Types of Mutual Funds.pdf

Canadian Investment Funds Course Unit 6: Types of Mutual Funds Introduction As a Dealing Representative, mutual funds are a core element of your role. As such, it is essential that you have knowledge about the different types of mutual funds. In order to make suitable recommendations for your client...

Canadian Investment Funds Course Unit 6: Types of Mutual Funds Introduction As a Dealing Representative, mutual funds are a core element of your role. As such, it is essential that you have knowledge about the different types of mutual funds. In order to make suitable recommendations for your clients, you must understand the structure of each fund type, and how each fund meets different investment goals. In this unit you will learn about the history and benefits of mutual funds. You will also learn about money market, fixed income, balanced, equity and specialty funds, and how they can address your clients' diverse investment requirements. This unit takes approximately 2 hour and 30 minutes to complete. Lessons in this unit: Lesson 1: Introduction to Mutual Funds Lesson 2: Mutual Fund Categories Lesson 3: Conservative Mutual Funds Lesson 4: Growth-oriented Mutual Funds Lesson 5: Other Investment Products and Investment Funds © 2021 IFSE Institute 197 Unit 6: Types of Mutual Funds Lesson 1: Introduction to Mutual Funds Introduction Mutual funds are central to the business of mutual fund dealers. As a Dealing Representative, your clients will expect you to have an in-depth understanding of mutual funds. This lesson takes approximately 20 minutes to complete. By the end of this lesson you will be able to: describe the history of mutual funds and the current environment describe the benefits of mutual funds: - liquidity professional management diversification low cost convenience differentiate between closed-end and open-end mutual funds 198 © 2021 IFSE Institute Canadian Investment Funds Course History of Mutual Funds The concept of mutual funds working to bring together investors for mutual benefit has been around for centuries. The first mutual fund was created in the Netherlands in the late 1700s, when a Dutch broker created a trust that was intended to provide small investors with a diversification of investments. This early type of mutual fund spread to England and France, and then to the United States in the late 1800s. The first open-end mutual fund was created in the U.S. in 1924. In Canada, the first mutual fund was established in 1932, known today as the CI Canadian Investment Fund. Recent Developments Mutual funds have grown in popularity since their inception in the Canadian market. The largest growth occurred in the 1990s, when the double-digit interest rates that had made fixed-income securities, such as guaranteed investment certificates (GICs), attractive to investors began to drop. Subsequently, investors' money flowed into mutual funds as Canadian savers sought investments with the potential for higher return opportunities. During the 2002 internet bubble crash and the 2008 credit crisis, mutual fund assets fell, as the value of most securities declined. During these periods of uncertainty and declining security prices, many investors lost confidence and sold their investments to avoid any further investment losses. Since the economic downturns in 2002 and 2008, the economy has rebounded. Investors' confidence has gradually returned, and as a result, the industry's assets under management have climbed back up to pre-crisis levels. The chart below shows the assets under management across the mutual fund industry over time. You can see the fluctuations, as investors have moved money into and out of the mutual funds market. Source: Investment Funds Institute of Canada (IFIC), Investment Funds Report 2020 © 2021 IFSE Institute 199 Unit 6: Types of Mutual Funds Closed-End vs. Open-End Mutual Funds Mutual funds can be structured in two ways: closed-end mutual funds and open-end mutual funds. Closed-end mutual funds The earliest mutual funds were closed-end mutual funds. These mutual funds issue a fixed number of units when the mutual fund is organized through an initial public offering (IPO). That number remains set until more units are authorized and issued. After the IPO, investors can buy and sell units of a closed-end mutual fund through a secondary market such as the Toronto Stock Exchange (TSX). This process does not normally involve the issuing company. Instead, transactions occur between buyers and sellers. The price of a closed-end mutual fund is subject to the market conditions of supply and demand. As a result, the market price of the units may not reflect the fund's underlying net asset value per unit (NAVPU). It may be higher or lower than the NAVPU. Open-end mutual funds In contrast to closed-end mutual funds, open-end mutual funds are offered continuously. There are no restrictions on the number of units issued by the investment fund manager. Rather, the investment fund manager will issue more units as investors' demand increases, and redeem the units when investors want to sell them. Unlike closed-end funds, open-end funds are bought and sold through the investment fund manager. As a result, the market price of open-end mutual funds always reflects its NAVPU. For the purpose of this course, we will focus our discussions on open-end mutual funds. Benefits of Mutual Funds Benefit Liquidity 200 Description Mutual funds are considered to be liquid investments that can be sold and converted to cash very quickly and easily. An investor simply needs to submit a redemption request to you, the Dealing Representative, or to the investment fund manager. The redemption proceeds are usually sent to the investor within two to three business days. Some mutual funds may be more restrictive on their redemption policy if the underlying assets within the mutual fund portfolio themselves cannot be easily sold. © 2021 IFSE Institute Canadian Investment Funds Course Benefit Description Professional Management Mutual fund investors benefit from the services of trained investment professionals. Portfolio managers have greater access to research and more sophisticated analytical tools than the average investor. They, with the help of their team, follow a rigorous process to research, analyze, and select only those securities that they believe best match the investment objectives of the mutual fund. Diversification Mutual funds reduce the risk of owning one security by holding different types of securities or securities from a number of different issuers. The average mutual fund can hold dozens or hundreds of different securities. The securities may vary across business sectors, geographical regions and other factors. By diversifying holdings, mutual funds can ensure that an event that affects one issuer or business sector does not affect the entire mutual fund portfolio. The average investor would find it difficult and very expensive to duplicate the level of diversification found in a mutual fund. The Fund Facts for a given mutual fund shows the type of investment held in the fund. Low Cost There is a cost