Alternative Managed Products PDF

Alternative Managed Products 13 CONTENT AREAS What Are Principal-Protected Notes? What Are Hedge Funds? What Are Closed-End Funds? What Are Exchange-Traded Funds? What Are Segregated Funds?...

Alternative Managed Products 13 CONTENT AREAS What Are Principal-Protected Notes? What Are Hedge Funds? What Are Closed-End Funds? What Are Exchange-Traded Funds? What Are Segregated Funds? LEARNING OBJECTIVES 1 | Identify and distinguish between the features, advantages, and risks of the various alternative managed products discussed. 2 | Identify and describe the costs associated with these alternative managed products. 3 | List and compare the requirements to consider before investing in each product. © CANADIAN SECURITIES INSTITUTE 13 2 INVESTMENT FUNDS IN CANADA KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. accredited investor incentive fees alternative managed products interval fund alternative mutual fund market sentiment annuitant maturity guarantee beneficiary minimum investment closed-end discretionary fund offering memorandum closed-end fund performance averaging formulas contract holder performance participation cap death benefits portfolio funds directional strategies principal-protected note event-driven strategies probate exchange-traded funds relative value strategies first-order risk reset option guaranteed minimum withdrawal benefit plan second-order risk hedge funds segregated fund high-water mark tracking error hurdle rate © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 3 INTRODUCTION Since the early 1990s, managed products have become popular investment vehicles for many investors, particularly those who consider direct investing in bonds or equities too complex or risky. These products are often appropriate for investors who have a limited amount of money to invest but want the benefits of diversification and professional investment management. Managed products include more than just mutual funds—the one constant in the investment industry is change. Continual innovation in financial markets, products, and the wealth management industry in general has resulted in an overwhelming number and variety of alternative managed products, which makes the process of making investment decisions all the more challenging. With more choice, investors have more homework to do before investing, and mutual fund representatives compete against new products they are not licenced to sell. Alternative managed products are professionally managed portfolios of basic asset classes and/or commodities and include segregated funds, hedge funds, alternative mutual funds, exchange-traded funds, closed-end funds and principal-protected notes (PPN). What distinguishes alternative managed products from other groups of investment products, such as mutual funds, is their use of complex investment strategies, such as the use of derivatives, leveraging and principal guarantees. The risk/return profiles of alternative managed products when compared to conventional asset classes are skewed by the use of these investment strategies. This chapter looks at the features, advantages, and costs of the most common classes of alternative managed products. WHAT ARE PRINCIPAL-PROTECTED NOTES? A principal-protected note (PPN) is a debt instrument. Like other debt instruments, a PPN has a maturity date upon which the issuer agrees to repay investors their principal. In addition to the principal, PPNs provide interest paid either at maturity or as regular payments linked to the positive performance of the underlying PPN asset. The underlying assets can be common stocks, indexes, mutual funds, exchange-traded funds, commodities or hedge funds. In Canada, PPNs are issued only by the six major banks (the Big Six). The banks function in three main roles: guarantor, manufacturer, and distributor. As the issuers of PPNs, the banks guarantee the return of principal at maturity. The value of the guarantee is based wholly on the perceived creditworthiness of the issuer. In the event of default, PPN investors rank equally with all other investors in the bank’s deposit notes. As manufacturers, they choose the underlying asset, the term to maturity, and any special features tied to interest payments. This role is almost always performed by a group that specializes in equity derivatives, which is typically part of the bank’s Capital Markets division. Banks distribute PPNs primarily through their investment dealer arm, although some banks use a third-party investment dealer or mutual fund dealer. COSTS OF PRINCIPAL-PROTECTED NOTES Many costs are associated with PPNs. These products are not mutual funds; as a result, they are not held to the transparency standards of mutual funds or prospectus-based financial products. In fact, the lack of transparency in these products prevents investors from clearly understanding all of the costs involved. It is particularly important, then, to determine their suitability before investing in PPNs. © CANADIAN SECURITIES INSTITUTE 13 4 INVESTMENT FUNDS IN CANADA PPNs are not protected by the Canada Deposit Insurance Corporation (CDIC); they are considered uninsured deposit notes. PPNs are not issued under a prospectus because they are not considered securities. In most provinces, those who sell PPNs require no special licensing. There are implicit as well as explicit costs to consider when purchasing a PPN. Explicit costs are described in the offering documents and include the costs identified in Table 13.1. Table 13.1 | Common Explicit Costs Attached to PPNs Commissions PPNs have been designed in many ways to resemble mutual funds. PPNs differ from mutual funds in that investors bear the cost of the commission at the time of purchase because the net asset value (NAV) of the PPN declines directly as a result of commissions paid. Management fees Like mutual funds, many PPNs carry a management fee for actively managing the PPN’s assets. Some PPNs, however, are issued without management fees. When a management fee is charged, it is charged to the assets of the PPN. Management fees affect the PPN’s performance, which in turn affects the final payoff received by investors. Early redemption Many PPNs carry an early redemption fee. A typical early redemption fee schedule runs fees from two to five years and declines over time. The purpose of the early redemption fee is to ensure that the PPN’s issuer receives the full fees it was expecting. Structuring costs and Some PPNs include an explicit charge for structuring, and most PPNs charge a fee for guarantee fees providing the capital guarantee. Implicit Costs include fees borne by investors that may or may not be immediately visible and that may or may not be openly disclosed in the documents. Table 13.2 identifies the more common implicit costs. Table 13.2 | Common Implicit Costs Attached to PPNs Performance Many mutual fund-based and income-producing PPNs use performance averaging Averaging Formulas formulas in which the PPN’s final payoff is based not on the value of the underlying asset at maturity, but on some average performance of the underlying asset over the life of the note. This average performance typically is based on the note’s monthly average NAV and may raise or lower the return to investors. Performance A PPN with a performance participation cap promises to pay the return earned by Participation Caps some particular asset up to a maximum amount. Example: An index-linked GIC might pay 60% of the return of the S&P/TSX 60 Index while guaranteeing investment principal. If the performance of the underlying asset exceeds the cap, investors would incur an opportunity cost because they could have earned a higher return on the investment if the cap did not exist. Price Returns vs. The final payoff is based on the underlying asset’s price return rather than its total Total Returns return. Total return refers to the change in price plus any income such as dividends or interest. Using price return rather than total return is a hidden cost because it underestimates the actual performance of the underlying asset. