Canadian Investment Funds Course PDF

Canadian Investment Funds Course Unit 11: Making Recommendations Introduction As a Dealing Representative, it is essential that you satisfy your suitability obligations when you make recommendations to your clients. This includes gaining a thorough understanding of each client’s personal and financi...

Canadian Investment Funds Course Unit 11: Making Recommendations Introduction As a Dealing Representative, it is essential that you satisfy your suitability obligations when you make recommendations to your clients. This includes gaining a thorough understanding of each client’s personal and financial circumstances, investment needs and goals, and other essential facts, and then identifying and recommending investments that will best help them achieve their objectives. This unit takes approximately 1 hour and 15 minutes to complete. Lessons in this unit: Lesson 1: Evaluating the Client Lesson 2: Selecting Mutual Funds Lesson 3: Asset Allocation Lesson 4: Tax Efficient Strategies © 2021 IFSE Institute 383 Unit 11: Making Recommendations Lesson 1: Evaluating the Client Introduction As a Dealing Representative, you need to follow a rigorous process in order to evaluate clients in order to satisfy your Know Your Client (KYC) obligation. In doing so, you are required to learn and understand the essential facts about each client. You have a regulatory obligation to know the client, know the product, and to form an opinion as to whether the investment product or strategy is suitable for the client. In this lesson you will review your requirements under the suitability obligation, with a focus on how to best work with your client to obtain the required information. You will also learn about selecting mutual funds, allocating assets, and applying the “Client’s Interests First” standard when making recommendations. This lesson takes approximately 35 minutes to complete. By the end of this lesson you will be able to: understand the importance of building trust and communicating with clients describe the benefits of situational questioning in obtaining Know Your Client (KYC) information demonstrate how to determine: - personal circumstances - financial circumstances - investment needs and objectives - investment knowledge - risk profile - time horizon understand how emotions and psychological bias affect investor behaviour understand the Know Your Product (KYP) obligation understand the suitability obligation discuss some best practices for providing service to your clients discuss the importance of maintaining proper documentation 384 © 2021 IFSE Institute Canadian Investment Funds Course Client Communication – Words and Body Language You don’t get a second chance to make a first impression. As a result, it is important to manage your client’s first impression of you. Although you often use words to communicate a message to your client, there are other aspects that are also important. These include the tone of your voice, the pace of your speech, and the volume of your voice. Your body language also sends a message including: the physical space between you and your client your clothing and appearance your posture the gestures you make your facial expressions the eye contact you make any physical contact (e.g. shaking hands) The pie chart above illustrates results from a famous study that attempted to demonstrate the importance of the three elements of face-to-face communication: words tone of your voice non-verbal communication The purpose of the study was to measure the importance of these elements when forming an impression of how much we like someone when they convey a message about their feelings. As you can see from the chart, non-verbal communications plays an important role in building rapport. Client Communication - Listening Skills Effective client communication also requires you to have effective listening skills. This means that you must actively listen to the message that a client is communicating. Active listening involves hearing, understanding, and interpreting what the client is saying before you respond. It is also important to pay attention to what your client says, i.e. their words; and how they say it, i.e. the tone of their voice and their body language. Sometimes, what a client does not say is just as important as what they do say. Therefore, you should encourage your client to fully describe their personal situation. Your client must have the impression that you want them to fully disclose and describe what they have on their mind. © 2021 IFSE Institute 385 Unit 11: Making Recommendations Building Trust Building trust is the first step towards gaining an understanding about your client. Allowing the client to express themselves and their concerns means that you must try to avoid talking too much. If you must talk, try to avoid asking questions related to your product or service. Instead, ask situational questions to gather as much information as the client is comfortable providing about their current circumstances. A client is more likely to answer questions if they have the impression that you genuinely care and are interested in them and their priorities. Some examples of situational questions include: What are your financial goals right now? What are your future financial goals? Do you see yourself in your current career five years from now? What is your current income? Are you able to comfortably cover your monthly expenses? Is it important for you to travel when you take time off from work? Where do you like to go? Do you have enough money left at the end of the month to put towards your financial goals? Do you have a plan to pay off your debt quickly? What options have you considered for saving towards your children’s post-secondary education? Do you have a pension plan at work? An RRSP? How long do you want to work? How much money would you like to receive annually once you semi-retire or retire? Identifying Problems The purpose behind asking situational questions is to help clients uncover any problems that may prevent them from reaching their goals. However, identifying a problem is not the same as wanting to act to address it in some way. A problem can only be addressed if a client explicitly indicates that he or she wants to act to fix the problem. In other words, the client expresses an explicit need to address the problem. On the other hand, a client who expresses dissatisfaction or concern may not be ready to address the problem. In this case, the client is said to have an implied need. 386 © 2021 IFSE Institute