benefit of owning a mutual fund because the expenses of running the fund are shared amongst thousands of investors. Professional management and the administration of the fund would be very expensive for a single investor. By sharing the costs with a number of investors, the cost of owning a mutual fund is affordable for most regular investors. Convenience With over 2,900 different mutual funds in Canada, investment fund managers are continuously competing for business by improving their customer service offerings so that investors can access their funds easily and quickly. For instance, some mutual fund companies allow investors to initiate account transactions online or by telephone. © 2021 IFSE Institute 201 Unit 6: Types of Mutual Funds Lesson 2: Mutual Fund Categories Introduction Mutual funds are collections of different securities, such as equities or bonds, selected by a portfolio manager to meet a given fund’s investment objectives. There are different types of mutual funds; each one intended to address different investment goals. As a Dealing Representative, you must be familiar with the different fund types so that you can help your clients to choose suitable investments. In this lesson you will learn about each of the major fund types and their main characteristics. This lesson takes approximately 20 minutes to complete. By the end of this lesson you will be able to: describe the role of the Canadian Investment Funds Standards Committee and how they set the categorizations of mutual funds explain the various types of income that can be generated and distributed by mutual funds and their main characteristics describe the major characteristics of the following mutual fund types: - money market funds fixed income funds balanced funds equity funds specialty funds compare the risk return relationships of the different types of mutual funds 202 © 2021 IFSE Institute Canadian Investment Funds Course Canadian Investment Funds Standards Committee Mutual funds consist of a collection of different securities, such as equities or bonds that are hand-picked by a portfolio manager in order to achieve a particular investment objective. To help investors make sense of the multitude of mutual fund offerings, the Canadian Investment Funds Standards Committee (CIFSC) sets the standards used to classify mutual funds into specific categories. Its classification of mutual funds is based on the mutual fund's investment mandate and the securities it holds. Understanding the different fund categories will help you as a Dealing Representative to evaluate and identify suitable mutual funds for your clients. For our purposes, we will discuss these major types of mutual funds and the more common categories within the types. Money Market Funds money market funds Fixed Income Funds Balanced Funds mortgage funds balanced funds bond funds tactical asset allocation funds target date funds Equity Funds equity funds (based on market capitalization) Specialty Funds Canadian dividend funds laboursponsored investment funds global equity funds real property funds commodity pools international equity funds sector funds Cash Holdings and Mutual Fund Categories It is important to note that all mutual funds hold a portion of their portfolio in cash. The cash is not an investment, but rather a reserve to meet the cash flow needs of the fund, such as fulfilling client redemption requests and buying additional securities. As the cash portion does not typically play a part in positioning the mutual fund to achieve its investment objective, it does not affect how the fund is categorized. As well, the portfolio manager has some discretionary over of the portfolio and may hold securities that are outside the primary mandate of the fund. For example, an equity fund may hold a portion of its assets in fixed income securities. For our purposes, we will simplify our discussions to concentrate on the main types of securities in each mutual fund category and the primary sources of income. © 2021 IFSE Institute 203 Unit 6: Types of Mutual Funds Income Generated and Distributed by Mutual Fund As a Dealing Representative, it is important that you be able to differentiate among the types of income earned and distributed by mutual funds. This will help you to understand: the likelihood the income will be earned the frequency of the income the tax implications of the income You need to consider all these factors when determining whether a mutual fund is suitable for your client. The table below lists the types of income distributed by mutual funds and their characteristics. Income Description Characteristics Interest interest payments from fixed-income securities such as treasury bills and bonds likelihood of payment is high especially from creditworthy issuers and frequency of payment is set out in the terms Canadian Dividend profit from Canadian companies distributed to common and preferred shareholders likelihood and frequency of payment is usually high with large, established companies Capital Gains profit from the sale of a security for a higher price than its original purchase cost only occurs when there is price appreciation Foreign NonBusiness Income interest or dividend payments from non-Canadian investments likelihood and frequency of payment is usually high with large, established issuers Return of Capital (not considered income for tax purposes) return of investor's money occurs when distributions exceed earnings in the mutual fund Mutual Fund Summary Before we discuss the mutual fund types in greater detail, the table below provides a brief profile of each grouping. 204 © 2021 IFSE Institute Canadian Investment Funds Course Mutual Fund Investment Objective Type of Income Underlying Investments Risk Classification Money Market Funds safety and income interest money market securities low Fixed Income Funds steady income interest and some capital gains bonds low, low to medium, medium Balanced Funds income and longterm growth interest, dividends, and capital gains equities and bonds low to medium, medium Equity Funds long-term growth capital gains, dividends, and other income equities medium, medium to high, high Specialty Funds long-term growth capital gains, dividends, and other income equities, real estate, commodities, and other investments high The risk classification of mutual funds is measured by the fund's historical price volatility, which is the amount and frequency of the net asset value per unit (NAVPU) fluctuations over time. Funds with high volatility experience significant rise and fall in their NAVPU over a short period while funds with low volatility have stable NAVPU. Risk Return Relationship Another consideration to keep in mind when evaluating mutual funds is the relationship between risk and return. More conservative mutual funds typically have lower returns in exchange for lower risk. More growth-oriented or aggressive mutual funds have the potential for higher returns but at a higher risk which can translate to potential losses. The following graph shows the risk return relationship of the mutual fund types in relationship to cash and each other. © 2021 