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 5 ADVANTAGES AND RISKS OF PRINCIPAL-PROTECTED NOTES Individual investors with relatively small amounts to invest can use PPNs to invest in markets they normally could not access. A PPN could use as its underlying asset a basket of selected commodities or a hedge fund. In this case, a PPN investor would not be subject to large investment minimums, accreditation requirements or margin calls that would normally be associated with direct commodity or hedge fund investments. In addition, a PPN can enhance the return available from cash or cash-equivalents such as GICs or T-bills. Today, with relatively low real interest rates (the nominal interest rate minus the expected rate of inflation) on most traditional cash equivalents, a PPN can produce a higher yield while still protecting the principal invested. Finally, PPNs may also be appropriate for the extremely risk-averse investor who has the ability but not the willingness to take equity-like risk. As long as the investor is convinced that the issuer’s guarantee is secure, investing in a PPN can provide the investor with exposure to equities, commodities and more without the risk of investing in them directly. While a PPN is free from risk of principal loss, it is not considered to be an entirely risk-free investment. Risks associated with PPNs include liquidity risk, performance risk, credit risk, and currency risk, described in Table 13.3. Table 13.3 | Risks Associated with PPNs Liquidity Risk Most PPNs offer liquidity. They usually can be resold to the issuer before maturity, at certain dates, with associated costs and advance notice. However, the issuer is under no obligation to buy back the notes. Investors should buy PPNs with the intention of holding them until maturity. Performance Risk The performance of a PPN may not exactly track the performance of the underlying asset. It can either underperform or outperform it. The mismatch in performance is likely in the early years of the PPN issue. Investors are not just purchasing an underlying asset’s returns with a principal protection feature tacked on, because many factors are involved in pricing a PPN, including interest rates, fees, the actual performance of the underlying asset, whether leverage has been used, and various explicit and implicit fees. Credit Risk The issuer may not be able to return the principal at maturity. Although the likelihood is small, especially because the issuers are large, well-known banks, the risk is still there. Currency Risk Because many PPNs track the returns from a foreign underlying asset that may be denominated in a foreign currency, investors may be exposed to currency risk. A change in the value of the foreign currency relative to the Canadian dollar will reduce the returns when reconverted to Canadian dollars. BEFORE INVESTING IN PRINCIPAL-PROTECTED NOTES PPNs are in some ways more difficult to evaluate than conventional investments. PPN issuers are not obligated to disclose as much information as they would if shares or a bond were brought to market. Still, the following points should be considered when evaluating a PPN: The creditworthiness of the issuer should be without question. The issuer is the only party investors can turn to for payment of principal and return. Investors should understand the calculation method used to arrive at the final variable return. Investors should understand the risk factors behind the underlying asset, whether it is a mutual fund, hedge fund or common stock. © CANADIAN SECURITIES INSTITUTE 13 6 INVESTMENT FUNDS IN CANADA The principal protection should be worth paying for. This is especially important for longer term equity-based PPNs (over five years), where the maturity horizon lowers the risk of loss. The principal protection might be worth the cost for an underlying basket of commodities but may not be worth the cost for an underlying mutual fund that has never lost money over the corresponding term of the PPN. Case Study | Paul Balances Risk and Reward (for information purposes only) Sandra is a mutual fund representative who works for the mutual fund arm of ABC Bank. She is meeting with her client Paul. Having suffered heavy investment losses during the most recent financial crisis, Paul moved most of his investment portfolio into GICs and has been wary of re-investing since then. However, Paul has since seen equity markets rebound sharply over the last few years and knows that he requires growth in his portfolio to reach his retirement goals. Given how low present GIC rates are, Paul wants to discuss with Sandra investment opportunities that will allow him to benefit from the performance of equity markets without putting his principal at risk. Sandra explains to Paul that mutual funds are not guaranteed as to their principal or return and that with the exception of money market funds, there is potential risk of negative returns in even the most conservative funds. However, Sandra suggests that if Paul wants to participate in the equity markets without placing his principal at risk, there is the option of principal-protected notes. Sandra explains to Paul that PPNs provide investors with a principal guarantee on their original investment. The investor’s return consists of a percentage of the market index’s return over a pre-set timeframe. Sandra suggests to Paul that the 3-year ABC Bank Canadian Equity Growth PPN would be an ideal fit. The PPN’s three-year term allows Paul to learn about how this solution can work to help him reach his goals while not locking him into a longer term. ABC Bank is a top Canadian chartered bank, so there is essentially zero issuer credit risk. Paul’s principal is guaranteed. The return of the PPN is linked to the S&P/TSX Composite Index’s return over the three-year period, so Paul will participate in the upside of the market’s performance while avoiding any downside. However, Sandra explains that the cost of the guarantee is that Paul will receive only 50% of the Index’s return at the conclusion of the three-year term and that if the return is negative, he will receive his principal back, but a nil return on his investment. Paul is willing to accept this cost given his desire to find the right balance between risk and reward that properly fits his needs. WHAT ARE HEDGE FUNDS? Hedge funds are lightly regulated pools of capital whose managers have great flexibility in their investment strategies. Hedge fund strategies are often referred to as alternative investment strategies. Hedge fund managers are not constrained by the rules that apply to mutual funds. The managers can take short positions, use derivatives for leverage and speculation, perform arbitrage transactions, and invest in almost any situation in any market where they see an opportunity to achieve positive returns. In addition to alternative strategies, the category of alternative investments includes alternative assets and private equity. These investments include, but are not limited to, real estate, commodities, and investments in securities that are not publicly listed (i.e., private equity). Despite the hedge fund name, some funds do not hedge their positions at all. It is best to think of a hedge fund as a type of fund structure, rather than a particular investment strategy. Another type of fund structure that utilizes alternative strategies is the alternative mutual fund, otherwise known as liquid alternatives or simply as liquid alts. This type of fund was recently introduced into Canada, replacing what were known as commodity pools. By regulation, alternative mutual funds are allowed greater use of short sales, leverage, and derivatives compared to mutual funds, but not to the same extent as hedge funds. Unlike hedge funds, alternative mutual funds can be sold to retail investors. Hedge funds, in contrast, have a more limited audience. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 7 DID YOU KNOW? Proficiency Standards to Sell Alternative Mutual Funds CIRO Registered Representatives (RRs) are able to deal in alternative mutual funds within their existing licensing approval category, however as with all products the dealer and the RR need to ensure that Know Your Product requirements are met. Mutual fund sales representatives are not allowed to distribute alternative mutual funds unless they possess one of the following: Passing grade for the Canadian Securities Course; Passing grade for the Derivatives Fundamentals Course; Successful completion of the Chartered Financial Analyst Program; or Any applicable proficiency standard mandated by a self-regulatory agency This proficiency requirement was the one aspect of the CSA regulation that governed commodity pools (NI 81-104) that has been retained at least for the time being. The CSA is evaluating proficiency requirements more generally and it is possible the requirements to deal in alternative mutual funds may change in the future along with other proficiency alterations. Because hedge fund managers have tremendous flexibility in the types of strategies they can employ, the manager’s skill is more important than for other alternative managed products. Additionally, a hedge fund’s investment objectives and investor suitability vary depending on the manager’s choice of strategy and the targeted risk/ return level. Like mutual funds, alternative mutual funds and hedge funds: Are pooled investments that may have front-end sales commissions. Charge management fees. Can be bought and sold through an investment dealer. Despite these similarities, there are differences to consider, summarized in Table 13.4. Table 13.4 | Comparing Mutual Funds to Alternative Mutual Funds and Hedge Funds Main Product Features and Regulatory Conventional Mutual Alternative Mutual Restrictions Funds Funds Hedge Funds Investment objective Maximize relative return Maximize absolute return, Maximize absolute return, while providing downside while providing downside protection in falling protection in falling markets markets Permitted short sale of Maximum of 5% of Maximum of 10% of Permitted as per offering a single issuer fund NAV fund NAV memorandum Permitted total short Maximum of 20% of Maximum of 50% of Permitted as per offering sales for fund fund NAV fund NAV memorandum © CANADIAN SECURITIES INSTITUTE 13 8 INVESTMENT FUNDS IN CANADA Table 13.4 | Comparing Mutual Funds to Alternative Mutual Funds and Hedge Funds Main Product Features and Regulatory Conventional Mutual Alternative Mutual Restrictions Funds Funds Hedge Funds Diversification – Maximum of 10% of NAV Maximum of 20% of NAV Limit set by offering concentration invested in securities of invested in securities of memorandum (issuer level) any one issuer any one issuer Fund NAV calculation Required to calculate Same as conventional Frequency set by offering frequency NAV weekly, unless they mutual fund memorandum (usually use specified derivatives monthly or quarterly) or short sell – in which case the NAV must be calculated daily Charging management Yes Yes As defined in offering fees permitted memorandum Charging performance Yes, but can only charge Yes, but performance fees Yes, but performance fees fees permitted performance fees tied to normally charged based normally charged based on a reference benchmark or on the total return of the the total return of the fund index fund itself itself Product redemption Usually daily Usually daily Usually monthly, sometimes quarterly Permitted investors General public General public Exempt, accredited, institutional, or minimum initial $150,000 investment Fund holdings disclosure Monthly: Top ten security Monthly: Top ten security Disclosure frequency (transparency) holdings holdings stipulated in offering memorandum (typically Quarterly: Complete Quarterly: Complete semi-annual or annual) fund holdings report fund holdings report Investor rights of Right to cancel investment Right to cancel investment No right of withdrawal withdrawal within 48 hours of receipt within 48 hours of receipt of confirmation purchase of confirmation purchase INVESTING IN HEDGE FUNDS Hedge funds are typically sold to investors without a prospectus. Securities regulators permit the sale of securities without a prospectus, but only under certain conditions and only to investors who meet exempt investor qualifications. The exempt market is composed of both institutional investors and individual investors. Common prospectus exemptions allowed by securities regulators include the accredited investor exemption, the minimum investment exemption, and the offering memorandum exemption. Typically, individual hedge fund investors must qualify as accredited investors. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 9 Accredited investor An accredited investor is described in National Instrument 45-106 as follows: exemption An individual who, either alone or with a spouse, beneficially owns financial assets with an aggregate realizable value (before taxes, but net of related liabilities) that exceeds $1 million. An individual whose net income before taxes exceeded $200,000 (or exceeded $300,000 if combined with a spouse’s income) in each of the two most recent years, and who has a reasonable expectation of exceeding that same income level in the current year. An individual who, alone or with a spouse, has net assets (which would include real estate, and which is again net of any related liabilities) worth at least $5 million. Persons relying on the accredited investor exemption to distribute securities to such an investor must obtain a completed and signed risk acknowledgement form from that individual accredited investor. The accredited investor exemption includes other categories of entities and individuals, as described in National Instrument 45-106. Minimum investment The minimum investment exemption is not available to retail investors. This exemption exemption allows the sale of securities to non-individual investors who make a prescribed minimum investment. National Instrument 45-106 sets this minimum at $150,000 across all jurisdictions in Canada. Offering memorandum The offering memorandum exemption allows an issuer to sell its securities based on an exemption offering memorandum being made available to investors. An offering memorandum is a document that provides information on the business and affairs of the issuer, including audited financial statements. It also describes certain rights of the investor, including a two-business-day right of withdrawal and a right of