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Chapter 5 - Mutual Funds, Hedge Funds and Pension Funds


Chapter 5 - Mutual Funds, Hedge Funds and Pension Funds What are they and how do they work? Business 4039 Standard Costs - Loads There are no-load funds but ... – PowerPoint PPT presentation

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Title: Chapter 5 - Mutual Funds, Hedge Funds and Pension Funds

Chapter 5 - Mutual Funds, Hedge Funds and Pension
  • What are they and how do they work?

Business 4039
Important Chapter Concepts
  • Mutual funds versus segregated funds
  • Compare and contrast mutual funds, pooled funds,
    segregated funds
  • Types of hedge funds
  • Types of pension Funds
  • What are pooled funds
  • How are mutual funds organized?

Important Chapter Concepts
  • Closed-end versus open end funds
  • NAVPS calculated
  • Daily marked-to-market
  • What is an income trust and how does it differ
    from a mutual fund?
  • MER
  • Trailer fees

Important Chapter Concepts
  • No-load funds
  • How are mutual funds regulated?
  • What are the advantages and disadvantages of
    investing in mutual funds?
  • Scandals and mutual funds
  • market timing
  • Late trading (backward pricing)
  • Directed brokerage fees

Important Chapter Concepts
  • What are pooled funds and how do they differ from
    mutual funds?

Important Chapter Terms
  • Fund
  • Mutual fund
  • Hedge fund
  • Pension fund
  • RRSP
  • RESP
  • Wealth management
  • Clone fund
  • Load fund
  • No-load fund
  • Bond funds
  • Equity funds
  • Balanced funds
  • RRSP-eligible
  • Marked-to-market
  • Open-end mutual fund
  • Closed-end mutual fund
  • REIT
  • MER

What is a Mutual Fund?
  • Is a separate, legally incorporated,
    equity-financed investment vehicle managed by an
    asset manager for the benefit of the equity
  • Unit holders the equity investors can
    receive, on demand, their proportionate share of
    the value of the funds assets. (except in
    closed-end funds)

Important Terms
  • Mutual fund
  • MER (management expense ratio)
  • NAVPS (net asset value per share)
  • Open-end fund
  • Closed-end Fund
  • Clone funds
  • Marking to Market
  • Load fund
  • Soft dollars

Important Terms Defined
  • Clone Funds mutual funds that mimic the cash
    flows of a portfolio of foreign stocks using
    foreign equity index futures and domestic bonds.
  • NOTE since the removal of the foreign content
    limits on RRSPs and RPPs, clone funds are now
    being wound done here in Canada

Important Terms Defined
  • Marking to Market adjusting asset and balance
    sheet values to reflect current market prices.
  • Note most mutual fund NAVPS are marked to
    market at the close of each business day. This
    allows the open-ended funds to sell additional
    units without diluting existing unit holders

Important Terms Defined
  • Load Fund a mutual fund with a sales commission
    that has to be paid by the investor upon either
    the purchase or the sale of the fund units.

Important Terms Defined
  • Soft dollars a service seller uses gains from
    an overpriced service to give the service buyers
    investment dealer a free or underpriced service.
  • Here, for example, the investment fund manager
    (who is also an investment dealer) uses mutual
    fund revenue to purchase advisory, data, or other
    services in return for the sellers commitment of
    the services to divert a certain volume of
    brokerage transactions to the investment fund

Where can Mutual Funds Be Purchased?
  • Mutual funds are sold by most financial
  • Credit unions (ethical funds)
  • Banks
  • Insurance Companies
  • Investment Companies
  • Brokerage Houses
  • Trust Companies
  • Independent Mutual Fund Dealers
  • You can usually set up a regular savings plan
    through your own financial institutionsaving as
    little as 25.00 per month.
  • You can invest in mutual funds outside or inside
    your RRSP.