IFSE Institute 205 Unit 6: Types of Mutual Funds Lesson 3: Conservative Mutual Funds Introduction Conservative mutual funds address the needs of those clients that require safety of capital and income. In some cases, there are opportunities for capital appreciation but the growth tends to be moderated by the lower level of risk taken in these portfolios. In this lesson you will learn about money market, fixed income, and balanced funds. This lesson takes approximately 40 minutes to complete. By the end of this lesson you will be able to: describe how the following mutual funds work and their main features: - 206 money market funds mortgage funds bond funds balanced funds tactical asset allocation funds target date funds © 2021 IFSE Institute Canadian Investment Funds Course Overview of Conservative Mutual Funds Investors with a lower risk profile will typically seek a more conservative mutual fund such as a money market, fixed income, or balanced fund. Money market and fixed income mutual funds focus primarily on safety of capital and steady income while balanced funds aim for a combination of income and growth. We will discuss the most common mutual fund categories: money market funds - money market funds fixed income funds - mortgage funds - bond funds balanced funds - balanced funds - tactical asset allocation funds - target date funds How Money Market Funds Work Money market funds are safe investments that are typically used as a temporary place to deposit money. The investment objectives are safety of principal (i.e. protection of investor's money) and income. A money market fund invests in low-risk, high quality fixed income securities with terms to maturity of one year or less. By law, the average weighted term to maturity of the portfolio must not exceed 180 days which makes the fund very stable. Although the investments within the fund fluctuate with general interest rate levels, money market funds are managed in such a way that the fund price remains constant, typically $1 or $10. Under rare circumstances, the net asset value per unit (NAVPU) may fluctuate. Money market funds pay interest on a monthly basis. You can reinvest the interest automatically or receive it as income. The investment returns move in the same direction as general interest rates and are usually better than the return received from a traditional bank account. © 2021 IFSE Institute 207 Unit 6: Types of Mutual Funds Money Market Funds Profile Investment Objective Safety and Income Type of Income Interest Holdings Client Suitability Risk Classification Treasury bills (T-bills), bankers' acceptances, commercial paper, provincial and municipal short-term paper domiciled in Canada. U.S. Money market funds are similar to Canadian money market funds but securities are denominated in U.S. currency. For investors who want principal protection and some income. Due to their low return, money market funds are better suited for short-term goals such as saving for an emergency fund. They can also be used as a temporary investment before investing in other mutual funds. U.S. money market funds are for investors who want to preserve their U.S. money for a short-term. Low How Mortgage Funds Work Mortgage funds are a type of fixed income mutual fund that invests in mortgage securities. The investment objective is steady income. Mortgage funds invest in mortgage securities, which are pools of mortgages combined together so they can be packaged as securities to be sold in the secondary market. Most mortgage securities hold National Housing Act (NHA) mortgages, which are fully insured mortgages, guaranteed by the Canada Mortgage and Housing Corporation (CMHC), a Government of Canada agency primarily involved in providing mortgage loan insurance. The portfolio will also be invested in some short-term bonds for liquidity. Compared with mortgage securities, short-term bonds can be converted into cash more quickly and simply, to meet the cash flow needs of the fund. Mortgage funds typically pay higher income than money market funds because mortgage rates are usually higher than the interest rates on money market securities. Income from mortgage funds is a combination of principal repayment and interest payments on mortgages. The principal repayment is retained in the fund and used to purchase new mortgages while the interest is distributed to the fund's unitholders. 208 © 2021 IFSE Institute Canadian Investment Funds Course Like other fixed income securities, the fund's price is affected by interest rates. If interest rates increase, the fund's price will decrease. Conversely, when interest rates decrease, the fund's price will increase. Mortgage Funds Profile Investment Objective Steady income Type of Income Interest and some capital gains Holdings Commercial, industrial and residential mortgages, as well as short-term fixed income securities. Client Suitability Investors who want income on a monthly basis. Risk Classification Low Mortgage funds are low-risk investments, but not risk free. The fund experiences lower price volatility than bond funds because its average term to maturity is usually under five years, which is lower than the average term to maturity of bond funds. Longer maturity typically involves higher risk because there is greater uncertainty in the long term (e.g. interest rates may go up in the future). Another reason the fund is lower risk than bond funds is that the mortgages held in the fund are guaranteed by the Government of Canada. How Bond Funds Work Bond funds are mutual funds whose holdings consist of bonds. The main objective of bond funds is to produce income in the form of interest, which can be paid to unitholders on a monthly basis. There may also be capital gains when bonds are sold. Bond funds can be classified in many different ways. Two basic ways in which bond funds are classified: by the creditworthiness of the bond's issuer by the average term to maturity Generally, investment grade bonds involve lower risk and therefore pay lower interest rates, while bonds with higher risk pay higher income to compensate investors for the additional risk. The mandate of the bond fund will specify whether a portfolio manager is restricted to investment grade bonds or is able to obtain higher rates of return with lower quality issuers. © 2021 IFSE Institute 209 Unit 6: Types of Mutual Funds Bond funds can also be classified according to the average maturity of the bonds held in the fund (maturity refers to length of time before the bond expires and the issuer is required to repay the principal). short-term bonds - bonds maturing within five years intermediate-term bonds - bonds maturing in five to 10 years long-term bonds - bonds maturing in 10 plus years Interest rate changes have a great impact on bond prices. When interest rates go up, the value of bond funds goes down. Conversely, when interest rates fall, the value of bond funds goes up. Bond Funds Profile Investment Objective Steady income Type of Income Interest and some capital gains Holdings Bonds Client Suitability Investors who want stable income. Risk Classification Low, Low to Medium, Medium