action for damages (and rescission) if the offering memorandum contains a misrepresentation. This exemption is subject to investment limits (e.g., $10,000 for investors who do not meet certain income and asset thresholds) and requires that investors sign a risk acknowledgement form. Additional restrictions and requirements that apply may vary between provinces, so it is best to consult your jurisdiction to determine their nature. The market for hedge funds can be grouped under the following two categories: Funds targeted toward high-net-worth and institutional investors Funds, and other hedge fund-related products, targeted toward the less affluent individual investor (i.e., the retail market) Hedge funds targeted toward high-net-worth and institutional investors are usually structured as a limited partnership or trust, and are issued by way of private placement. As mentioned, in the broader retail market, alternative mutual funds are now available as a way to gain access to alternative investment strategies. Other retail vehicles through which alternative strategies can be accessed are closed-end funds and exchange-traded funds (described later in the chapter). © CANADIAN SECURITIES INSTITUTE 13 10 INVESTMENT FUNDS IN CANADA HEDGE FUND STRATEGIES Hedge fund investment strategies span all asset classes, all regions of the world and all levels of market capitalization. Hedge funds nevertheless can be placed into three major categories based on the strategies they use—relative value, event-driven and directional. The three strategies are listed in order of increasing expected return and risk: Relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related stocks, bonds or derivatives in different markets. Hedge funds using these strategies usually have low or no exposure to the underlying market direction. Their returns are due to the manager’s skill in identifying mispriced securities. Event-driven strategies seek to profit from unique events such as mergers, acquisitions, stock splits and stock buybacks. Hedge funds that use event-driven strategies have medium exposure to the underlying market direction. Directional strategies bet on anticipated movements in the market prices of equities, debt securities, foreign currencies and commodities. Hedge funds using these strategies have high exposure to trends in the underlying market. The manager focuses on predicting and understanding the opportunities generated by trends in different market indicators. COSTS OF HEDGE FUNDS In addition to management and administration fees, hedge fund managers often charge an incentive fee based on performance. Incentive fees are usually calculated after the deduction of management fees and expenses and not on the gross return earned by the manager. This detail can make a significant difference in the net return earned by investors. Incentive fees may be calculated in relation to a high-water mark, a hurdle rate or both. A high-water mark ensures that a fund manager is paid an incentive fee only on net new profits. In essence, a high-water mark sets a bar (based on the fund’s previous high value), above which the manager earns incentive fees. It prevents the manager from “double dipping” on incentive fees following periods of poor performance. EXAMPLE ABC Hedge Fund is launched with a net asset value of $10 per unit. At the end of the first year, the fund’s net asset value rises to $12 per unit. For the first year, the manager is paid an incentive fee based on this 20% performance. At the end of the second year, the fund’s net asset value has fallen to $11 per unit. The fund manager receives no incentive fee for the second year and will not be eligible to receive an incentive fee until the fund’s net asset value rises above $12 per unit. A hurdle rate is the rate that a hedge fund must earn before its manager receives an incentive fee. Hurdle rates are usually based on short-term interest rates to reflect the opportunity cost of holding risk-free assets such as T-bills. EXAMPLE ABC Hedge Fund has a hurdle rate of 5%, and the fund earns 20% for the year. The incentive fees will typically be based on the 15% return above the hurdle rate, subject to any high-water mark. ADVANTAGES AND RISKS OF HEDGE FUNDS There are many advantages of investing in hedge funds including the focus on absolute returns, lower correlation with traditional asset classes, and the potential for lower volatility and higher returns. Table 13.5 outlines these advantages. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 11 Table 13.5 | Advantages of Hedge Funds Focus on Absolute, Hedge fund managers seek to achieve positive or absolute returns in any market not Relative, Returns condition (up markets, down markets, trendless markets) not just returns that beat a market index, which is the goal of most mutual funds. A mutual fund manager might be satisfied with losing less than the benchmark, but a hedge fund manager in the same position would be disappointed with the results. Lower Correlation Although correlations can change over time, hedge fund returns usually have a with Traditional low correlation to the returns on traditional asset classes, such as equity and debt Asset Classes securities. If these low correlations are maintained over time, hedge funds can provide diversification benefits and help lower overall portfolio risk. The extent to which a hedge fund provides diversification benefits depends on the type of hedge fund and on market conditions. Potential for Lower The different strategies and opportunity to use derivatives, and short sell securities give Volatility and Higher hedge funds a greater potential to earn higher returns relative to mutual funds. These Returns characteristics also give hedge funds the opportunity to reduce overall market volatility. On the other side, hedge funds are subject to several types of unique risk: lighter regulatory oversight, manager and market risk, liquidity constraints, and investment strategy risk. Table 13.6 outlines these risks. Table 13.6 | Risks of Hedge Funds Light Regulatory Hedge funds are generally not required by securities laws to provide the comprehensive Oversight initial and ongoing information associated with securities offered through a prospectus. This lack of transparency may create a situation in which hedge fund investors may not always know how their money is being invested. Market Risk Hedge funds do not seek to produce returns “relative” to a particular index, but strive to generate positive returns regardless of market direction. This risk, also referred to as first-order risk, is the risk associated with the direction of interest rates, equities, currencies and commodities. Liquidity Constraints Unlike mutual funds, hedge funds are typically not able to liquidate their portfolios on short notice. Holding less-liquid investments often produces some of the excess returns generated by hedge funds. This liquidity premium is part of the trade-off against traditional investments. In light of this, there are often various forms of liquidity constraints imposed on hedge fund investors. This risk is also referred to as second-order risk, and is related to aspects of trading, such as dealing, implementing arbitrage structures, or pricing illiquid or infrequently valued securities. Investment Even if hedge fund managers try to mitigate risk, the methods they use may be difficult Strategy Risk to understand. As a result, there is a risk that investors may not fully understand the techniques being used. It is the