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Chapter 3 Investment Funds. Learning objectives. Distinguish between direct and indirect investing. Define open-end and closed-end investment funds. State the major types of mutual funds and give their features. Define exchange-traded funds (ETFs).

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Chapter 3 investment funds l.jpg

Chapter 3Investment Funds


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Learning objectives

  • Distinguish between direct and indirect investing.

  • Define open-end and closed-end investment funds.

  • State the major types of mutual funds and give their features.

  • Define exchange-traded funds (ETFs).

    inguish between direct and indirect investing.

  • Define open-end and closed-end investment funds.

  • State the major types of mutual funds and give their features.

  • Define exchange-traded funds (ETFs).


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Indirect Investing

  • Refers to buying and selling the shares of intermediaries that hold a portfolio of securities

    • Shares are ownership interest in the underlying portfolio

    • Shareholders are entitled to portfolio income

    • Shareholders also pay expensesefers to buying and selling the shares of intermediaries that hold a portfolio of securities

    • Shares are ownership interest in the underlying portfolio

    • Shareholders are entitled to portfolio income

    • Shareholders also pay expenses


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Investment Fund

  • Financial company or trust fund that sells shares to the public and uses the proceeds to invest in marketable securities

    • Acts as conduit for distribution of dividends, interest, and realized gains

    • Offers the benefits of diversification

    • Offers professional management

      Offers professional management


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Fund Types

  • Unit Investment Trust: an unmanaged, fixed-income security portfolio put together by a sponsor and handled by an independent trustee

    • Passive investments designed to be bought and held with capital preservation as a major objective

    • Currently represent a very small part of total investment company assetsUnit Investment Trust: an unmanaged, fixed-income security portfolio put together by a sponsor and handled by an independent trustee

    • Passive investments designed to be bought and held with capital preservation as a major objective

    • Currently represent a very small part of total investment company assets


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Fund Types

  • Closed-end investment fund: No additional shares sold after initial public offering

    • Share prices determined and traded in a secondary market

    • Price may not equal Net Asset Value of the shares

      • Net Asset Value (NAV): Total market value of the security portfolio divided by total shares


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Fund Types

  • Open-end investment fund: Shares continue to be sold to the public at NAV after initial sale that capitalizes the company

    • Shares may be sold back (“redeemed”) to the company at NAV

    • Capitalization constantly changes

    • Popularly called mutual funds


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Types of Mutual Funds

  • Money Market Funds

    • Objectives of income and liquidity

    • Short-term money market instruments

    • Low risk and high liquidity

  • (a) Mortgage Funds

    • Investment terms may be  5 years

    • Riskier than money market (more interest rate risk), but less risky than bond funds (shorter maturities)

      (b) Bond Funds

    • Objectives of income and safety

    • Subject to capital gains/losses due to interest rate risk


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Types of Mutual Funds

  • (a) Balanced Funds

    • Objectives of safety, income and capital appreciation

    • Min./max. rules apply for percentage invested in each asset class.

      (b) Asset Allocation Funds

    • Similar objectives as balanced funds, but typically not restricted by asset class percentage rules

  • Equity/Common Stock Funds

    • Objective of capital gains

    • Bulk of assets are in equity, but other assets held for liquidity, income and diversification purposes

    • May vary greatly in degree of risk and growth objectives


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Types of Mutual Funds

  • Growth Funds

    • Tend to invest in small-cap stocks, i.e. small companies with growth potential

    • Riskier than equity funds (small firms pay no dividends)

  • Specialty Funds

    • Objective of superior capital gains (through minimal diversification)

    • Tend to focus on one industry, market, or segment

    • International/Global Funds, for example, invest in foreign securities (and carry the risk of foreign exchange exposure)


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Types of Mutual Funds

  • (a) Real Estate Funds

    • Invest in income-generating properties for long-term growth and capital gains

    • Portfolio valuation is based on infrequent external appraisal

    • Less liquid than other funds – investors may need to give advance notice when selling

      (b) Ethical Funds

    • Relatively new type of fund

    • Investments are guided by moral criteria (e.g., not investing in tobacco-related firms)


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Types of Mutual Funds

  • Index Funds

    • Objective is to mirror the performance of a market index (e.g., S&P/TSX 60)

    • Generally lower management fees than other funds.