Canadian Investment Funds Course Example Amber, a new Dealing Representative, is interviewing a potential client for the first time named Aziz. During the meeting, Aziz tells Amber that he is very concerned about the future cost of his children’s education. Amber recognizes that Aziz is only expressing an implied need. Amber asks Aziz a question regarding the implication of the increasing cost of education. Aziz tells Amber that his children may not be able to go on to post-secondary education if the cost is too high and they don’t have adequate financial resources. During this part of the interview, Aziz indicates that he would like to save for the future cost of his children’s education. At this point, Aziz has indicated that he has an explicit need to act to address the problem. Offering Solutions One aspect of the role of a Dealing Representative is to help clients address their problems by helping clients realize the implications of not acting on them. If a client is concerned about the cost of his or her children’s education, it is the role of the Dealing Representative to help the client understand that not acting to address the problem may result in added financial strain on the client’s or children’s finances when it is time for the children to go to college or university. If a Dealing Representative does not take the time to ask the right situational questions to uncover potential problems, the client may have larger problems in the future or the client may find another Dealing Representative who is better able to understand the client’s needs. Example Amber recognizes that Aziz would like to find a solution to the problem of the increasing cost of education and what it could mean for the future of his children’s education. Aziz is happy that Amber is able to offer a number of options. After providing Aziz with the features and benefits of each option presented, Amber and Aziz work together to determine which solution will best meet Aziz’s needs. Suitability Requirement As a Dealing Representative, you have a regulatory obligation to know the client, know the product, and to form an opinion as to whether the investment product or strategy is suitable for the client. © 2021 IFSE Institute 387 Unit 11: Making Recommendations When you are considering offering or recommending an investment product or investment strategy to a client, you are obligated to first: learn the essential facts about the client learn the essential facts about the investment product and/or investment strategy determine whether the investment product and/or investment strategy is suitable for the client 1. Know Your Client (KYC) 3. Suitability Determination 2. Know Your Product (KYP) Under the suitability obligation, you are required to ensure that any orders you accept and any recommendations that you make are suitable based on the essential facts relative to the client. However, the suitability obligation extends beyond orders and recommendations. You are also required to make a suitability determination every time that you take any other investment action for a client. Step 1: Know Your Client Under the Know Your Client (KYC) obligation, you are required to collect and consider specific information to learn the essential facts about each client to ensure that clients are well served by investments that suit their individual financial needs. In order to satisfy your KYC obligation, you are expected to take reasonable steps to: establish the identity of the client ensure that you collect and consider sufficient information about the client's: - personal circumstances financial circumstances investment needs and objectives investment knowledge risk profile time horizon You are also required to collect important information as required under other laws and regulations including legislation governing tax reporting, Proceeds of Crime (Money Laundering) and Terrorist Financing, and privacy. 388 © 2021 IFSE Institute Canadian Investment Funds Course Knowing your client involves having meaningful conversations with your clients that allow you to truly know and understand their means, needs, limitations, circumstances, finances, and investment goals. When having these conversations with your clients, it is often more effective to have a broad-ranging conversation that covers the information you are required to know, rather than simply asking blunt questions. From a compliance point of view, the more information you have about your client’s situation, the better. The following section provides suggestions about some of the types of questions that might help you to get the information you need. KYC Criteria Personal Circumstances Financial Circumstances © 2021 IFSE Institute Suggested Questions What is your contact information and address? What is your date of birth? What is your marital status? Do you have dependents? How many? Are there any other persons who are authorized to provide instructions on the account? Who? Are there any other persons who have a financial interest in the account? Who? What is your employment status? What is your occupation? Is your work situation stable? What is your income and cash flow? What are your sources of income? Is your level of income consistent or does it vary? Do we need to make allowances for discrepancies in income from paycheque to paycheque? Do you expect your current income to increase or decrease significantly in the next few years? Do you have any financial resources that you can use to generate additional income? What assets do you have (fixed and liquid)? What sort of savings do you have? What debts and financial obligations do you have? Do you have a lot of fixed expenses, or are you able to adjust your spending easily if you need to? 389 Unit 11: Making Recommendations KYC Criteria Investment Needs and Objectives Investment Knowledge and Experience Risk Profile Time Horizon Additional Questions Suggested Questions What are your liquidity needs from your investments? Are you using borrowed funds to invest? Are there any tax consequences to be considered? What do you want to achieve from investing? When do you want to achieve this goal? Do you have more than one goal? Is your goal realistic? What is your understanding about investing? Have you ever invested before? In what types of investment products? What do you understand about the risks of investing? What do you understand about the relationship between risk and return? What do you understand about the taxation of investments? How would investment losses impact your financial circumstances? What would happen to your financial well-being if you lost all or part of your investment? How would you react if your investment decreased by 10%? 