The portfolio manager can minimize some of the risks associated with bonds, such as interest rate changes and creditworthiness of issuers, by maintaining a diversified portfolio of different bonds. Also, the portfolio manager can adjust the bond maturities to take advantage of different stages of the economic cycle. Longer maturity bonds can be used when interest rates are low or falling and short-term maturity during periods of high or rising interest rates. How Balanced Funds Work Balanced funds invest in a combination of equities and bonds. The investment objective of balanced funds is a combination of long-term capital growth and income. The bond holdings in balanced funds offer a measure of stability and income, while the equity portion provides some income through dividends and long-term growth, in the form of capital appreciation. With the combination of bonds and common shares, balanced funds have the potential to provide a higher return than a bond fund but with lower volatility than an equity fund. Balanced funds are required to have a fixed asset allocation. This means a fund must hold a minimum percentage of bonds and common shares according to the objectives set out in its prospectus. For instance, a balanced fund may be required to hold an asset allocation of 60% equities, 35% bonds, and 5% cash. Instead 210 © 2021 IFSE Institute Canadian Investment Funds Course of exact percentages, there is usually a range specifying the minimum and maximum limits for each asset class. The investment goal of the mutual fund will determine its asset allocation. To achieve the goal, the portfolio manager can use: strategic asset allocation - The portfolio manager analyzes the long term expected returns and risk levels of each asset class to set a target asset mix that would match the requirements of the balanced fund. From time to time, the value of the securities in the mutual fund may change and cause the assets held in the fund to deviate from the fund's strategic asset allocation. When this happens, the portfolio manager must rebalance the mix, to return to the strategic asset allocation. tactical asset allocation - Tactical asset allocation is when a portfolio manager temporarily changes the asset allocation from its strategic asset mix, in order to take advantage of short-term opportunities in the market. In balanced funds, this is usually a short-term strategy with the portfolio manager returning the mutual fund to its strategic asset allocation once the market opportunity has passed. Balanced Funds Profile Investment Objective Income and long-term growth Type of Income Interest, dividends, and capital gains Holdings Common shares (equities) and bonds Client Suitability Investors who want income and growth. Risk Classification Low to Medium, Medium How Tactical Asset Allocation Funds Work Tactical asset allocation funds are also referred to as asset allocation funds. The investment objective is longterm capital growth and income. While balanced funds must stay within a set asset mix, tactical asset allocation funds generally have no restrictions on the allocation of assets within the portfolio. The portfolio manager has the flexibility to change the asset allocation of the fund to adjust to changing market conditions and economic forecasts. For instance, the portfolio manager can change the asset allocation from 65% equities, 35% bonds, and 5% cash to 80% equities, 15% bonds, and 5% cash. © 2021 IFSE Institute 211 Unit 6: Types of Mutual Funds Asset Allocation Funds Profile Investment Objective Income and long-term growth Type of Income Interest, dividends, and capital gains Holdings Common shares and bonds Client Suitability Investors seeking income and growth. Risk Classification Low to Medium, Medium The risk of asset allocation funds varies according to the individual fund mandates and objectives. They may be higher risk than balanced funds since the portfolio manager does not have to invest a minimum percentage of the portfolio in fixed income. How Target Date Funds Work Target date funds (also known as life-cycle funds) are a kind of asset allocation fund that focuses on a specific future date and changes the asset mix throughout the life of the fund. The investment objective of target date funds is to provide a balance of income and long-term capital growth, relative to the target date. The purpose of a target date fund is to meet an investment goal at a specific time in the future, such as the start of an investor's retirement or a child's post-secondary education. The investor purchases a target date fund that matches a significant life event. In the early stages, the mutual fund portfolio holds a greater percentage in equities. Over time, the asset mix is adjusted away from equities and towards fixed income, thereby reducing risk exposure as the target date approaches. Example Wilma is 40 years old, and plans to retire in 25 years when she turns 65. She can buy a fund with a target date set for 25 years from now. Over the next 25 years, the portfolio manager will adjust the asset allocation of the fund to gradually lower the equity holdings while increasing the bond holdings in the fund. When the fund matures in 25 years the fund’s portfolio will be largely composed of bonds, with a lower percentage of the fund invested in equities. The portfolio at the target date will be suited to Wilma’s retirement needs. NOTE: The asset allocation will vary among target date funds offered by different investment fund managers. 212 © 2021 IFSE Institute Canadian Investment Funds Course Target Date Funds Profile Investment Objective Income and growth Type of Income Interest, dividends, and capital gains Holdings Common shares and bonds Client Suitability Investors who want the convenience of having the mutual fund deal with asset allocation and fund re-balancing. Risk Classification Low to Medium, Medium The risk level of target date funds changes as the asset mix is adjusted throughout the fund's life. It may start off higher in the early stage of the fund and decline as the mutual fund reaches its target date. © 2021 IFSE Institute 213 Unit 6: Types of Mutual Funds Lesson 4: Growth-oriented Mutual Funds Introduction Growth-oriented mutual funds offer investors the opportunity for capital appreciation. Typically, these funds are suitable for investors with long time horizons and higher risk levels. Growth-oriented mutual funds can range from steady growth to aggressive or speculative growth. Although index funds and fund of funds are not separate categories (instead they will fall under one of the existing categories), it is important to understand how these funds work. In this lesson you will learn about equity funds, specialty funds, index funds and fund of funds. This lesson takes approximately 40 minutes to complete. By the end of this lesson you will be able to: describe how the following mutual funds work and their main features: - equity funds - Canadian dividend funds - global equity funds - international equity funds - sector funds - labour-sponsored investment funds - real property funds - commodity pool funds explain how