responsibility of investors to understand the strategies and investment products used by the hedge fund manager, as well as the fund’s risk profile. © CANADIAN SECURITIES INSTITUTE 13 12 INVESTMENT FUNDS IN CANADA BEFORE INVESTING IN HEDGE FUNDS As noted previously, hedge funds operate in a more relaxed regulatory environment than traditional investments and in a culture in which disclosure of management techniques, trades, and analytics is not required. Many hedge funds are small, have complex legal structures, and may rely on a single manager using complex strategies. To “Know the product” is thus an important part of the decision to invest in a hedge fund. Some of the key areas investors should focus on include: Fund track record Consider only those single-strategy hedge funds that have at least a two-year track record and $25 million under management. Risk characteristics Investor’s risk profile should be consistent with the risk characteristics of the hedge fund. Identify different measures of the fund’s risk and risk-adjusted return and compare them with the same measures for the fund’s peers. Hedge fund manager Examine the experience and reputation of the hedge fund firm and manager. The fund manager should have many years of experience with the trading system under use. Focus on the individuals making the investment decisions rather than on the sales representatives trying to sell the fund. Hedge fund features Read the marketing material, the prospectus, offering memorandum, or information statement. Do not rely solely on sales presentations for information. Understand the fund’s fee and expense structure, the potential use of leverage, and the liquidity terms. Return statistics Understand the nature of return statistics published in marketing materials. The results should encompass enough market cycles to prove the trading system to be reliable over time. Tax treatment Understand the tax implications of the fund. Some hedge funds are taxed annually while others are taxed only upon disposition. Some funds regularly distribute income while others distribute a combination of capital gains and income. Currency risk Know whether the fund is exposed to currency risk, whether the manager intends to hedge that risk, and whether the manager has expertise in hedging currency risk. WHAT ARE CLOSED-END FUNDS? A closed-end fund is a managed pool of securities traded on a stock exchange. The pool is similar to a mutual fund in that the closed-end fund invests in most of the same types of assets, such as stocks and bonds. However, unlike a conventional open-end mutual fund that continually issues and redeems units, a closed-end fund has a fixed number of shares. The number of shares or units in closed-end funds remains fixed, except in rare cases of an additional share offering, share dividend, or share buy-back. Funds that have the flexibility to buy back their outstanding shares are periodically known as interval funds or closed-end discretionary funds. They are more popular in the United States. Like mutual funds, closed-end funds pay management fees from the assets of the portfolio. Unlike mutual funds, closed-end funds generally have lower costs because of lower portfolio turnover and lower marketing costs. Buying a closed-end fund is similar to buying an individual stock, requiring no more than a brokerage commission. In contrast, buying a mutual fund could require payment of a front-end sales charge plus ongoing trailer fees. These fees can eat up a significant proportion of an investor’s return. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 13 ADVANTAGES AND RISKS OF CLOSED-END FUNDS Closed-end funds offer certain opportunities for investment returns not available to investors in regular mutual funds, such as short selling or leverage. Thus, closed-end funds can boost total return. In working with a closed-end structure, money managers are not subject to unpredictable cash flow in and out of the fund. They have the flexibility to concentrate on long-term investment strategies without having to reserve liquid assets to cover redemptions, as they would be with regular open-end mutual funds. Open-end mutual funds must keep a certain percentage of their funds liquid, in case of redemptions. Typically, a closed-end fund is closer to being fully invested than an open-end fund. 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. Moreover, because there are only a fixed number of units to be administered, investors in closed-end funds may benefit from lower management expense ratios (MERs) than open-end funds similar objectives. Closed-end funds have risks relating mainly to trading, liquidity, and leverage. They do not necessarily trade at their net asset value. In an open-end fund, the fund NAV is the sum of the value of the constituent securities, but in a closed-end fund, there is often a discount to the NAV. This discount may become especially significant in volatile markets, negatively affecting investors who want to sell their shares. In bear markets, closed-end fund shareholders may suffer as the value of the underlying assets declines and as the gap between the discount and the net asset value widens. Partly because of the divergence of trading prices from net asset value, closed-end funds are less liquid than open- end funds. With trading taking place on a stock exchange, buyers and sellers must be found in the open market—the fund itself does not usually issue or redeem units. Also remember that commissions are paid at the time of purchase and at the time of sale. In addition to liquidity risk, there is leverage risk. A closed-end fund can use borrowed money in the management of the portfolio, which magnifies the gains and losses in the net asset value. BEFORE INVESTING IN CLOSED-END FUNDS One of the main requirements with the purchase of a closed-end fund is understanding the discount or premium at which the fund may trade. Market demand as well as the underlying asset value can create situations where the fund trades at a discount, at par or at a premium relative to the combined net asset value of their underlying holdings. For instance, an increase or decrease in the discount can indicate market sentiment, which is the general feeling or mood of investors to the anticipated price movement of the stock market. 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. WHAT ARE EXCHANGE-TRADED FUNDS? Exchange-traded funds (ETFs) are baskets of securities that are constructed like mutual funds but traded like individual stocks on an exchange. ETFs are similar to index mutual funds in that they will hold the same stocks, bonds or other securities in the same proportion as those included in a specific market index. © CANADIAN SECURITIES INSTITUTE 13 14 INVESTMENT FUNDS IN CANADA EXAMPLE The iShares CDN S&P/TSX 60 Index Fund holds a basket of stocks that represents the S&P/TSX 60 Index and trades under the symbol XIU on the TSX. The S&P/TSX 60 Index consists of 60 of the largest and most liquid stocks traded on the Toronto Stock Exchange. The iShares CDN S&P/TSX 60 will hold the same 60 stocks as the S&P/TSX 60 Index. An investment in an ETF combines attributes of both index mutual funds and individual stocks. Like an index mutual fund, an ETF represents a passive style of investing which attempts to match the performance of an index, such as the S&P/TSX 60 Index mentioned in the example above. Since ETF performance mirrors the index it tracks, if the index falls, so will the ETF. Like stocks, and unlike index mutual funds, ETFs are