20%? 30%? or more? How would you feel if you lost all or part of your investment? What is your time horizon in relation to your investment goals? When will you need to access the money in your investment(s)? What would cause you to liquidate your investment(s)? Do you have insurance of any type? Investor Questionnaires can also be useful tools for learning, collecting, and considering the pertinent details about clients. You should consult with your mutual fund dealer about which Questionnaires are approved for use and how to use them. 390 © 2021 IFSE Institute Canadian Investment Funds Course Your KYC Responsibilities Under regulatory requirements, you are expected to: have a meaningful interaction with the client during your KYC process discuss with the client their role in keeping KYC information current tailor the KYC process to reflect the nature of the relationship with the client - For example, the regulators expect that extensive KYC information will be required if you are offering an ongoing and fully customized service or an investment product or strategy that is illiquid or highly risky. The regulators expect you to help your clients understand KYC terminology, inquire about any noted KYC responses which appear inconsistent, and provide assistance to help clients define their investment needs and objectives. You are expected to be particularly conscientious in your KYC discussions with vulnerable or unsophisticated clients. The KYC requirement is an ongoing obligation. It does not end after the initial KYC is recorded and considered when the new account is opened. You are responsible for periodically reviewing and updating the KYC information on file for your clients. Client Refusal A great deal of care should be taken when obtaining the Know Your Client information. It may occur that a client does not want to disclose the required information. Since the Know Your Client (KYC) obligation is mandatory, you may have to consider whether you will need to reject the client's business in cases where they are unwilling to provide the necessary details about themselves. In these cases, you will need to consult with your Compliance Department. Behavioural Finance The field of behavioural finance is one that tries to explain why clients make the decisions they make. Psychological biases, cognitive errors, and emotions can all play a part in how investors go about making decisions. As a Dealing Representative, it is important to know that investors’ behaviour is not always predictable. An awareness of the main concepts of behavioural finance will help you to be more aware of the errors in decision-making that we can all be susceptible to. Traditional finance held that people are rational decision makers. Psychological biases arise because people rely on a combination of facts, probabilities, moods, and feelings in order to make a decision. In this sense, we are not computer-like. Cognitive errors occur due to our tendency to think through investment problems in a certain way. © 2021 IFSE Institute 391 Unit 11: Making Recommendations Investor Behaviour Investors can have a tendency to become overconfident. In other words, they tend to overestimate their knowledge and underestimate the risk of a given situation. You should know that overconfidence can lead to excessive trading or risk taking. Investors may also tend to sell winners too early and ride losers too long. This is known as the disposition effect. It comes about because people tend to perform actions that increase joy, i.e. selling a stock or fund that is up; and they tend to avoid actions that increase pain, i.e. selling a stock or fund that has gone down. Step 2: Know your Product Under the KYP obligation, you are required to learn the essential facts about each investment product and investment strategy in order to fulfill your suitability obligation. What You Should Know Your dealer is required to perform a reasonable level of due diligence on investment products and strategies before approving them for sale by their Dealing Representatives. The firm is required to develop an investor profile for investment products and strategies that have been approved by the firm. You should be fully versed in your firm’s investor profiles for the investment products and strategies that you offer to your clients. Investor Profile investors who the product would be suitable for investors who the product would not be suitable for investor profiles including: - personal circumstances financial circumstances investment needs and objectives risk profile time horizon investment knowledge concentration limits other restrictions/controls As a Dealing Representative, you are required to take reasonable steps to understand the essential facts about the investment products and strategies you offer to your clients as detailed below. 392 © 2021 IFSE Institute Canadian Investment Funds Course You must take reasonable steps to understand the investment product/strategy’s: structure features risks initial and ongoing costs the impact of those costs Your KYP Obligations For each individual product and strategy that offer to clients, you are required to take reasonable steps when conducting your due diligence. You should not simply rely on the representations of the issuer, or its similarity to another issuer’s product, or that other firms are already offering the product. You are also expected to: apply a more detailed consideration of investment products and strategies that are more complex or risky have a general understanding of the types of securities that are available through your firm in order to fulfill your obligation to consider a reasonable range of alternatives when making a suitability determination take reasonable steps to understand investments when acquired by transfer-in or by client-directed trade Under your KYP obligations, you are required to: have a thorough understanding of the investment product and/or investment strategy clearly explain the investment product/strategy to clients Not only is it important for you to understand any product or strategy that you recommend, it is important that you know that your client understands it. A nod of the head may not be enough. You might have to ask some probing questions to verify that your client understands the information you have provided them. Unapproved Investment Products and Strategies Under the KYP obligation, you are prohibited from