index funds work discuss the main features of a fund of funds 214 © 2021 IFSE Institute Canadian Investment Funds Course Overview of Growth-Oriented Mutual Funds Investors who are seeking higher returns and can tolerate a greater amount of risk will be interested in growth-oriented mutual funds. These funds experience greater fluctuation in their pricing and subsequently in their returns. Individual growth-oriented funds also vary in their risk levels. As with other mutual funds, the underlying securities in the portfolio determine the level of risk. We will explore various equity funds as well as briefly discuss some specialty funds in the industry. equity funds - Canadian dividend funds - Canadian equity funds - global equity funds - international equity funds - sector funds specialty funds - labour-sponsored investment funds - real property funds - commodity pools Index funds and fund of funds are not considered separate mutual fund categories. Instead, they are classified as one of the previously discussed categories according to their underlying investments. Given their popularity with investors, there is a brief discussion about these products. How Equity Funds Work Equity funds invest primarily in the common shares of corporations. The investment objective of equity funds is long-term capital growth. There are many categories of equity funds, ranging from mutual funds that invest in a diversified portfolio of companies to ones that invest in specific economic sectors, countries or regions. Portfolio managers may also invest based on market capitalization or size of the companies. Market capitalization is defined as the total market value of a corporation's outstanding shares. Generally, there are three market capitalization groups: small market capitalization (small cap) - smaller companies (e.g. between $100 million and $1.5 billion) medium market capitalization (medium or mid cap) - medium sized companies (e.g. between $1.5 billion to $5 billion) large market capitalization (large cap) - large, established companies, often called blue chip (e.g. over $5 billion) © 2021 IFSE Institute 215 Unit 6: Types of Mutual Funds The market capitalization that defines a small, medium and large cap companies varies across investment fund managers. The above amounts are given as examples. Equity Funds Profile Investment Objective Long-term growth Type of Income Capital gains, dividends, and other income Holdings Primarily invested in common shares but may also hold preferred shares. Client Suitability Investors with a higher risk profile and longer time horizon. Investors need to be able to withstand the potential losses that may occur. Risk Classification Medium, Medium to High, High In terms of risk, small cap corporations are higher risk than large cap corporations. A more narrowly focused mutual fund is riskier than a well-diversified portfolio. Therefore, the risk level will depend on the securities in the portfolio. How Canadian Dividend Funds Work Canadian dividend funds provide investors with periodic dividend income by investing in shares of corporations that regularly pay dividends. The investment objective is to provide income and long-term capital growth. Dividend-paying corporations are typically large, established businesses with a history of providing steady dividend payments. The common and preferred shares held in a Canadian dividend fund generate taxpreferred dividend income. Dividends from Canadian companies benefit from the dividend tax credit. This credit reduces the amount of tax the investor pays on their dividend income. Canadian Dividend Funds Profile Investment Objective Income and growth Type of Income Dividends and capital gains Holdings Invests primarily in common shares of Canadian corporations that regularly pay dividends. May also hold preferred shares. Client Suitability Investors who want steady tax-preferred income and the opportunity for some long-term capital growth. 216 © 2021 IFSE Institute Canadian Investment Funds Course Canadian Dividend Funds Profile Risk Classification Medium Dividend funds are a moderate risk investment. They are higher risk than bonds because the market valuation of common shares fluctuates as market conditions and investor sentiment changes. However, dividend-paying shares experience lower volatility than non-paying dividend shares. How Canadian Equity Funds Work Canadian equity funds invest in securities of Canadian companies. The investment objective is long-term capital growth. Canadian equity funds invest the majority of its portfolio in Canadian companies. The portfolio managers seek to create a diversified portfolio by selecting individual securities that meet their criteria. Investors may receive income from the mutual fund that is tax-preferred in the form of dividends and capital gains. Canadian Equity Funds Profile Investment Objective Long-term growth Type of Income Capital gains, dividends, and other income Holdings Common shares of Canadian companies Client Suitability Investors seeking capital growth over the long term. These investors should be able to tolerate some short-term price volatility. Risk Classification Medium, Medium to High, High How Global Equity Funds Work Global equity funds are free to seek opportunities in any country or region, free of geographic restriction, in their pursuit of long-term capital growth. Global equity funds can invest in securities of corporations throughout the world including Canada and the U.S. The geographic allocations for individual global equity funds vary from one another since the portfolio managers determine where the best opportunities lie for their respective mutual fund. Some global equity funds may be more heavily weighted in developed countries while others find better prospects in emerging markets. © 2021 IFSE Institute 217 Unit 6: Types of Mutual Funds Global equity funds typically involve more risk than Canadian equity funds. These risks associated with the foreign countries include: fluctuations in the currency exchange rate unstable political environment economic uncertainties Global Equity Funds Profile Investment Objective Long-term growth Type of Income Capital gains, dividends, and foreign income Holdings Common shares of foreign, Canadian, and U.S. companies Client Suitability Investors who seek growth from investment opportunities around the world including North America. Canada represents less than 5% of the global market, and its market is largely concentrated in three sectors: energy, finance and materials. Global equity funds provide the opportunity for Canadian investors to gain broader diversification into different markets. Risk Classification Medium, Medium to High, High How International Equity Funds Work International equity funds invest in securities of corporations outside of North America. The investment objective is long-term capital growth. In contrast to global equity funds, international equity funds hold only securities issued by foreign corporations. International equity funds are typically higher risk than global equity funds because they are completely invested in foreign companies. Therefore, international equity funds are more greatly impacted by the currency, political, and economic risks associated with the countries they chose to invest in. For emerging and developing countries, these risks can be magnified because their markets are less regulated than markets in developed countries. NOTE: Global equity funds are only partially exposed to the risks identified above since some of their holdings are in domestic corporations. 