traded on an exchange and can be bought and sold throughout the trading day. In this way, ETFs provide investors with a flexible way to participate in the performance of the underlying index. In Canada, there has been significant growth in the number of ETFs and the companies that offer them. As of April 2021, there were a total of 824 ETFs listed on the Toronto Stock Exchange offered by more than 30 ETF companies. ADVANTAGES AND RISKS OF EXCHANGE-TRADED FUNDS Table 13.7 identifies the many advantages ETFs have over conventional investment vehicles. Table 13.7 | Advantages of ETFs Buy the Market ETFs allow the investor to diversify and “buy the market” or a segment of the market in one transaction without having to purchase all the stocks individually. Professional As with mutual funds, the investor benefits from professional management. Management Low Management MERs tend to be lower than on other index and actively managed products. Both index Costs mutual funds and ETFs tend to have lower MERs than active mutual funds because the fund managers are not spending time or money researching companies in which to invest. Lower Operational ETFs have lower operational costs in general, as they use stock exchanges’ sponsored Costs facilities to record ownership of units and daily transactions. Mutual funds must keep a back office running to keep such records. Cash Drag ETFs do not have the same cash drag that index mutual funds have. Mutual funds must keep a portion of their assets in cash or “liquid” to satisfy any redemption requests. ETFs do not have this requirement and can remain fully invested. Tax Efficiency ETFs are regarded as a tax-efficient investment. The relatively low trading turnover typically generates few capital gains that must be distributed to unitholders and taxed in their hands. ETFs are subject to the same risks as individual stocks trading on an exchange, including: Market risk and sector risk if the ETF tracks a specific industry. Trading risk as there is no guarantee that the ETF will trade close to its net asset value or that there will be an active trading market for the ETF. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 15 If the ETF tracks a foreign index, then the investor is also exposed to foreign security risk. Many foreign markets tend to be less liquid and less efficient than North American markets and may have more government intervention. Foreign currency risk because nominal returns in the investor’s domestic currency will be reduced if the currency is strong against the foreign currency. Not all ETFs fully replicate the benchmark index. The degree to which an ETF fails to mirror the index returns is known as tracking error. It is costly to perfectly match the index, so managers take a representative sample that behaves close to the index. Some ETFs may not include all the securities, and some may include securities not in the index. Many ETFs have restrictions regarding the percentage holdings of any one security. Because ETFs are not subject to individual stock or sector exposure limits that are normally part of a mutual fund’s investment objective they are subject to concentration risk. If particular sectors have had extraordinarily large gains, then it is possible for the ETF to be highly concentrated in a single stock (in excess of 10%) or sector (in excess of 40%). COSTS OF EXCHANGE-TRADED FUNDS Rather than paying a front-end load as is the case with some mutual funds, the cost to purchase an ETF is the commission charged by a broker or discount broker when both buying and selling the ETF units. Fees that are indirectly charged to the investor include management fees, distribution fees and other operating expenses. As previously stated, these tend to be lower than for most other comparable mutual funds. International ETFs, especially those in emerging markets, tend to have higher fees than domestic ETFs. The MERs on Canadian ETFs can range from as low as 0.17% to as high as 1.70%. International MERs range as high as 1.00%. MERs are typically substantially lower than for comparable equity or index mutual funds, or even bond mutual funds. BEFORE INVESTING IN EXCHANGE-TRADED FUNDS Aside from the fundamentals of the underlying ETF assets, the value of an ETF lies in its low management costs. But not all ETFs are created equally. The recent popularity of ETFs has spawned an explosion of new issues. For instance, there are ETFs that track portfolios of alternative assets such as gold, oil, and international real estate. MERs for these specialty ETFs are normally higher than typical stock index ETFs. Investors looking to purchase a specific ETF should make sure costs are low and liquidity is high to justify the ETF label. EXCHANGE-TRADED FUNDS Can you compare exchange-traded funds to mutual funds? Complete the online learning activity to assess your knowledge. WHAT ARE SEGREGATED FUNDS? A segregated fund is actually an insurance contract with two parts: an investment that produces the return and an insurance policy that covers the risk. The segregated fund is like a mutual fund, with all the associated market risks and benefits of professional management. But a segregated fund comes with death benefits and a maturity guarantee attached that protects the investor’s principal from market declines. The guarantee ensures that the investor will get back, at maturity or death, up to 100% of their investment, regardless of how markets perform or the market value, whichever is greater. © CANADIAN SECURITIES INSTITUTE 13 16 INVESTMENT FUNDS IN CANADA Segregated funds, like mutual funds, can be bought or sold at any time. However, to qualify for the guarantee, investors must hold the fund for a minimum period, usually ten years. If the investor sells prior to the maturity date, they will receive the market value, which may be less than their original investment. Because segregated funds are insurance contracts, they are regulated by provincial insurance regulators. This means you need to be a licensed insurance representative to sell them. Essentially, a segregated fund contract covers the following three parties: The contract holder—the person who purchased the contract. The annuitant—the person on whose life the insurance benefits are based. The beneficiary—the person who will receive the benefits payable under the contract upon the death of the annuitant (a contract may have more than one beneficiary). ADVANTAGES AND RISKS OF SEGREGATED FUNDS Clear advantages of segregated funds include maturity guarantees, reset dates, death benefits, creditor protection and bypassing probate. Maturity guarantees. One of the key features associated with segregated funds is the maturity guarantee, which is the promise that the contract holder or beneficiary will receive at least a partial guarantee of the return of the money invested. Provincial legislation requires that the guarantee be at least 75% over a contract term of at least a 10-year holding period. Some insurers have increased the minimum statutory 75% guarantee to 100%. EXAMPLE Leslie has invested in a segregated fund over the past ten years that includes a 100% maturity guarantee. Assume that the amount invested was $100,000. The market value of the fund at maturity is $95,000. Since the market value of the fund is less than the amount invested, Leslie is paid a $5,000 maturity guarantee. Reset options. Although segregated fund contracts have at least a ten-year term, they may be renewable when the term expires, depending on the annuitant’s age. If renewed, the