entities in a variety of countries and denominated in the currencies of such countries. The Fund will be managed so as to be prudently diversified at all times among different regions, countries and securities. Under certain market conditions, short-term securities may be held within the portfolio.” This is exactly the kind of investment objective to expect from a global bond mutual fund invested in government securities. Portions of the Investment Portfolio shown below and presented in Figure 12.7 reveal that the diversification of the fund extends to nine countries (including Canada). Belgium $3,296,264 (2.8%) Canada $14,195,190 (12.1%) Finland $3,366,934 (2.9%) France $10,229,732 (8.7%) Germany $20,693,569 (17.6%) Italy $8,484,775 (7.2%) Netherlands $3,129,604 (2.7%) United Kingdom $8,751,246 (7.4%) USA $36,704,681 (31.2%) Supranational $8,653,625 (7.4%) Total $117,505,620 © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 17 Figure 12.7 | Diversification in a Global Government Bond Portfolio Belgium: 3% Supranationals: 7% Canada: 12% Finland: 3% France: 9% USA: 31% United Kingdom: 7% Germany: 18% Netherlands: 3% Italy: 7% It is not immediately apparent whether this Fund hedges the value of the Canadian dollar. The following statement appears at the end of the section on “Derivatives” in the prospectus: “The Crystal Global Government Bond Fund will be permitted to invest in forward currency and currency futures contracts for the purpose of protecting itself from exchange rate fluctuations to the extent determined by the portfolio advisor. Such forward and futures contracts shall not exceed three years in duration and shall be limited to the market value of the foreign securities owned by the Fund and quoted in that currency. Adjustments shall be made to such forward and futures contracts owned by the Fund to ensure that these contracts are limited as above, which adjustment shall be made at least weekly and more frequently if necessary having regarded market conditions….” As discussed earlier in this chapter, some global mutual funds hedge foreign exchange risk. If clients invest in a global mutual fund to diversify beyond Canadian dollars, they may not want to buy units of a fund that hedges its exposure. Instead, they may want to invest in a fund that does not reduce the foreign exchange exposure through hedging. CRYSTAL EMERGING MARKETS FUND The investment objective of the Crystal Emerging Markets Fund is: “… to achieve long-term capital appreciation through investment, primarily in equity securities. Under normal conditions, at least 65% of the Fund’s total assets will be invested in emerging country equity securities, which for this purpose means common and preferred stock (including convertible preferred stock), bonds, notes and debentures convertible into common or preferred stock, stock purchase warrants and rights, equity interests in trusts or partnerships and American, global or other types of depository receipts. As used herein, an “emerging country” is any country that the World Bank has determined to have a low- or middle-income economy. The Fund seeks to achieve its investment objective by investing primarily in (1) equity securities in companies whose principal trading market is in an emerging country, (2) equity securities, traded in any market, of companies that derive significant annual revenue from either goods produced, sales made or services rendered in emerging countries, or (3) equity securities of companies organized under the laws of, and with a principal office in, an emerging country. The Fund will be managed so as to be prudently diversified at all times among different regions, countries and securities. Under certain market conditions short term securities may be held within the portfolio.” © CANADIAN SECURITIES INSTITUTE 12 18 INVESTMENT FUNDS IN CANADA This statement of investment objectives sets out clearly what the portfolio manager may invest in. The Statement of Investment Portfolio (not shown) indicates that the Fund has equity investments in 26 countries and bond investments in two countries. This Fund does not hedge the value of the Canadian dollar. WHAT ARE SPECIALTY MUTUAL FUNDS? Specialty mutual funds are funds that restrict the investment objectives in some particular way. Of course, in a sense, all mutual funds are specialized. However, specialty mutual funds tend to concentrate investments in securities or industries to a far greater degree than other funds. Examples of specialty mutual funds are precious metals funds and natural resource funds. Each type of specialty mutual fund can be thought of as comprising its own mutual fund category. RISK FACTORS OF SPECIALTY MUTUAL FUNDS Specialty mutual funds have risk factors consistent with the make-up of their investment portfolios, just like the other types of funds. For example, gold funds rise and fall with the value of gold and securities based on the price of gold. However, many specialty mutual funds have an additional risk factor that other funds generally avoid: a lack of diversification. Because of their specialization, specialty mutual funds tend to construct portfolios that are not as well diversified by industry sector as more standard types of funds. For example, a real estate mutual fund is exposed to the risk of the real estate market alone, and a resource mutual fund tends to invest only in firms in the natural resource sector of the economy. In comparison to traditional Canadian equity funds, for example, the lack of diversification in specialty funds can be striking. To what extent is this lack of diversification a problem for clients? The answer to this question depends to a great extent on how the particular specialty mutual fund fits in with the client’s current portfolio. If a less-than-well- diversified specialty mutual fund is a client’s only investment, there could be a problem. Your clients get the most diversification benefit by holding securities that have a low degree of correlation. That is, they get a reduction in total risk from holding a portfolio of two uncorrelated stocks, but no risk reduction if the stocks are perfectly (positively) correlated. The same logic works for portfolios as for individual securities. EXAMPLE Imagine you have a client with a portfolio consisting of an equity fund and a bond fund. The client may be able to get