offering investment products or investment strategies that have not first been approved by your dealer. © 2021 IFSE Institute 393 Unit 11: Making Recommendations Step 3: Suitability The suitability obligation requires you to know the client, know the product, and to form an opinion as to whether the investment product is suitable for the client. You are obligated to ensure that any orders you accept and any recommendations you make are suitable based on the essential facts relative to your clients. However, the suitability obligation extends beyond orders and recommendations. You are required to make a suitability determination every time that you: open a new client account; accept an order; make a recommendation; purchase, sell, deposit, exchange, or transfer investments for a client’s account; make a recommendation or decision to continue holding an investment; take any other investment action for a client; accept a client account (e.g. from another Dealing Representative); become aware of a material change in a client’s circumstances; become aware of a change in an investment within the client’s account; conduct a review of the client’s KYC information; or any time that you exercise discretion, where permitted, to take any of the actions above. Under NI 31-103 and CP 31-103, you are required to satisfy a number of standards when making a suitability determination: 1. assess suitable options; 2. apply the “Client’s Interest First” standard; and 3. document the basis for each suitability determination. Assessing Suitable Options The assessment of whether an investment is suitable for a client involves the objective analysis of the KYC information for the client and the KYP information for the investment product and/or strategy. You should weigh and consider whether the impact of the proposed action on the client’s account will be suitable for the client, after the action has been completed. Suitability assessment commonly starts with a comparison of the risk of the investment product/strategy compared to the risk profile of the client. This risk-based approach is an effective starting point and there are also correlations that can be made by comparing the KYC and KYP information related to investment objectives, time horizon, age, and investment knowledge. While these elements are key in determining 394 © 2021 IFSE Institute Canadian Investment Funds Course suitability, all aspects of the client’s KYC, the investment’s KYP, and the client’s existing holdings need to be considered. After considering what the impact will be when the proposed action has been completed, the KYC and KYP information should be compared and used to consider whether: the KYC and KYP are aligned and the investment product/strategy is deemed suitable after the consideration of reasonable alternatives available through the registered firm the concentration of any investments within the account(s) are over-weighted the investments in the account provide sufficient liquidity to meet the client’s liquidity needs “Client’s Interest First” Standard Following the assessment of suitable options for the client, you are then required to apply the “Client’s Interest First” (CIF) standard. Therefore, in addition to the consideration of KYC and KYP factors, you must assess whether the proposed action is one that puts that client’s interest first. Under the CIF standard, you are required to put the client’s interest first, ahead of your own interests and any other competing considerations, such as a higher level of remuneration or other incentives. You are required to consider, amongst other factors, the potential (or actual) impact of costs on the client’s return on investment. Costs include all direct and indirect costs, such as: fees commissions charges trailing commissions any other costs associated with a proposed action You are expected to assess both the: relative costs of the options available to clients impact of those costs on the client’s overall return from any compensation paid, directly or indirectly, to you Some investment products or strategies that are assessed to be suitable for a client, based on KYC and KYP, may not meet the “Client’s Interest First” standard. Where you are not able to offer a client an investment option that is suitable and puts the client’s interests first because the option is not available through your dealer, the regulators expect you to decline the client’s account. © 2021 IFSE Institute 395 Unit 11: Making Recommendations Documenting the Basis for Suitability Determination Once you have made a suitability determination, you are required to document the reasonable basis for your suitability determination and how you have met your obligation to put the client’s interest first including the: relevant facts key assumptions scope of data considered analysis performed Trades Proposed by the Client Trades and instructions which are proposed by the client, as opposed to being recommended by the Dealing Representative, are known as client-directed trades or unsolicited transactions. All such transactions are subject to the suitability obligation and you are required to make a suitability determination. If you receive instructions from a client which, in your view, will result in an unsuitable outcome, you are required to: inform the client that the transaction is not suitable and provide the basis of your suitability determination recommend alternative action which is suitable obtain recorded confirmation of the client’s instruction where they proceed with the action despite the suitability determination You and your dealer are under no obligation to accept a trade from a client that is determined to be unsuitable. Best Practices for Investment Planning The first and most important step in the planning process is to establish a rapport with your client. It is important that you are able to convey a sense of trust. Effective client communication, through the use of written service agreements, can help establish trust. A written service agreement, also known as a clientplanner engagement document, clearly outlines what you will be doing for the client, over what period of time, and at what cost. In addition, the agreement will outline the documents that you will require from the client and how you will safeguard the client’s financial information. Be sure to follow your firm’s policies and procedures governing service agreements and planning engagement documents. In the initial meeting with your client, it may be beneficial to outline your approach to financial planning and the concepts or ideas that form the foundation of your approach to the financial planning process. Most importantly, you should clarify your responsibilities to your client, which should include an explanation of how you are compensated and any conflicts of interest. 