218 © 2021 IFSE Institute Canadian Investment Funds Course International Equity Funds Profile Investment Objective Long-term growth Type of Income Capital gains and foreign income Holdings Common shares of foreign companies Client Suitability Investors who already have Canadian and U.S. investments, and want to add international investments to their portfolios. Risk Classification Medium, Medium to High, High How Sector Funds Work Sector funds are mutual funds with a narrow investment focus. The investment objective is long-term capital appreciation. According to their investment mandate, sector funds concentrate their holdings in a particular industry or sector. There are a number of different categories of sector funds. Some examples include: technology funds financial services funds healthcare funds natural resources funds precious metals funds Sector Funds Profile Investment Objective Long-term growth Type of Income Capital gains, dividends, and other income Holdings Common shares of corporations in a specific industry, sector, or geographical region Client Suitability Investors who have a higher risk profile. Their concentrated portfolios mean investors' fortunes are tied to the prospects of the specific industry, sector, or geographic region. Investors should have a long time horizon to weather the volatile nature of sector funds. © 2021 IFSE Institute 219 Unit 6: Types of Mutual Funds Sector Funds Profile Risk Classification Medium to High, High Sector funds' narrow focus makes them higher risk compared to diversified equity funds that have broader exposure to different business sectors or regions. These funds have the potential of offering extremely high returns but with huge downside risk. How Labour-sponsored Investment Funds Work Labour-sponsored investment funds (LSIFs) provide money for Canadian start-up companies. They are also known as labour-sponsored venture capital corporations (LSVCCs). The investment objective is long-term capital appreciation, with tax benefits in the form of tax credits. LSIFs provide capital to small- to mid-sized Canadian start-up companies in exchange for ownership shares in the company. The federal government offers unitholders a 15% tax credit on a maximum of $5,000 investments per year. In addition, some provincial governments offer a further 15% tax credit. IMPORTANT: The Government of Canada announced in the 2013 Federal budget, that the 15% federal tax credit is to be eliminated gradually, ceasing by 2017. Provincial tax credits have also undergone some changes, with each province having its own amendments. For instance, Ontario eliminated the tax credit as of 2012. Investors must hold on to LSIFs for eight years to maintain the credits. Otherwise, the credits must be returned to the government. While some companies that receive funding from LSIFs have been successful, many others fail within the first few years. Labour-Sponsored Funds Profile Investment Objective Long-term growth Type of Income Capital gains, dividends, and other income Holdings Shares of small to mid-sized Canadian start-up companies Client Suitability Investors seeking higher returns along with tax benefits Risk Classification High The low liquidity of LSIFs, combined with the fact that they are invested in high risk companies makes LSIFs a high risk investment choice. Investors should have high risk profile and long investment time horizon. 220 © 2021 IFSE Institute Canadian Investment Funds Course How Real Property Funds Work Real property funds invest in real estate properties. Investors receive returns from rental income, as well as capital gains from properties sold at a profit. The investment objective of real property funds is steady income and long-term capital growth. Unlike other mutual funds, these funds are not priced daily. Real property fund values are based on the appraisal value of the properties held in the portfolio, which do not change daily. Unit prices are set monthly or quarterly. Because unit prices are set less frequently, investors may only be able to redeem the funds at specified times. Also, if the fund does not have enough cash on hand, the redemption requests may only be partially filled. Real Property Funds Profile Investment Objective Long-term growth Type of Income Capital gains, dividends, and other income Holdings Residential, commercial or industrial properties, and in securities from companies involved in real estate management or development. Client Suitability Investors who want exposure to the real estate sector. The investors should have a high risk profile and be willing to invest for a long period. Risk Classification High These funds are high risk because they are invested in one business sector, rather than holding a diversified portfolio. In addition, real property funds are less liquid than other types of mutual funds since investors may not be able to convert their investment into cash when they want. How Commodity Pool Funds Work Commodity pools are mutual funds that are permitted to use or invest in specified derivatives and physical commodities beyond what is permitted by National Instrument 81-102. These funds are governed by National Instrument 81-104. The investment objective is capital growth. Commodity pools are similar to other mutual funds except they are able to employ alternative trading strategies for their portfolios. Commodity pool managers engage in speculative trading by investing in: specified derivatives physical commodities © 2021 IFSE Institute 221 Unit 6: Types of Mutual Funds Some of the investments that may be found in a commodity pool are commodity futures and forward contracts for grains, meats, metals, energy products, and coffee. Commodity Pool Funds Profile Investment Objective Speculation Type of Income Other income Holdings Options contracts, commodity futures, and forward contracts Client Suitability For sophisticated investors who are able to understand and accept the high risk associated with commodity pools. Risk Classification High Commodity pools are high-risk investments because they involve speculative trading, which is a strategy of making quick profits by buying and selling assets in a very short period. As a result, commodity pool fund performance can be extremely volatile. IMPORTANT: Please note that a mutual fund registration is not sufficient to sell these products. Additional proficiency and registration are required. Contact your Compliance Department for more information. Index Funds Index funds base their investment mandate on a specific market index. These funds seek to replicate the performance and return of a market index by investing in the same securities as those held by