Transcript ch03.ppt
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).
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 expenses
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. Money Market Funds
Objectives of income and liquidity
Short-term money market instruments
Low risk and high liquidity
2. (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
3. (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
4. 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
Types of Mutual Funds
5. 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)
6. 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
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
8. 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.
9. 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
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
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 1/10th 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
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 smallcap, mid-cap, industry-based, style-based,
and bond ETFs available
There are now a growing number of smallcap, 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
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