  • Dividend Funds

    • Objective of tax reduction through favourable treatment of dividend

    • Inappropriate for RRSPs or RRIFs

    • Price changes are driven by interest rates and market trends


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Types of Mutual Funds

  • ranked from lowest risk/return to highest risk/return as follows:

  • Money market

  • Mortgage

  • Bond

  • Balanced

  • Dividend

  • Equity

  • Real estate

  • Specialty

    http://finance.yahoo.com/funds


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Mutual Fund Categories

  • Money market mutual funds invest in a portfolio of money market securities

    • Treasury bills

    • Commercial paper

    • Short-term government bonds

    • Low risk

    • Not insured by the federal government


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Mutual Fund Categories

  • Equity, bond, and income funds invest in portfolios of securities consistent with the objectives of the particular fund

    • Objectives set by the fund’s board

    • Disclosure of objectives to investors through a prospectus


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Equity Funds

  • Most mutual fund assets are in equity funds rather than bond or income funds

  • Most equity funds are either:

    • Value funds, which invest in undervalued stocks as determined by fundamental financial analysis

    • Growth funds, which invest in stocks of firms expected to show future rapid earnings growth


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Equity Funds

  • Closed-End Funds

    • NAV > market price, selling at a discount

    • NAV < market price, selling at a premium

    • If the value of the portfolio remains unchanged, an investor can gain or lose if the discount narrows or widens over time

    • Trade at premiums and discounts across time, and variance is great


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Exchange-Traded Funds (ETFs)

  • Units of these trusts hold shares of firms in market indices in proportion to their weights in the index

  • Differences from traditional mutual funds: http://finance.yahoo.com/etf

    • Traded throughout the day on exchanges

    • Lower management fees (e.g., 0.08% to 0.25% versus 2.5% average for active equity funds versus 0.75% average for Index funds)

    • Lower portfolio turnover – reduces capital gains income and taxes payable

    • Permit short-selling

    • May be purchased on margin


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Canadian-Based ETFs

  • I-60s

    • Represent units in the S&P/TSX 60 Index

    • Trade on the TSX (ticker: XIU).; units are valued at 1/10th the value of the S&P/TSX 60 Index; for example, if index is valued at 450, each unit is valued at $45

    • Dividends are paid every quarter; MER is 0.17%

  • DJ40s

    • Represent units in the Dow Jones Canada Index Participation Fund, which hold stocks that mimic those of the Dow 40 Index; MER is 0.08%


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Canadian-Based ETFs

  • TD S&P/TSX Index Fund

    • The S&P/TSX Composite Index is the underlying index; MER is 0.25%

    • There are now a growing number of small-cap, mid-cap, industry-based, style-based, and bond ETFs available

  • There are now a growing number of small-cap, mid-cap, industry-based, style-based, and bond ETFs available


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Differences between ETFs and Mutual Funds

  • ETFs

    • Trade all day on exchanges, can be bought on margin, and can be shorted

    • Currently passive in nature

    • Can be traded at discount or premiums.

    • Offer an important advantage over funds with regard to flexibility on taxes

  • Mutual Funds

    • Bought and sold at the end of the trading day when the NAV is calculated

    • Most are actively managed

    • Trade at NAV

    • Mutual fund mangers may have to sell shares to pay those who want to leave the fund, thereby generating capital gains


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Other Funds

  • Segregated funds

    • Provide death benefits

    • Must guarantee a minimum percentage (75% is required, 100% is usually offered) of investor’s payments will be returned at fund maturity (or at death of owner)

    • Structured to prevent fund assets from being seized by creditors if investor declares bankruptcy

    • Upon owner’s death, assets may be transferred to beneficiaries without being subject to probate fees


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Other Funds

  • Labour Sponsored Venture Capital Corporations (LSVCCs)

    • No 10% maximum ownership restriction

    • Restrictions on transferability and redemption

    • Valuation may not be based exclusively on market prices

    • Tax advantages – federal & provincial tax credits offered


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Performance

  • Reported on a regular basis (usually daily) in the popular press

  • Measured over a given time period as a percentage of initial investment

    • Total returns include reinvested dividends and capital gains

    • Average annual return reflects the mean compound growth rate of investment over a given time period


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Performance

  • Investors relate the performance to some benchmark to judge relative performance

  • An important issue is expenses: funds with low MERs provide better returns in the long run

  • Mutual fund ratings: best known rating system is provided by Morningstar


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International Funds

  • Some mutual funds specialize in international securities

    • Canadian investors can participate in emerging market economies

    • International diversification

    • International funds or global funds emphasize international stocks

    • Single-country funds concentrate assets

      • Actively or passively managed


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New Directions in Funds

  • Mutual fund “supermarkets”

    • Various mutual fund families can be purchased through a single source

    • Brokerage account may provide access

    • “Supermarket” managers earn fee

  • On-line investment services

    • Internet used to provide mutual fund information and to make transactions


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