396 © 2021 IFSE Institute Canadian Investment Funds Course You should place client education at the forefront of your relationship with your clients. The financial planning industry operates in a highly complex environment which can make it difficult for anyone, let alone a Dealing Representative, to understand which course of action will allow the client to meet their financial objectives. Client education empowers the client to understand and make decisions for themselves, with the help of their Dealing Representative to aid in the implementation of the plan. Documentation You should maintain all client documents and recorded notes in the client’s file and any electronic documents should be backed up and stored safely. Any changes to a previously agreed upon strategy should also be signed off by the client. If the client decides to proceed with an investment that you have not recommended, this should be clearly highlighted in the client’s file as an unsolicited trade along with: the basis for your suitability determination alternative action which is suitable where applicable, recorded confirmation of the client’s instruction to proceed with the action despite the suitability determination. © 2021 IFSE Institute 397 Unit 11: Making Recommendations Lesson 2: Selecting Mutual Funds Introduction Once you have collected and considered the essential facts about your client through the KYC process, the next step is to identify and recommend investment products and strategies that best meet your clients’ needs. In this lesson you will learn about the information available on mutual funds that will help you, as a Dealing Representative, assess and select suitable options. This lesson takes approximately 15 minutes to complete. By the end of this lesson you will be able to: identify where to find information explain what type of mutual fund information to research explain how to compare and select mutual funds 398 © 2021 IFSE Institute Canadian Investment Funds Course Mutual Fund Information According to fundlibrary.com, there are more than 15,000 distinct mutual funds in Canada. With so many investment options, it can be easy to become overwhelmed when it comes to trying to figure out which investment options are appropriate for each client. Your dealer will have an approved list of mutual funds and/or mutual fund companies which you can select from. Through their relationships with mutual fund providers, your firm may be able to provide sufficient information about the funds they have approved. However, there are a number of other information sources that you can access. Mutual Fund Research Your clients will expect you to have information available to help them make decisions for their financial future. The Fund Facts makes it easier for investors to find and use key information about a mutual fund. You are responsible for understanding the basic components of a Fund Facts and what each of these components cover. The table below highlights the major sections of the Fund Facts and the information provided within each section. Section Information Provided Fund Name the name of the investment fund Quick facts fund code, series start date, value of fund, MER, investment fund manager (IFM), portfolio manager (PM), distributions, minimum investment required What does the fund invest in? top 10 holdings, a pie chart of the investment mix (depending on the fund, by asset class, business sector, or geographic region) How risky is it? an explanation of volatility, the fund’s risk rating (from low to high), reference to the risk section of the prospectus, a statement that the fund is not guaranteed How has the fund performed? a bar chart of the year-by-year returns for the past 10 years (or years available if less than 10), best and worst 3-month returns, average return (annual compounded return over the past 10 years) Who is this fund for? the objectives of an investor who should invest in the fund, the objectives of an investor who should not invest in the fund A word about tax general statement advising of potential taxes payable in registered and nonregistered plans How much does it cost? Sales charge option (front-end or DSC), fund expenses (management expense ratio (MER), trading expense ratio (TER)), other fees (short-term trading fee, switch fee, change fee), and trailer fees © 2021 IFSE Institute 399 Unit 11: Making Recommendations Section Information Provided What if I change my mind? Investor rights including right to withdraw from the agreement to purchase, right to cancel purchase, right to claim damages For more information contact information for the investment fund manager (IFM), who to contact for the fund’s prospectus and other disclosure documents, link to CSA “Understanding Mutual Funds” brochure Comparing Mutual Funds There are many ways to quantitatively analyze a mutual fund. One possible way is to use key indicators, such as 5-year annualized return, 5 years of annual returns, quartile rankings, volatility, MER, portfolio manager start date, and the Sharpe ratio. The example below provides a mutual fund comparison between two sample Canadian equity funds. The 5-year annualized rate of return is a measure of the return of the mutual fund over the past 5 years. However, this number does not provide any insight into the consistency of returns. In order to measure consistency, the annual rate of return should be considered as well. Quartile rankings and volatility provide some insight into how the fund has performed relative to other Canadian equity funds with respect to return and risk, respectively. The management expense ratio represents the overall cost of the fund on an annual basis. The portfolio manager’s start date allows you to determine how much of the past return may have been a function of a manager who has lots of experience in managing that fund. Finally, the Sharpe ratio is a measure of the rate of return of the fund per unit of risk. Key Indicators Rhizome Canadian Equity Fund Strata Canadian Equity Fund 2.01% 3.62% 5-year Annualized Return Annual Returns Quartile Rankings Volatility 2012 2011 2010 2009 2008 2012 2011 2010 2009 2008 8.93 -12.14 7.95 19.47 -29.45 4.59 -9.11 11.62 21.53 -27.34 2 3 4 1 2 4 4 1 4 3 Low Low 2.50% 2.46% Portfolio Manager Start Date October, 2007 May, 2013 3-year Sharpe Ratio 