Who Can Sell Mutual Funds?
  • The organization that markets (sells) mutual
    funds must be licensed in the province where it
    offers these products.
  • In addition, the person working for the licensed
    organization must also be licensed under either
  • MFDA (Mutual Fund Dealers Association)
  • IDA (Investment Dealers Association)
  • In order to qualify for licensing, the individual
    must complete an accredited course of studies,
    have completed a supervised 90 day training
    program and have satisfied the accrediting body
    of their personal integrity through a thorough
    background check. For example
  • the MFDA will expect you to have completed the
    Canadian Investment Funds Course through the
    Investment Funds Institute of Canada, or the
    Investment Funds in Canada Course through the
    Institute of Canadian Bankers or the Canadian
    Securities Course through the Canadian Securities

What is a Mutual Fund?
  • A financial organization that accepts funds from
    hundreds, if not, thousands of investors, pools
    these funds and invests them in bonds, stocks,
    real estate, precious metals or other investments.

Mutual Fund
What is a Mutual Fund?
  • It is a pooled investment
  • Pooled investments are managed portfolios that
    groups of investors invest in.
  • Other examples include pension funds, labour
    sponsored venture capital corporations,
    segregated funds, etc.

Mutual Fund
What is a Mutual Fund?
  • A mutual fund is a financial organization that
    accepts funds from numerous investors, pools
    these funds and invests them in bonds, stocks,
    real estate precious metals and other
    investments. It then issues shares or units to
    investors in proportion to the funds each
    investor contributes.
  • Conceptually, it is not a stock or bond, its a
    way of investing.

Mutual Fund
Legal Structures of Canadian Mutual Funds
The Mutual Fund Complex
  • A series of organizations and individuals
    responsible for the day to day administration of
    the mutual fund, its investment strategies, the
    safe keeping of unit holders contributions and
    investments held by the fund and the selling and
    redemption of fund units.

Typical Mutual Fund Complex
  • Consists of four things
  • The mutual fund itself
  • The mutual fund manager portfolio advisor
  • The custodian
  • The distributor

About The Mutual Fund
  • Can be organized in two ways
  • As a corporation
  • As a unit trust

Mutual Fund Complex
The Mutual Fund Complex
  • Behind every mutual fund is a series of
    organizations and individuals that are
    responsible for the day-to-day administration of
    the fund, its investment strategies, the
    safekeeping of unitholders contributions and
    investments held by the fund, and the selling and
    redemption of fund units.
  • Together, we refer to this series of
    organizations and individuals as a mutual fund
    complex. A typical fund complex consists of
  • the fund itself
  • the mutual fund manager and portfolio advisor
  • the custodian
  • the distributor

The Mutual Fund ComplexThe Fund Organization
  • Mutual funds may be organized as either a unit
    trust or as a corporation.
  • Some funds may operate in isolation, while others
    are part of a family of funds that includes a
    variety of mutual funds that specialize in
    different financial markets or have different
    investment objectives.
  • Corporate Form of Organization
  • an incorporated fund is subject to the Canada
    Business Corporations Act or similar provincial
  • Certain types of income (e.g. interest income)
    earned by an incorporated fund may be taxable
    first as income to the fund, and then in the
    hands of investors in the fund.

The Mutual Fund ComplexThe Fund Organization
  • Unit Trusts
  • is the most common form of open-ended mutual fund
    organization today (largely because of a 1972
    change in tax laws which permitted income earned
    by unit trusts to flow through to investors
    without being taxed in the hands of the trust.)
  • organizational structure formed by a declaration
    of trust and is subject to trust laws
  • the right to vote on certain matters concerning
    the fund is guaranteed in the legislation under
    which the fund is created, through National
    Policy Statement No. 39
  • a trustee or a number of trustees act as the
    governing body.
  • Trustees may be individuals or a corporate entity
    that has the power to act as a trustee (such as a
    trust company)
  • Trustees are responsible for the supervision of
    the funds operations and adherence to its
    investment policies. They have the power to
    enter into contracts on behalf of the fund for
    any required services.

