W. Sean Cleary Charles P. Jones

INVESTMENTS:

Analysis and Management

Second Canadian Edition

Chapter 3

Investments 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).

Learning Objectives

• Explain the transactions behind indirect investments.

• Understand how the performance of investment funds is measured.

• Discuss the opportunities for investing indirectly internationally.

Indirect Investing

• Alternative to direct investment in or ownership of securities • 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 expenses

Total Net Assets 1993 to 2003

150 100 50 0 450 400 350 300 250 200

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

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

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 assets

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

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

Types of Mutual Funds

1.

2.

   Money Market Funds Objectives of income and liquidity Investments include short-term money market instruments Attractive to investors seeking 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

Types of Mutual Funds (cont’d)

3.

4.

  (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

Types of Mutual Funds (cont’d)

5.

6.

  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)

Types of Mutual Funds (cont’d)

7.

   (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)

Types of Mutual Funds (cont’d)

8.

9.

  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

Types of Mutual Funds (cont’d)

• Each type of fund has different risk-return characteristics. In general, they can be ranked from lowest risk/return to highest risk/return as follows: 1. Money market 2. Mortgage 3. Bond 4. Balanced 5. Dividend 6. Equity 7. Real estate 8. Specialty

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

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

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

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

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:    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

Canadian-Based ETFs

• •    I-60s Represent units in the S&P/TSX 60 Index Trade on the TSX (ticker: XIU).; units are valued at 1/10 th 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%

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

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

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

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

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

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

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

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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