0.13 0.41 MER 400 © 2021 IFSE Institute Canadian Investment Funds Course The two funds in the table above are fairly similar. This should be expected since they are both Canadian equity funds and they have similar MERs. The annualized return and the Sharpe ratio of the Strata fund is slightly higher. Selecting Mutual Funds The decision on which mutual fund to suggest for a client’s portfolio is not straight forward. There are often a number of mutual fund options and combinations that will meet a client’s investment needs and objectives. As a result, many dealers provide their Dealing Representatives with access to software that will help in the decision-making process. The primary objective of software tools is to help you bring together a client’s personal circumstances, financial circumstances, investment needs and objectives, investment knowledge, risk profile, and time horizon. Using a software selection tool, you can select a number of mutual funds that will meet the client’s investment needs and objectives. You can then perform a quantitative analysis to determine which funds are most suitable for the client given what you know about the client from the KYC form. In our previous example under the section titled “Comparing Mutual Funds”, it appears that the Strata fund may be a slightly better choice for the Canadian equity portion of a client’s portfolio since it offers a slightly better return at the same level of risk. One issue may be the portfolio manager’s start date, which may suggest that you should further assess the fund to ensure that it is well aligned with the suitability requirements of the client. All aspects of the client’s KYC, the investment’s KYP, and the client’s existing holdings need to be considered. You cannot assess suitability only on a trade by trade basis. You must encompass a portfolio approach in order to consider the impact of factors such as risk, concentration of investments, and liquidity in the client’s portfolio. When your assessment of the mutual funds is complete, you are then required to apply the “Client’s Interest First” standard. Therefore, in addition to KYC and KYP factors you have evaluated, you must assess whether the proposed action is one that puts that client’s interest first. © 2021 IFSE Institute 401 Unit 11: Making Recommendations Lesson 3: Asset Allocation Introduction As a Dealing Representative, it is important that you understand the factors to consider when determining how to allocate clients’ assets to best achieve their investment needs and objectives. In this lesson, you will learn about asset allocation and the factors to consider when allocating assets, the life cycle hypothesis, as well as how to re-balance a client’s portfolio. This lesson takes approximately 15 minutes to complete. By the end of this lesson you will be able to: discuss asset allocation differentiate between strategic and tactical asset allocation explain the life cycle hypothesis discuss re-balancing the portfolio 402 © 2021 IFSE Institute Canadian Investment Funds Course Allocating Assets To achieve protection of capital, growth, and diversification, you may want to advise clients to hold a variety of investments, including mutual funds. The process of mixing investment assets among different types of investment products, such as cash, fixed income, equity, real estate, derivatives, private investments, and collectibles, is commonly known as asset allocation. No one type of mutual fund is the best performer over all time periods. In some years, equity funds are the top performers, while in others, bond funds have been the leaders. From time to time, money market funds have produced higher returns than either bond or equity funds. By choosing the optimal mix of investments at any given time, an investor should theoretically be able to generate higher and more stable risk-adjusted returns rather than by investing in one type of asset. When investing in mutual funds, there are three ways of implementing an effective asset allocation strategy. 1. You can decide upon an asset allocation strategy and periodically rebalance the asset allocation every one or two years, or when material changes arise. This is known as strategic asset allocation. 2. You can periodically shift the proportion (also known as the weighting) of different types of funds within a client’s account according to your assessment of investment opportunities. This is known as tactical asset allocation. 3. You can take advantage of asset allocation services offered by some mutual fund organizations. These services advise investors on appropriate changes in asset mixes among different funds, often based on a computer model. One such automated approach is life cycle investing, where the amount of riskier assets held decreases as the investor moves closer to retirement. Asset Mix The following table gives examples of some common asset allocations. Name Description Sample Asset Mix Aggressive Growth This portfolio has a 100% weighting in equities with a goal of maximizing return at an acceptable level of risk. 100% equities Growth This portfolio has a heavy weighting in equities with a smaller percentage allocated to fixed income. 70-90% equities; 10-30% fixed income © 2021 IFSE Institute 403 Unit 11: Making Recommendations Name Description Sample Asset Mix Balanced This portfolio holds a significant portion of equities with a smaller percentage allocated to fixed income and cash. 50-60% equities; 35-40% fixed income; 5-10% cash Conservative This portfolio has a heavy weighting in fixed income with a smaller component in equities. 10-30% equities; 60-70% fixed income; 10-20% cash Ultra-Conservative This portfolio is suitable for investors who wish to establish an emergency fund or who want minimal exposure to risk. 100% cash Example: Aggressive Growth Bob is a single, 27-year-old lawyer working for a major downtown law firm. His annual income before taxes is currently $70,000, with the possibility of six figures in the next few years. So far, Bob has saved $30,000 towards his goal of retiring at age 65. Bob has a good understanding of financial markets and has even invested in individual stocks over the past two years. He considers himself a risk taker and his income potential affords him the luxury of taking such risks. Given Bob's high risk profile and income potential, an aggressive growth portfolio seems appropriate for him. Bob is a knowledgeable and experienced investor with a long time horizon. His main objective is to pursue long-term growth opportunities. Example: Balanced Joe Campbell is a 45-year-old account representative and his wife, Jane, is a 43-year-old nurse. They have 2 children aged 8 and 10. Their goal is to retire at age 60, but they can wait until age 65 if necessary. Combined, they have an after-tax income of $78,000. Since $54,000 goes to expenses, they have $24,000 per year to invest. Both Joe and Jane have company pensions and their RRSP assets are worth $65,000. They are inexperienced investors but are willing to accept some risk as long as the investments are of good quality. Essentially, they are comfortable with a moderate amount of risk. With their medium risk profile, the Campbells should probably consider a balanced portfolio. 