maturity guarantee on a ten-year contract would “reset” for another ten years. The reset option allows the contract holder to protect accrued values inside the fund. EXAMPLE If a $50,000 ten-year segregated fund has increased in value by $11,000, the investor can use the reset option to protect the full $61,000. But the reset option resets the 10-year clock on the fund’s guarantee. Many insurers issuing segregated funds have added greater flexibility in the form of more frequent reset dates. In some cases, holders of segregated fund contracts may lock in the accrued value before the original 10-year period has expired (and extend the maturity date by 10 years). Death benefits. The death benefits associated with segregated funds meet the needs of investors 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 will receive payouts amounting to at least the original guaranteed amount. The amount of the death benefit is equal to the difference, if any, between the net asset value of the fund and the guaranteed amount. Table 13.8 illustrates the death benefits when the market value of the units held in the segregated fund is below, the same as, or higher than the guaranteed amount. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 17 Table 13.8 | Death Benefits Guaranteed Market Value Amount Paid to Amount at Death Death Benefit Beneficiaries $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 As the table shows, death benefits are paid only when the market value of the fund is below the guaranteed amount. EXAMPLE From the table above, when the market value at death is $9,000, the beneficiary will receive a death benefit payment of $1,000. Therefore, in addition to the payment of the $9,000 market value of the fund, the total payment to the beneficiary is $10,000. When the market value at death is above the guaranteed amount, there is no death benefit payable because the beneficiary receives the full market value of the investment which is higher than the guaranteed amount. Creditor Protection. Another advantage is that segregated funds may offer protection from creditors that is not available through other managed investment products. Creditor protection is available because segregated funds are insurance policies. The insurance company rather than the contract holder owns the fund’s assets and insurance proceeds fall outside the provisions of bankruptcy legislation. EXAMPLE Suppose that a self-employed professional died and left a non-registered investment portfolio of $300,000 and business-related debts of $150,000. If the portfolio were made up of mutual funds, then creditors would have a claim on half of the portfolio, leaving only $150,000 for the surviving family members. If the entire portfolio had been held in segregated funds, then $300,000 would be payable directly to the deceased person’s beneficiaries. Bypassing Probate. Investing in segregated funds can help investors avoid the costly probate fees levied on assets held in investment funds. Probate is the official process of verifying a will as genuine. Since segregated fund contracts are insurance policies, and not assets of the contract holder, they are not regarded as part of the deceased’s estate. The proceeds of a segregated fund pass directly into the hands of the beneficiaries. In addition, the proceeds of a segregated fund are payable immediately. There is no waiting for probate to be completed, and payment cannot 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. COSTS OF SEGREGATED FUNDS Like mutual funds, segregated funds incur fees related to switching, trailers, sales and management expenses. In addition, segregated funds have costs related to maturity guarantees and death benefits. Investors should also recognize that there is a cost to investing in a managed product that offers such guarantees. For segregated funds, the cost is in the form of higher MERs compared to mutual funds that do not offer this guarantee. © CANADIAN SECURITIES INSTITUTE 13 18 INVESTMENT FUNDS IN CANADA The shorter the term of the maturity guarantees, the higher the risk exposure of the insurer and the higher the cost of the guarantees. Also, segregated funds with a large equity component have a costlier guarantee than a similar segregated fund with a more balanced portfolio. These relationships are based on the premise that there is a greater chance of market decline (and hence a greater chance of collecting on a guarantee) over shorter periods and that the chance of loss increases with the portfolio’s risk. The cost of the segregated fund also varies with the level of principal protection the contract affords. EXAMPLE A fund with a 100% minimum benefit guarantee will be more expensive than a fund offering a 75% minimum benefit guarantee. Typically, a guarantee will add between 50 and 300 basis points (100 basis points = 1.00%) above the MER of a standard mutual fund. This ensures that a segregated fund will typically lag the performance of its conventional mutual fund counterpart. BEFORE INVESTING IN SEGREGATED FUNDS There are certain factors to consider in the selection of a segregated fund. Death benefits may have conditions that reduce payouts to the beneficiary. It is important to check the contract for details on exclusions and age limits. For example: Once the insured person reaches a threshold age, the beneficiary may be required to accept a reduced percentage of benefits. When deposits have been made over a period of time and benefits vary according to the client’s age, the death benefit is calculated according to a formula that factors in the amount of deposits and the client’s age when they were made. Benefits may be lower than expected. A client of a certain age might be excluded outright from buying a company’s segregated funds. Some firms may require that the individual on whose life the death benefits are based be no older than 80 at the time the policy is issued. SEGREGATED FUNDS How well do you know the terms associated with segregated funds? Complete the online learning activity to assess your knowledge. GUARANTEED MINIMUM WITHDRAWAL BENEFIT PLANS When clients near their retirement, losses in their portfolio can be particularly serious. Earlier in the investment cycle, good years can balance off bad years, but in retirement the extra return from later good years can be lost, since part of the portfolio has to be withdrawn for income. To counter the risk of retirement funds being impaired by a few bad years at the wrong time, insurance companies have developed guaranteed minimum withdrawal benefit (GMWB) plans. Industry experts predict there is the potential for tremendous demand for this product, particularly as the baby boomers approach retirement. A GMWB is similar to a variable annuity. With a variable annuity the amount of monthly payment to the annuitant varies according to the value of the investments in a segregated fund into which premiums are placed. Many variable contracts provide a “floor” below which benefits may not fall. The floor for benefits is usually equal to 75% of premiums paid, regardless of what happens to the value of the variable annuity fund. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 19 With a GMWB: The client purchases the plan, and the GMWB option gives the plan holder the right to withdraw a certain fixed percentage (7% is typical) of the initial deposit every year until the entire principal is returned, no matter how the fund performs. At a minimum, clients receive their principal. The underlying investment account can be based on a variety of indexes, funds, etc. Under one plan, clients can buy the GMWB several years in advance of their withdrawals. In this case, the guaranteed amount can grow by 5% every year until withdrawals begin. Every three years, throughout the term of the plan, if the underlying fund has risen, the guaranteed amount is reset upwards. When the guaranteed amount increases, the payment period is extended, and the regular payments may also be increased. These plans have advantages besides guaranteeing principal repayment and the possibility of sharing in the increased value of a mutual fund. EXAMPLE If a client buys the plan several years before withdrawals begin, the guarantee increases by 5% each year until withdrawals start, even if the fund decreases in value. During this period, if the market rises, the three-year reset is in effect. This reset compounds the value of the 5% increases in the guarantee. If a client starts to take payments immediately after purchasing the plan, she will be susceptible to earlier losses in the portfolio. In other words, she may never be able to receive more than the principal repayment. It is necessary to purchase the plan several years in advance of withdrawal, in order to build up the guarantee. The bonuses come in those years regardless of the behaviour of the underlying fund. These plans are especially suitable for clients with 5 to 10 years to retirement, who cannot afford significant losses in their portfolio during that time. These clients also want to be able to share in the growth of selected financial markets. GMWB plans provide the potential for growth but with a guaranteed income floor that provides a secure income stream as a base. The income stream can now also be assured for the life of the investor. This provides further peace of mind, knowing that the investment can provide income for life. GMWB plans come with fees levied to manage the underlying mutual fund(s) and fees levied to fund the GMWB guarantee. The investor may have to pay sales charges when depositing or withdrawing from the contract depending on the sales charge option of the fund(s) chosen. PORTFOLIO FUNDS Portfolio funds, which invest in other funds instead of buying securities directly, allow investors to hold a diversified portfolio of segregated funds through a single investment. The responsibility for choosing or rebalancing the asset mix usually rests with the fund company. Management expenses for portfolio funds are generally higher than for stand-alone segregated funds and guaranteed investment funds, because the investor pays for the asset allocation service, on top of the management costs for the underlying funds. ATERNATIVE MANAGED PRODUCTS TERMINOLOGY How well do you know the terminology of the variety of alternative managed products? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 13 20 INVESTMENT FUNDS IN CANADA SUMMARY 1. Identify and distinguish between the features, advantages, and risks of the various alternative managed products discussed. PPNs Structured as debt instruments that include a principal guarantee and interest payments. Performance is tied to an underlying asset. Investors can access markets they normally could not access with a small investment while still protecting the principal invested. Less transparent than the information available with mutual funds, and this makes them more difficult to evaluate. Risks include market, liquidity, credit, and currency risks. Hedge Funds Lightly regulated pools of capital run by managers who have great flexibility in applying a variety of investment strategies. Manager focus is on absolute returns in any market condition, lower correlation with traditional asset classes, and the potential for lower volatility and higher returns. Risks include complex investment strategies, lighter regulatory oversight, market, and liquidity risks. Closed-End Funds A managed pool of securities traded on a stock exchange that has a fixed number of shares. Offer certain opportunities for investment returns not available to investors in regular mutual funds, such as short selling and leverage. Risk relates mainly to trading, liquidity, and leverage. They do not necessarily trade at their net asset value. Exchange-traded Funds Baskets of securities that are constructed like mutual funds but traded like individual stocks on an exchange. ETFs are similar to index mutual funds in that they will hold the same stocks, bonds or other securities in the same proportion as those included in a specific market index. Key advantages include diversification though ‘buying’ the market, low management and operational costs, and tax efficiency. Subject to the same risks as individual stocks, including market and sector risk, trading risk, foreign exchange risk, and tracking error. Segregated Funds An insurance contract with two parts: an investment that produces the return and an insurance policy that covers the risk. Includes a maturity guarantee that protects the principal from market declines. Death benefits, creditor protection and opportunity to reset the term are additional advantages. Exposure to the markets, much like mutual funds, is a key risk. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      ALTERNATIVE MANAGED PRODUCTS 13 21 2. Identify and describe the costs associated with these alternative managed products. PPNs Lack of transparency in these products prevents investors from clearly understanding all of the costs involved. Not protected by the Canada Deposit Insurance Corporation (CDIC). Explicit costs include commissions, management fees, early redemption fees, and structuring costs. Implicit costs include performance averaging formulas and performance participation caps, and price returns vs. total returns. Hedge Funds Costs include administration fees, and incentive fees subject to a high-water mark. A high-water mark ensures that a fund manager is paid an incentive fee only on net new profits. Closed-End Funds Costs include commissions charged at time of purchase and less liquidity relative to mutual funds. Exchange-traded Funds Costs include commissions charged at the time of purchase, management fees, distribution fees, and other operating expenses. Segregated Funds Higher MERs is an important cost to consider. Like mutual funds, segregated funds incur fees related to switching, trailers, sales and management expenses. In addition, segregated funds have costs related to maturity guarantees and death benefits. 3. List and compare the requirements to consider before investing in each product. PPNs Creditworthiness of the issuer should be without question and the degree of leverage being used. An understanding of the calculation method and the risk factors associated with the underlying asset. The principal protection should be worth paying for. Hedge Funds Fund and manager track record are key concerns. The underlying strategies and fund features must also be considered. Closed-End Funds Determine whether the discount at which a fund is trading is below historical norms. Exchange-traded Funds Understand the underlying asset being tracked and the risks associated. Historical performance. Segregated Funds Review all contract details for limitations and other conditions. Review the maturity guarantees and death benefit requirements. © CANADIAN SECURITIES INSTITUTE 13 22 INVESTMENT FUNDS IN CANADA REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 13 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 13 FAQs. © CANADIAN SECURITIES INSTITUTE