more risk reduction without sacrificing return by adding another mutual fund that is not well correlated with the returns of the existing portfolio. That additional mutual fund might be a specialty fund, such as natural resource fund, or a real estate fund. In itself, the specialty fund is poorly diversified, but put together with the existing portfolio, the client can have still more diversification. The key thing to remember is that no investment should be considered in isolation from the client’s existing portfolio. It is not a good investment strategy for clients to buy a specialty mutual fund as their only investment, as they may be exposing themselves to more risk than necessary to earn the same expected return. HYPOTHETICAL EXAMPLES OF SPECIALTY FUNDS The following examples compare three different types of specialty mutual funds—a resource fund, a precious metals fund, and a special growth fund—in terms of their investment objectives, investments, and risks. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 19 CRYSTAL RESOURCE FUND The investment objective of the Crystal Resource Fund is: “…to provide capital growth by investing primarily in stocks of Canadian natural resource companies. This Fund invests in the stocks of companies primarily engaged in the precious metals, base metals, oil and gas, and forest products sectors, which have high growth potential. The Fund may invest in small cap companies and purchase and sell commodities such as precious and other metals and minerals.” The prospectus has the following to say about risks: “Because it invests in only a few sectors of the economy, the value of the Fund may vary more than funds that invest in many different industries. Its value is also affected by movements in commodity prices and changes in global economic conditions. Because it may invest in smaller companies, the value of the Fund may vary more than funds that invest only in larger, established corporations.” As is the case with many specialty mutual funds, the goal is to earn capital gains. It is notable that this specialty mutual fund invests in the types of firms, industries and securities that other types of specialty mutual funds invest in. The prospectus states, for example, that this Fund may buy securities of small capitalization firms. Specialty small cap mutual funds do exist, and there are also mutual funds that specialize in only one commodity (e.g., gold). In a sense, the Crystal Resource Fund is more diversified than some other specialty mutual funds. The $35,289,000 Investment Portfolio, presented in Figure 12.8, indicates the following partial breakdown by investment area: oil and gas, $7,991,000 (22.6%); gold and precious metals, $14,169,000 (40.2%); paper and forest products, $2,104,000 (6.0%); industrial products, $1,430,000 (4.1%); metal and minerals, $6,904,000 (19.6%); and money market securities $2,691,000 (7.6%). These securities are held for liquidity purposes: either to meet redemption demand or to take advantage of perceived market opportunities. Figure 12.8 | Diversification in a Resource Fund Money market securities 8% Oil and gas 23% Metal and minerals 20% Industrial products 4% Paper and forest products Gold and precious 6% 39% © CANADIAN SECURITIES INSTITUTE 12 20 INVESTMENT FUNDS IN CANADA CRYSTAL PRECIOUS METALS FUND According to the investment objectives of the Crystal Precious Metals Fund: “This Fund seeks to provide long-term capital growth by investing primarily in precious metals (gold, silver and platinum) in the form of bullion, coins, receipts and certificates, and in common shares and other securities of Canadian and foreign companies involved directly or indirectly in the exploration, mining and production of these metals. The Fund will not purchase silver and platinum in excess of 20 percent of its net asset value. The Fund may from time to time have a large portion of its assets in cash or cash equivalents in response to changing market conditions. Because the Fund invests in a specialized sector, it is particularly sensitive to changes in that sector. The price of gold and other precious metals can swing dramatically because of international monetary policy, political events and speculation. In addition, the price of gold may be affected by political conditions in South Africa, which remains the world’s largest producer. Changes in the sector will affect the value of the precious metals held by the Fund, as well as the value of the companies in which the Fund has invested. The price of precious metals is quoted in U.S. dollars, so the unit value of the Fund will be affected by changes in the value of the U.S. dollar relative to the Canadian dollar.” This Fund is more specialized than the resource fund described above, since it invests only in the precious metals sector. According to its Annual Report, 58% of the Fund’s assets, shown in Figure 12.9, consist of the common shares of Canadian firms engaged in gold and precious metals mining activities ($118,040,000). The Fund also holds gold and silver certificates worth $43,661,000 (21%) and shares of foreign metal and mining firms worth $35,399,000 (17%). Figure 12.9 | Assets of a Precious Metals Fund Common shares of Gold and silver Canadian firms certificates 58% 21% Shares of foreign metal and mining firms 17% CRYSTAL SPECIAL GROWTH FUND The simplified prospectus for the Crystal Special Growth Fund describes the objectives, investment policy and additional risk factors as follows: Objective The objective of this Fund is to generate long-term capital appreciation by directing investments into areas of emerging trends and values. Investment Strategy To achieve this objective, the Fund invests primarily in smaller companies. The emphasis is on analyzing and picking individual stocks rather than industry sectors. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 21 Risks The Fund invests in smaller companies, generally lower than $500 million in market capitalization. The securities of smaller companies are often less liquid, less marketable and more volatile than those of larger companies. It is possible to think of this Fund as simply an equity mutual fund, except that it specializes in small capitalization (or small cap) firms. These are typically firms making and marketing new types of products for which market demand may be difficult to determine. In addition, many small-cap firms can be bought only on the OTC market and may trade infrequently. This makes the market for shares of these firms less efficient. In the Investment Portfolio, shown below in summary form and presented in Figure 12.10, Canadian equities account for 84.5% of the special growth fund portfolio. Canadian equities Industrial products $44,321,217 (24.4%) Consumer products $28,538,870 (15.7%) Communications & media $25,576,540 (14.1%) Oil and gas $21,316,424 (11.7%) Gold and precious metals $9,468,408 (5.2%) Other industries $24,382,502 (13.4%) Total $153,603,961 (84.5%) Foreign equities $16,556,495 (9.1%) Note that cash and short-term investments make up the balance (6.4%) of the portfolio. Figure 12.10 Foreign equities 9.1% Industrial products Other industries 24.4% 13.4% Gold and precious metals 5.2% Consumer products 15.7% Oil and gas 11.7% Communications & media 14.1% © CANADIAN SECURITIES INSTITUTE 12 22 INVESTMENT FUNDS IN CANADA FUND WRAPS A fund wrap program provides a series of portfolios with multiple mutual funds to reflect pre-selected asset allocation models. Each model is designed to meet the needs of a group of investors sharing a similar client profile. In contrast to a balanced mutual fund, a fund wrap generally outsources the management and security selection within each asset category to different managers. Responsibility for the asset allocation decision falls to the wrap sponsor. For convenience, all administrative, management and trading costs are usually rolled into one wrap fee. Fund wrap investors hold the unitized value of the fund of funds, but they do not hold title to the underlying funds or to the funds’ underlying securities. Fund wraps are available with advisor compensation either built in or excluded (fee-based approach), increasing the flexibility and acceptability of these products. From a trading point of view, there is no substantial difference between fund wraps and traditional mutual funds. From the client’s point of view, the purchase, redemption and reporting process is the same as for mutual funds. From the mutual fund salesperson’s point of view, the process also is largely the same, with differences only in details of compensation. From a regulatory point of view, fund wraps constitute a specific investment structure. A fund of funds exists as a legal entity, in addition to the legal existence of the underlying mutual funds. Thus, specific regulatory provisions govern the development and promotion of fund wraps. Regulations include, for example, prohibitions against “double dipping” (charging fees twice for the same services or components). Otherwise, trading fund wraps as units is essentially the same as trading fund units. Fund wraps can be funds of funds or portfolio allocation services. With a fund of funds, the client owns units of a pool of mutual funds, while in a portfolio allocation service, the client owns units of several mutual funds in the proportions established through the allocation service. Thus, in a portfolio allocation service, the investor actually owns units of the constituent mutual funds rather than units of a fund holding other funds. RISKIER MUTUAL FUNDS How do equity, balanced, and specialty funds compare? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 12      RISKIER MUTUAL FUND PRODUCTS 12 23 SUMMARY After reading this chapter, you will be able to: 1. Describe and compare and contrast the composition of different equity mutual funds. Equity mutual funds invest in the common and preferred shares of publicly-traded companies. Equity mutual funds as a group have the goal of earning capital gains, sometimes with a current dividend income component. Canadian equity mutual funds can be categorized into three fairly distinct types: “standard” equity funds, equity growth funds and equity index funds. ESG issues are some of the most important drivers of change in the world today. ESG considerations include climate change, water scarcity, Indigenous and community relations, and diversity and inclusion. 2. List and describe the investment objectives, comparative returns and the volatility of the different types of equity mutual funds. Equity growth funds pursue capital gains. Some dividend income may be earned, but probably not much. An equity index fund has the goal of generating capital gains. It intends to do this by constructing an investment portfolio designed to mimic a particular stock market index. Balanced mutual funds have the objective of earning current income and capital gains while at the same time preserving capital. A new type of balanced fund has emerged in recent years: target-date funds. These funds have a maturity date and the risk of the fund decreases as the maturity date approaches. The primary objective of a global equity fund is to earn capital gains over the long term. The investment objectives of specialty mutual funds is to concentrate investments in securities or industries to a far greater degree than other funds to achieve better returns than diversified investments. The average return performance of equity funds parallels that of the TSX Index, and equity and growth funds are much more volatile than the returns on money market funds. Since balanced mutual fund are composed of both bonds and equities, their returns generally fall somewhere between bond fund returns and equity fund returns. 3. Describe the features and key types of specialty mutual funds. Specialty mutual funds tend to concentrate investments in specific securities or industries. Specialty mutual funds are generally not well diversified and are exposed to the risk inherent to the industry or sector. A fund wrap program provides a series of portfolios with multiple mutual funds to reflect pre-selected asset allocation models. In contrast to a balanced mutual fund, a fund wrap generally outsources the management and security selection within each asset category to different managers. From a trading point of view, there is no substantial difference between fund wraps and traditional mutual funds. Fund wraps can be funds of funds or portfolio allocation services. © CANADIAN SECURITIES INSTITUTE 12 24 INVESTMENT FUNDS IN CANADA REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 12 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 12 FAQs. © CANADIAN SECURITIES INSTITUTE