The Mutual Fund ComplexThe Fund Manager and
Portfolio Advisor
  • Regardless of organizational structure, directors
    and trustees are ultimately responsible for the
    management of a mutual funds investment
    portfolio as well as the day-to-day operations of
    the fund.
  • To assist with this latter task, the directors or
    trustees of the fund may enter into a contract
    with a management (investment) company to provide
    management services, rather than hiring staff to
    perform day-to-day administration. A firm that
    provides these services is commonly known as an
    administrative manager. Trustees and managers
    are often the same company.

The Mutual Fund ComplexThe Custodian
  • To protect investors and as a part of internal
    control mechanisms, the administrative and
    custodial functions of mutual funds are kept
  • The custodian is responsible for the safekeeping
    of all the funds investments.
  • National Policy Statement No. 39 requires that a
    mutual funds cash and securities be deposited
    with, and held by, a custodian.
  • The custodian must be a Canadian chartered bank,
    a Canadian trust company having shareholders
    equity of not less than 10 million, or in some
    cases a subsidiary of a Canadian Chartered bank
    or trust company that meets prescribed financial
  • The custodian also holds all income earned by the
    fund until it is reinvested or distributed by the
    fund. The custodian makes all payments for the
    funds investments.

The Mutual Fund ComplexThe Distributor
  • The distributor is the sales and marketing arm of
    the mutual fund organization.
  • It is responsible for bringing in assets to the
    fund in the form of new fund units.
  • Securities laws require each mutual fund to
    designate a principal distributor to assume the
    distribution responsibilities, usually under
    contract with the funds administrative manager.
  • In many cases, the administrative manager will
    assume the role of principal distributor, and
    will distribute or arrange for distribution by
    carrying out its distribution responsibilities
    through its employees or by subcontract with one
    or more of the following distribution channels

The Mutual Fund ComplexThe Distributor
  • the following distribution channels
  • Proprietary (in-house) selling organizations that
    market only the funds offered by one mutual fund
    group. (eg. Investors Group)
  • Mutual fund specialists employed by a mutual fund
    dealer who is not aligned or affiliated with any
    particular fund.
  • Stockbrokers employed by investment dealers.
  • Employees of financial institutions such as
    banks, trust companies, credit unions, and
    caisses populaires or their securities
  • Employees of mutual fund groups that deal
    directly with the public and exclusively market
    their proprietary funds.

The Mutual Fund ComplexThe Registrar and
Transfer Agent
  • This entity carries out two duties
  • Registrar the role of the Registrar is to
    safeguard against excess distribution of units or
    shares which would dilute the value of the fund.
    This is particularly important when share or unit
    certificates are reissued. Since issuance of
    share or unit certificates is now the exception
    rather than the rule, the role of the registrar
    is decreasing in importance.
  • Transfer Agent maintains the register of owners
    of units or shares of the fund and records all
    transfers of ownership of units. This register
    is constantly changing as investors buy and
    redeem units. The transfer agent may also
    provide dividend distribution services.
  • These functions are usually provided by a trust
    company or other third-party service provider.
    In many cases, the same trust company that acts
    as the funds custodian will perform these duties.

Management Fees
  • The costs of managing the fund are borne by the
    fund itself.
  • These include
  • Bank charges
  • Commissions
  • Investment analysis costs
  • Salary and bonuses for the portfolio manager
  • Investors need to be advised of the management
  • Easiest way to compare management expenses is by
    using the management expense ratio (MER)

  • The Management Expense Ratio is reported in
    annual percentage terms.
  • For example
  • 2.5 or 250 bps (basis points)
  • If the fund earned a gross return of 10 and it
    incurred an MER of 2.5, then the net return to
    the unitholder is 7.5
  • If the fund earned a gross return of 0 and it
    incurred an MER of 2.5, then the net return to
    the unitholder is -2.5