404 © 2021 IFSE Institute Canadian Investment Funds Course Example: Conservative Rick and Marilyn Brady are both 64 years old and looking forward to retiring next year. Rick owns a hardware store in the small town where the Bradys reside, while Marilyn works as the town's primary care physician. The Bradys live comfortably, but do not have an extravagant lifestyle. Over the years, they have been able to accumulate $700,000 in their RRSPs and another $475,000 in non-registered funds. They started investing in mutual funds 20 years ago, but their financial advisor retired last year and they are looking for someone new to help them. Although they have a solid understanding of mutual funds, the Bradys feel that once they enter retirement, they do not want to worry about their finances. Since the couple want to preserve their capital and begin drawing an income next year, a conservative portfolio would seem appropriate for their needs. Strategic and Tactical Asset Allocation Strategic asset allocation is an action plan of setting a target asset mix to achieve a certain level of growth over a long investment time horizon. From time to time, the values of the securities in the mutual fund may change and cause the fund’s assets to deviate from its strategic asset allocation. When this happens, the portfolio manager would rebalance the mix back to its strategic asset allocation. Tactical asset allocation is when the portfolio manager temporarily changes the asset allocation from its strategic asset mix to take advantage of short-term opportunities in the market. Tactical asset allocation is usually a short-term strategy and the portfolio manager usually returns the mutual fund to its strategic asset allocation. Strategic and tactical asset allocation strategies are complementary investment strategies. For example, a portfolio manager may set up a portfolio with a specific strategic asset allocation and may also identify a range within which the portfolio asset allocation may be shifted to accommodate a tactical asset allocation strategy. © 2021 IFSE Institute 405 Unit 11: Making Recommendations Example In designing her portfolio asset allocation strategy, Linda Rockbottom, portfolio manager for Richperson Investments decides on the following parameters for the Anova International Equity Fund: Strategic Asset Allocation Tactical Asset Allocation Canadian Equity 20% 15%-25% U.S. Equity 20% 15%-30% International Equity 20% 15%-35% Canadian Bonds 40% 25%-50% By setting up a tactical asset allocation strategy with a long-term strategic asset allocation focus, Linda is in a position to “tilt” her portfolio in the short- and medium-term based on market expectations. Life Cycle Investing Lifecycle mutual funds are an alternative to strategic or tactical asset allocation funds. Life cycle investing assumes that as you move through life, the investment strategy you should follow will change. A traditional approach is to use the investor’s age as the basis for changing the asset allocation of a lifecycle mutual fund. As the investor gets older, the asset allocation changes from riskier assets to less risky assets. This would be like starting out with an aggressive growth mutual fund in the client’s 20s and moving towards a conservative portfolio as the client approaches, or is in, retirement. In other words, lifecycle mutual funds move the investor away from equities towards fixed income and cash. Usually, lifecycle mutual funds will automatically move the investor away from riskier assets towards less risky assets. Lifecycle mutual funds are also known as target date funds or lifestages funds. Although there is some merit to lifecycle funds, you should always keep in mind that the client’s personal circumstances, financial circumstances, investment needs and objectives, investment knowledge, risk profile, and time horizon should be the basis for deciding which asset allocation strategy is appropriate. It is important to be aware that a client’s KYC profile will change over time including their investment needs and objectives, risk profile, time horizon, liquidity needs, financial circumstances, and so on. Some of these criteria will clearly change in a particular direction. For example, an investor’s knowledge and experience, and age will increase over time. On the other hand, the investor’s time horizon will decrease. Other factors are less predictable such as a client’s investment needs and objectives, risk profile, and financial circumstances. You can best serve your clients by helping them to clarify their investment needs and objectives, understand their risk profile, and regularly assess their financial circumstances by regularly updating their Know Your Client (KYC) information. 406 © 2021 IFSE Institute Canadian Investment Funds Course KYC must be reviewed with clients and, where necessary, updated no less than: when there is a material change in the client’s circumstances and/or KYC criteria every 36 months Portfolio Re-Balancing As a client’s personal and financial circumstances change over time, their portfolio will need to be re-balanced. Before making any changes to a client’s portfolio, it is important to consider the taxes and fees associated with any plan. Taxes are only a concern for non-registered portfolios since registered savings plans either defer, or completely eliminate, the taxation of capital gains from the disposition of investments. However, re-balancing a client’s non-registered portfolio will have tax implications. Since re-balancing both registered and non-registered portfolios can likely involve the disposition of mutual funds and investment into new funds. you will need to give serious consideration to any fees and costs involved in the re-balancing of the portfolio. A portfolio manager who manages a mutual fund that follows a strategic asset allocation will most likely rebalance