ch03.ppt

Chapter 3

Investment Funds

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).

Learning objectives

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

Indirect Investing

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

Investment Fund

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

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

Fund Types

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 rules4. 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

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

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

1.Money market2.Mortgage3.Bond4.Balanced5.Dividend6.Equity7.Real estate8.Specialtyhttp://finance.yahoo.com/funds

Types of Mutual Funds

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

Mutual Fund Categories

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

Equity Funds

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

Exchange-Traded Funds (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%

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

Canadian-Based ETFs

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

Differences between ETFs and Mutual 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

Other Funds

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

Performance

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

International 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

New Directions in Funds