Standard Costs - MERs
  • Range from .2 to gt 3, depending upon the
    type of fund.
  • The lowest MERs are for money market mutual funds
  • The highest MERs are typically for balanced
    mutual funds
  • Consists of management salaries and
    administrative expenses
  • May contain a 12B-1 fee to cover the funds
    advertising expense
  • High MERs dont necessarily translate to above
    average returns

Standard Costs - Loads
  • There are no-load fundsbut remember, there will
    still be MER expenses borne by such a fund and
    potentially, back-end feesbe sure to check the
    fine print!
  • Front-end load
  • Back-end load (often decreasing)
  • These loads or fees equate to a sales
    commission paid to the financial intermediary
  • They reduce/inhibit the investments liquidity

  • Net asset value per share is the price of the
    mutual fund.
  • It is calculated at the end of each business day
    on a unit basis and then reported in the press.
  • It is like the share price that you see
    reported for a common stock.

Advantages of Mutual Funds Over Direct Investment
  • Professional Management
  • Broad Diversification
  • More Reliable Estimates of Risk and Return
  • Past Performance Record
  • Record Keeping and Safekeeping
  • Flexibility of Purchase and Sale
  • Automatic Reinvestment Plan

Disadvantages of Mutual Funds Over Direct
  • Management Fees
  • High Cost for Short-term Investment
  • Vulnerable to Massive Redemption
  • Professional Management is Not Infallible
  • Tax Implications

Mutual Fund Types
  • Open-ended vs. Closed-ended
  • Vary by Asset Classes, Investment Strategy, etc.
  • Examples include Sector, Index, Regional,
    Growth, Balanced, Socially-Responsible

Recent Trends
  • The mutual funds industry enjoyed explosive
    growth as falling interest rates made bank
    deposits less attractive than the returns
    available from mutual funds.
  • As the baby boom generation entered its
    high-savings years, demand for long-term
    investment vehicles increased.
  • In-house money market mutual funds of banks and
    trust and loan companies offered higher interest
    plus easy transfer to and from bank accounts,
    while bond funds and equity funds offered the
    promise of participating in capital gains.
  • Mutual fund aggregate assets (at cost) grew more
    than 11 fold over the 1990s.

Total Net Assets by Mutual Fund Type
Source Investment Funds Institute of Canada,
December 1999.
Top 10 Mutual Fund Companies in Canada by Assets
under Management
Source Dominion Bond Research Service, The
Canadian Mutual Fund Industry, February 2000..
  • Mutual funds are sold under a variety of laws and
    regulatory agencies.
  • As securities distributed by investment dealers
    and financial advisors, they fall under
    provincial securities laws.
  • As bank, trust company, credit union, and
    insurance services, they fall under the Bank Act,
    Trust and Loan Companies Act, Insurance Companies
    Act, and/or various provincial statutes and are
    the responsibility of OSFI and the appropriate
    provincial FI regulators.

  • The Investment Funds Institute of Canada is the
    national industrial association for both
    manufacturers and distributors of mutual funds.
  • IFIC is NOT a SRO it is a trade association
  • IFIC has no regulatory role.
  • Its primary purposes are to disburse information
    concerning the industry and to reflect the
    industrys concerns to government and the public
    at large. (Advocacy)

Mutual Fund Dealers Association
  • Established in 2000
  • MFDA is the SRO for the distribution end of the
    mutual fund industry.
  • Mutual funds manufacture is essentially the
    creation of publicly traded securities. This
    activity is already fully covered under
    securities regulation so no additional SRO is
    required for it.