the portfolio each year on a pre-determined date. A portfolio manager, or investment committee, will regularly review a mutual fund’s tactical asset allocation strategy and make changes as market forces dictate. A portfolio manager who uses a lifecycle asset allocation strategy will change a client’s asset allocation as they get older. © 2021 IFSE Institute 407 Unit 11: Making Recommendations Lesson 4: Tax Efficient Strategies Introduction As a Dealing Representative, you must understand your client's tax situation and how your recommendations can impact their personal income tax. In this lesson, you will learn about different tax efficient strategies and tax efficient mutual funds. You will also learn how to structure a client’s portfolio to maximize tax efficiency. This lesson takes approximately 10 minutes to complete. By the end of this lesson you will be able to: discuss various tax efficient strategies discuss tax efficient mutual funds discuss structuring a client’s portfolio for tax efficiency between registered and non-registered plans 408 © 2021 IFSE Institute Canadian Investment Funds Course Tax Efficiency Tax is an integral part of any investment strategy. As a Dealing Representative, you must understand your client's tax situation and how your recommendations can impact their personal income tax. Since there is different tax treatment for the various types of income, it is possible to arrange a portfolio to be more tax efficient. Tax efficiency refers to investment strategies that minimize taxes when investing. In general, income that does not have preferential tax treatment, such as interest income, should be held in registered plans as much as possible. Income with preferential tax treatment, such as dividends and capital gains, should be held in non-registered plans as much as possible. In some instances, the structure and/or investment objective of the mutual fund itself will result in a tax efficient investment. Tax Efficient Mutual Funds With respect to mutual funds, the following types of funds tend to be the most tax efficient: funds that invest heavily in equities funds that use index investing funds that use a buy-and-hold strategy corporate class structure funds NOTE: You should be aware of any tax implications that may arise from your recommendations. Ensure that your client seeks tax advice from a qualified professional. Taxation of Registered Plans and Non-Registered Accounts Registered plans are savings plans that are defined in the federal Income Tax Act, registered with the Canada Revenue Agency (CRA), and administered by various financial institutions. These types of plans are granted special tax status wherein contributions may be tax deductible and taxes payable on any investment earnings may be deferred or eliminated. There are also a number of limitations/restrictions on these plans including how withdrawals are treated for tax purposes. The table below highlights the tax implications of contributions, investment earnings, and withdrawals for the five main types of registered accounts. Account Type Tax-free Savings Account (TFSA) © 2021 IFSE Institute Are Contributions Tax Deductible? No Are Investment Earnings Taxable Every Year? No Are Withdrawals Tax-Free? Yes 409 Unit 11: Making Recommendations Account Type Are Contributions Tax Deductible? Are Investment Earnings Taxable Every Year? Are Withdrawals Tax-Free? Registered Education Savings Plan (RESP) No No EAP & investment income withdrawals are taxable; Withdrawals of subscriber contributions are tax-free Registered Retirement Savings Plan (RRSP) Yes No No Registered Retirement Income Fund (RRIF) No No No Registered Disability Savings Plan (RDSP) No No DAP & investment income withdrawals are taxable; Withdrawals of contributor contributions are taxfree NOTE: EAP refers to educational assistance payments and DAP refers to disability assistance payments. When considering flexibility alongside tax efficiency, TFSAs are the most tax efficient savings alternative since withdrawals are tax-free and can be re-deposited the following calendar year with no negative impact on the plan-holder’s contribution room. RRSPs are very effective savings vehicles since any deposits result in a tax deduction. The value of an RRSP is enhanced if the tax refund is reinvested into the RRSP. Types of Income Depending on the types of investments held within a registered or non-registered plan, the types of income that may be earned include the following: interest income Canadian dividend income other income, such as income from foreign property capital gains or losses As mentioned earlier in this lesson, interest income does not have preferential tax treatment, whereas dividends and capital gains do have preferential tax treatment. As such, investments that generate interest income should be allocated to your clients’ registered portfolios before being added to your clients’ non410 © 2021 IFSE Institute Canadian Investment Funds Course registered portfolios. Investments that generate dividends and capital gains should be allocated to your clients’ non-registered portfolios before being added to your clients’ registered portfolios, since the preferential tax treatment is not available in registered plans. Example Maria holds a bond mutual fund and an equity index mutual fund in a non-registered account. She wants to contribute one of these funds to her RRSP, where it will be sheltered from tax. From a tax efficiency point of view, which one should she contribute? Maria's bond fund generates mostly interest income, which if held in her non-registered account, would be fully taxable. Alternatively, her index fund generates dividends and capital gains, which receive preferential tax treatment. Furthermore, the index fund does not have a lot of trading in the portfolio, which means that capital gains are minimized. Therefore, Maria should contribute the bond fund to her RRSP. Note: When making any contributions to an RRSP in kind, there may be a tax consequence arising from the disposition and contribution. © 2021 IFSE Institute 411 Unit 11: Making Recommendations Summary Congratulations, you have reached the end of Unit 11: Making Recommendations. In this unit you covered: Lesson 1: Evaluating the Client Lesson 2: Selecting Mutual Funds Lesson 3: Asset Allocation Lesson 4: Tax Efficient Strategies Now that you have completed these lessons, you are ready to assess your knowledge with a 10-question quiz. To start the quiz, return to the IFSE Landing Page and click on the Unit 11 Quiz button. 412 © 2021 IFSE Institute