the index, either by investing in them directly or by using derivatives. For instance, a Canadian index fund that is meant to match the performance of the Standard & Poor's / Toronto Stock Exchange (S&P/TSX) Composite Index, would attempt to invest in the same portfolio of securities as those held in the S&P/TSX Composite Index. Index funds fall into different mutual fund categories depending on the underlying securities of the fund. An index fund that is tracking the S&P/TSX Composite Index would be part of the equity fund category while an index fund that tracks the DEX Universe Federal Bond Index (Canadian market benchmark for bonds) would be part of the fixed income mutual fund category. The risk classification will depend on the securities held in the portfolio. The value of the mutual fund changes in line with the holdings of the index. While the intention of these mutual funds is to replicate the return of a specific market index, its return will not perfectly match the index. This discrepancy is called the tracking error. An index fund's return tends to lag that of the specific market index since there are costs associated with managing the index fund that are not applicable for the market index. Furthermore, the index fund may only hold a sampling of the securities of the market index. The 222 © 2021 IFSE Institute Canadian Investment Funds Course portfolio manager tries to conform as closely as possible but it may not always be possible to reproduce the identical basket of securities. Fund of Funds A fund of funds (FOF), also called a wrap fund or a managed portfolio solution, invests in a basket of mutual funds from the same investment fund manager. Essentially, the FOF creates a diversified portfolio to meet a specific investment objective using mutual funds instead of individual bonds and equities. The illustration below is an example of how a fund of funds is structured. Fund of Funds Canadian Equity Fund US Equity Fund Bond Fund International Equity Fund Canadian Dividend Fund These investments are suited for investors who want a simple solution. These investors do not have the time or expertise to customize a portfolio of their own, nor do they have the discipline to rebalance their portfolio. Investment Options FOFs offer investors the convenience of a pre-set investment portfolio. They establish a target asset allocation of cash, fixed income, and equities to meet its investment mandate. Investment fund managers usually offer a series of managed portfolios that range from conservative to moderate to aggressive growth. Since the funds may hold a mix of stocks and bonds, the FOFs may provide steady income or long-term capital growth, or a combination. The risk level varies according to the asset mix of the FOFs. The diversified nature of these funds makes them lower risk than stand-alone mutual funds, which invest directly in stocks and bonds. Multiple Portfolio Managers FOFs employ a multi-manager approach, which means the investor gets the professional expertise of a portfolio manager from each mutual fund held in the fund of funds. This way, the investor can get professional investment management across asset classes, sectors, countries, and investment styles. Automatic Rebalancing FOFs automatically rebalance their portfolios to adhere to their target asset allocations. For instance, if the value of equity holdings increases, the portfolio manager may reduce the equity holdings to return the fund to its target asset allocation within the fund of funds. © 2021 IFSE Institute 223 Unit 6: Types of Mutual Funds Multiple Fees As a Dealing Representative, it is important for you to be mindful of the FOFs fee structure. There may be two sets of management expense fees involved: the management fees of the fund of funds the management expense fees of the underlying mutual funds 224 © 2021 IFSE Institute Canadian Investment Funds Course Lesson 5: Other Investment Products and Investment Funds Introduction Besides mutual funds, there are several investment options available in the financial market. Some products have similar features to mutual funds. We will explore a sampling of these other products in this lesson. It is important to note that you may require additional proficiency and registration to provide advice on these products. Check with your dealer before doing so. In this lesson you will learn about exchange-traded funds, principal protected notes, pooled funds, hedge funds, income trusts, and segregated funds. This lesson takes approximately 30 minutes to complete. By the end of this lesson you will be able to describe the following: describe the major characteristics of exchanged-traded funds describe the major characteristics of principal protected notes describe the concept of pooled funds describe the concept of hedge funds describe the concept of income trusts describe the major characteristics of segregated funds © 2021 IFSE Institute 225 Unit 6: Types of Mutual Funds Understanding Other Investment Products and Investment Funds In addition to having knowledge about mutual funds, you should have a basic understanding of some of the other products available to the public since your clients may inquire about these investments. It is important to understand that some of these products are exempt from the prospectus requirement which means they will not have the same level of disclosure, transparency or reporting requirements as mutual funds. Your access to reliable, accurate or up-to-date information may be limited. Therefore, some of these products may pose a higher risk. Furthermore, securities regulation or your mutual fund dealer may impose additional requirements or restrictions on these products. For instance, clients may have to qualify for an exemption before they can invest. A common exemption is the accredited investor exemption where individual investors have to meet financial thresholds to qualify. Another example is your dealer may restrict the concentration of the investment to 5% of the investor's overall holdings. This prevents the investor from holding too much of a potentially higher risk investment. Before providing any advice on these products, be sure to check with your mutual fund dealer. Exchange-Traded Funds (ETFs) Similar to mutual funds, exchange-traded funds (ETFs) are open-end investment funds that hold a basket of securities. There are a variety of investment options. ETFs can engage in active management and alternative investment strategies but for our purposes, we will focus on the more traditional style ETFs that are designed to copy the performance of a specific index. Passive Management Similar to index funds, ETFs are considered passive investments because the portfolio manager invests in the same basket of securities as those in a specific index. ETFs can track broad-based market indexes such as the TSX or S&P, where most business sectors are represented. There are also ETFs that track niche markets that are invested in a specific sector or industry, such as commodities or agriculture. Exchange-Traded Since ETFs are traded on a stock exchange, they can be bought and sold