Standards of Practice
  • Standards of practice for mutual fund
    distributors are spelled out by both IFIC and by
    the Canadian Securities Administrators.
  • CSA has adopted standardized disclosure in a
    format understandable to the average Canadiana
    simplified prospectus and annual information
    form. (see SEDAR)
  • The simplified prospectus sets out in plain
    language the purpose and management of the fund.
  • The annual information form gives such important
    information as appropriate benchmarks of fund
    performance (ie. the management expense ratio)

Regulatory Violations
  • The explosive growth of the mutual funds industry
    in the mixed regulatory environment has created
    opportunities for abuse
  • Violation of best execution obligation. Here in
    the investment fund manager channels brokerage
    services through an affiliated investment dealer
    that charges higher commissions than competitors.
  • Soft dollar arrangements. Here the investment
    fund manager uses mutual fund revenue to purchase
    advisory, data or other services in return for
    the sellers commitment of the services to divert
    a certain volume of brokerage transactions to the
    investment fund manager.
  • In both cases, the investment funds manager is
    breaking her fiduciary obligation to act
    exclusively in the unit holders best interest.

Market Timing and Mutual Funds
  • Involves short-term trading of mutual funds that
    seeks to take advantage of short-term
    discrepancies between the price of a mutual
    funds shares and out-of-date values on the
    securities in the funds portfolio.
  • See page 132 of your text and Table 5-11 that
    addresses mutual fund investigations in the early
    2000s in the U.S.
  • A number of mutual funds came under investigation
    in Canada and were found guilty of
    permitting/aiding market timing practicesthis
    included Investors Group, C.I. Funds

The Investment Advisor
  • The investor is confronted with a myriad of
    choices among stocks, bonds and derivatives.
  • Mutual fund companies continually add to the
    number of bewildering choices available to the
    retail investor.
  • To meet the personal financial planning needs of
    savers, financial institutions now employ
    financial advisor (financial consultants) etc.
  • Abuses are common, so responsible financial
    planners have tried to raise their professional
    standards and public awareness of their service.
  • Professional organizations (for example,
    Financial Planners Standards Council of Canada)
    have created professional designations such as
    CFP (Certified Financial Planner)in order to
    improve education and training.
  • The CSA has decided that the title planner in
    the context of financial planner or mutual
    funds planner and insurance planner become a
    restricted title that will require accreditation
    before a salesperson can use it.

Fund Links
  • Talvest Mutual Funds
  • CI Funds
  • Investors Group
  • Franklin Templeton Investments
  • Morningstar an organization dedicated to
    following and reporting on mutual fund
  • Please note these are just samples of
    organizations there are thousand of others like
    these organizations.

Segregated Funds
  • Segregated funds are often viewed as mutual
    fundshowever, they do have special features that
    distinguish them from a common mutual fund.
  • Nevertheless they are pooled investments offered
    by Insurance companies.

Segregated Funds
  • Segregated Funds are an insurance product,
    combining a mutual fund-like investment with the
    protection of an insurance policy. As with mutual
    funds, an investor's money is pooled with the
    contributions of other investors to purchase a
    portfolio of securities. The value of the units
    purchased is based on the value of the underlying
    securities and will change in response to market
  • Segregated funds are the investment portion of
    variable life insurance policies as such they
    usually guarantee return of principle if held for
    a given period of time and are also

Hedge Funds
  • Take note of the differences between hedge funds
    and mutual funds
  • That hedge funds are often organized as limited
    partnershipsand are structured such that they
    lay outside of normal regulatory boundaries (499
    limited partners, must have annual incomes of
    over 200,000 and net worth exceeding 1,000,000
    and must invest a sizeable amount of money)
    this classifies them as sophisticated investors
    who dont require regulatory over site.
  • Over 7,000 hedge funds involve over 860 billion
    at year-end 2003.
  • Of course, the LTCM debacle has affected the
    industry in many different ways.
  • Hedge funds have become important to Canadian
    investors during times of poor stock market
    performance and when interest rates and inflation
    remain low.

Pension Funds
  • Pension assets are the next largest source of FI
    assets after the big 6 banks.
  • Significant players in the markets.
  • Only the largest manage their assets in-house
    most employ managers
  • Prudential regulation may be provincial or
    federal (OSFI)