throughout the day. Transactions must be made through an investment dealer or broker. The market price is determined by supply and demand conditions and varies continuously during the day. The market price may also differ from the net asset value of the ETF. Like stocks, trades are placed using the bid ask price process. Buyers of ETFs place a “bid” on a price and the seller will “ask” for a specific price. When the bid and ask prices are matched the ETFs are sold. 226 © 2021 IFSE Institute Canadian Investment Funds Course Low Cost An attractive feature of ETFs is their low management expense ratios (MERs). However, broker commissions are charged when an investor buys or sells an ETF because ETFs trade on the stock exchange. Tracking Error The return of ETFs will not be perfectly identical to the indexes they track since the ETFs may not have exactly the same securities as the index at all times. Also, management fees will affect the return of the fund. Principal Protected Notes (PPNs) Principal protected notes (PPNs) are debt instruments issued by creditworthy financial institutions that provide two main features: the repayment of the original principal upon maturity of the instrument performance linked to that of an underlying asset (e.g. market index, investment fund, foreign currency) Since PPNs are debt instruments, the issuer is obligated to repay the principal at maturity. However, it does not offer a fixed coupon rate. Instead, its return is linked to the underlying asset that is specified. If the return from the underlying asset is positive, this is what the investor will receive when the PPN matures. If the return of the underlying asset is negative, the investor receives only the principal back. PPNs offer investors the opportunity to participate in the upside of an underlying asset without the downside risk since their principal is guaranteed at maturity. Example Carrie invests in a PPN issued by a Canadian bank. The note is repayable in seven years' time and linked to the S&P/TSX Composite Index. At maturity, Carrie will receive a return equal to the positive return, if any, of the S&P/TSX Composite Index over the term of the note. If the return of the index over the period is negative, she will only receive her original principal back. Pooled Funds Pooled funds and mutual funds share many similarities. They both pool together investor monies, are structured as unit trusts, have professional portfolio managers make investment decisions, offer a variety of investment options, and provide liquidity through redemptions. © 2021 IFSE Institute 227 Unit 6: Types of Mutual Funds However, pooled funds have some distinct differences: they do not have to file prospectuses with the provincial securities commissions they are only available to accredited investors (i.e. sophisticated and high-net-worth investors) they have high minimum investments requirements they benefit from economies of scale which lowers the management fees Hedge Funds Hedge funds are investment funds with the following characteristics: they are privately distributed, which means they do not have to file a prospectus their objective is typically to generate positive returns in all market conditions they have broad investment mandates Hedge funds are only available to accredited investors who must deposit a minimum amount into the fund. In contrast to mutual funds where portfolio managers are judged relative to a benchmark, hedge fund managers strive for positive absolute returns. In other words, their objective is to perform independent of market conditions. Hedge funds are free to invest in any type of security (e.g. gold, currencies, distressed securities) and are able to employ alternative strategies such as leverage and short selling to achieve high returns. Leverage is using borrowed money to amplify returns and short selling is selling a security that is borrowed from another investor. In addition to the management fee, hedge funds charge a performance fee that applies if they achieve superior fund performance. Generally, these funds can be extremely high risk especially if they involve speculative trading and leverage (which can magnify investment losses). Income Trusts Income trusts are trusts that invest exclusively in one or more operating companies, with the objective of distributing cash flow to their investors (unitholders). Unitholders have a right to the income and capital of the trust. The underlying operating company usually has a consistent cash flow of interest, royalties, or lease payments and these are passed along to unitholders. These units are traded on the stock exchange. 228 © 2021 IFSE Institute Canadian Investment Funds Course Prior to 2006, income trusts were very popular because of their favourable tax treatment since they were not subject to corporate tax. However, since that time the Federal government now requires all income trusts to pay corporate tax before any distributions are made. Segregated Funds Segregated funds are the life insurance industry's equivalent to mutual funds. They are variable annuities, which are investment products offered through life insurers and that can only be sold by licensed life agents. The technical term for a segregated fund is individual variable insurance contract (IVIC). The value of the contract is linked to that of an underlying investment fund selected by the investor. The insurer may hedge its investment risk by investing the proceeds of sale of the segregated fund in units of the underlying fund. Segregated funds have some key distinctions from mutual funds: Investors do not own the units of the underlying fund. Instead, investors own an insurance contract whose value is linked to that of the underlying fund. The insurer owns the units of the underlying fund. In addition to interest, dividends, and capital gains, segregated funds can flow capital losses to investors. Segregated funds guarantee the return of at least 75% (sometimes 100%) of the capital invested to the investor at maturity of the contract (usually ten years) or death of the contract holder. Redemption of the segregated fund at any other time is subject to the current market value. Some segregated funds allow investors to reset the principal amount at periodic intervals. Resets lock in increases in the value of the segregated fund. Segregated funds charge higher management fees to cover the cost of the guarantees. Investors can designate a beneficiary to the contract. Investor monies may be protected from creditors. These funds are suited for investors who want the benefit of investing in the equity market, but also some protection of their principal from market volatility. © 2021 IFSE Institute 229 Unit 6: Types of Mutual Funds Summary Congratulations, you have reached the end of Unit 6: Types of Mutual Funds. In this unit you covered: Lesson 1: Introduction to Mutual Funds Lesson 2: Mutual Fund Categories Lesson 3: Conservative Mutual Funds Lesson 4: Growth-oriented Mutual Funds Lesson 5: Other Investment Products and Investment Funds 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 6 Quiz button. 230 © 2021 IFSE Institute