Unit 2: Mutual Fund Basics

Canadian Investment Funds Course

www.ifse.ca © 2007

2-1

Unit 2: Mutual Fund Basics Welcome to Mutual Fund Basics. In this unit, you will learn about the basics of mutual funds so you can then match investments to meet your client's needs. This unit takes approximately 1 hour and 45 minutes to complete. You will learn about the following topics:

• Mutual Fund History • Benefits of Mutual Funds • Roles and Functions • Purchases and Redemptions • Mutual Fund Fee Structure

To start with the first lesson, click Mutual Fund History on the table of contents.

Lesson 1: Mutual Fund History

www.ifse.ca © 2007

2-2

Lesson 1: Mutual Fund History Welcome to the Mutual Fund History lesson. In this lesson, you will learn about the origins and history of mutual funds, as well as understand the differences between closed-end funds and open-end funds. This information may be helpful when dealing with clients who are new to mutual funds. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following:

• describe the origins and history of the mutual fund industry • differentiate between open-end and closed-end mutual funds • describe recent developments in the mutual fund industry


www.ifse.ca © 2007

2-3

Origins

Mutual funds date back to the second half of the 19th century. Many details of mutual funds have changed but the basic premise remains the same: investors pool their money to invest in a portfolio of securities run by a professional manager. A description of an early British fund, The Foreign and Colonial Trust, notes that it provides, "the investor of moderate means with the same advantages as the large capitalist, in diminishing the risk of investing … by spreading the investment over a number of different stocks." Early mutual funds were known as closed-end funds, while the mutual funds that we sell today are primarily open-end funds.

Closed-end Funds The earliest mutual funds were closed-end funds. These funds issue a set number of shares when the company is organized. That number remains set until more shares are authorized and issued. Since there is a set number of shares, interested investors can purchase the fund from current shareholders only, usually on a stock exchange. This process does not normally involve the issuing company. The price of the shares may or may not reflect the net asset value per share (NAVPS). The NAVPS is based on the value of the investments held by the fund, while the price is subject to market conditions. For example, a closed-end fund issues 1,000,000 shares to Investor A for $10 per share. Investor A gives the fund $10,000,000. The fund then invests this money and does not have any dealings with Investor A or other investors until the next share offering. If Investor A wants to sell these shares, he or she must find a buyer through the stock exchange. The new buyer may offer a price that differs from the NAVPS of the shares in the closed-end fund. Let's assume the NAVPS is $10 per share. Investor B believes the outlook for the economy is poor and is willing to pay only $9 per share. If Investor A agrees, he or she can sell the shares at a discount since the price is below the NAVPS. Investor C believes the economic outlook is positive and is willing to pay $11 per share. In this case, Investor A receives a premium since the price he or she gets is above the NAVPS. Open-end Funds The majority of mutual funds sold today are open-end funds. Instead of buying open-end funds on a stock exchange, investors deal directly with the fund company.

Lesson 1: Mutual Fund History

www.ifse.ca © 2007

2-4

If an investor wants to purchase mutual fund units the mutual fund company creates new units for the investor. If an investor wants to redeem units, the mutual fund company takes the units back and retires them. Because investors are buying and selling constantly, the number of units outstanding changes from day to day. This is different from closed-end funds, which have a fixed number of outstanding units or shares. The purchase or sale price of a unit of an open-end fund reflects the NAVPS of the underlying investments. For example, if Investor A wants to buy $10,000 of an open-end fund, he or she would purchase directly from the fund company. If the price per unit is $10, then the fund company issues 1,000 new units to Investor A. Investor B wants to purchase $50,000 of the same fund. He or she follows the same procedure as Investor A and the fund company issues 5,000 new units. If the price rises to $11 and Investor A wants to redeem 200 units, then he or she would sell the units back to the fund company for this price. If the price falls to $9 and Investor B wants to redeem all 5,000 units, then he or she would sell them back to the fund company for this price. In both situations, the fund company retires the shares. Unlike closed-end funds, the unit price and NAVPS are always the same for open-end funds. Exercise: Comparing Closed-end and Open-end Funds

Recent Developments There has been enormous growth in the Canadian mutual fund industry in the past 25 years. By May 2007, there were over 1,900 mutual funds in Canada, with assets (holdings) under administration of over $710 billion. Competition in the mutual fund market is healthy, with the focus on quality investment management and customer service. Factors behind this growth in funds include the following:

• declining interest rates on deposit-type investments • high returns on many mutual funds • affordable professional management • increased savings by the baby boom generation • growing awareness of mutual funds as an investment

alternative • concern over retirement income • increased demand for convenience, time-saving, and

variety


www.ifse.ca © 2007

2-5

Lesson 2: Benefits of Mutual Funds Welcome to the Benefits of Mutual Funds lesson. In this lesson, you will learn about the factors that make mutual funds attractive investments, so you can better inform your clients. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following:

• define the factors that make mutual funds attractive

Lesson 2: Benefits of Mutual Funds

www.ifse.ca © 2007

2-6

What Makes Mutual Funds Attractive to Investors?

Professional Management Mutual fund investors benefit from the services of trained investment professionals. Fund managers must meet high standards of education and experience before they can be registered by provincial regulators as portfolio managers. Portfolio managers have greater access to research and more sophisticated analytical tools than the average investor. They, with the help of their team, research, analyze, and select only those securities that they believe best match the investment objectives of the fund. Selection is made after a rigorous analysis of the markets, industries, and securities in which they choose to invest. Even the most sophisticated investors may not have the time required to research and monitor every security in their investment portfolios. Mutual funds allow investors to benefit from the expertise of a professional portfolio manager in a cost-effective way.

Diversification Diversification is when you spread your investment among many different securities to reduce the overall risk of your portfolio. Most individual investors do not have enough savings to diversify beyond a small number of investments. However, the combination of your savings with those of other investors in a mutual fund creates a large pool of wealth that allows the portfolio manager to purchase several shares or units in different companies. He or she would have no problem investing in 100 or more different securities within one fund. By investing in a mutual fund, your return is no longer dependent on the fortunes of one or two investments. Instead, with the same amount of cash, you have diversified across every security held within the fund. Even if you could afford to invest directly in every security held within a mutual fund, and rebalance the portfolio when necessary, you would pay a fortune in commissions. Mutual funds provide a way to make the same investments at a fraction of what it would cost to do so yourself.

Jim has $500 to invest and decides to purchase shares in one company, A Ltd. Since Jim has all his money in A Ltd., his total investment value will coincide with any fluctuations in the price of the stock. If the stock drops 50% in value, his investment will drop by the same amount and will only be worth $250.


www.ifse.ca © 2007

2-7

However, if Jim decides to invest his $500 in a mutual fund where A Ltd., is only 10% of the portfolio, then a 50% drop in the company's stock will only decrease Jim's total investment value by $25. All things being equal, his total investment value would then be worth $475. How Diversification Works

Flexibility Suitability for a wide range of investors The many categories of mutual funds allow investors with different investment objectives to find an investment vehicle to suit their goals: income, capital appreciation, safety of capital, or a combination. Mutual funds also offer options for investors with any risk profile, from extremely conservative to highly speculative. The nature of mutual fund investing allows investors with even small amounts of capital to participate in the market. Most fund companies accept initial investments of $500 to $1,000 and allow regular purchases of $25 or less. Transferability In many cases, investors can also conveniently switch among funds offered by a fund company. This allows investors to change their investment to suit a change in market conditions or their financial objectives. Holdings can usually be switched from one fund to another — for example, from a bond fund to an equity fund — on the same day. Income choice Depending on the nature of the mutual fund, investors can choose the type of income to be received. Some mutual funds may generate returns in the form of interest income, dividend income, or capital gains. For example, an investor, who wants to receive a monthly income but is concerned about tax implications, may choose to invest in a dividend fund, which will provide the income needed with preferential tax treatment.

Lesson 2: Benefits of Mutual Funds

www.ifse.ca © 2007

2-8

Liquidity Liquidity refers to the ability to buy or sell an investment quickly, often because there are lots of available buyers and sellers at a given price. With a few exceptions, such as real estate funds and labour sponsored investment funds, mutual funds can be conveniently and quickly purchased and redeemed (bought and sold). Investors can purchase funds from many sources, including the following:

• financial institutions (banks, trust companies, and credit unions) • brokerage firms • mutual fund dealers • mutual fund companies (if registered as dealers) • independent financial planners and consultants

To redeem units, investors submit a redemption request directly to the fund management company or their distributor (who forwards the request to the fund management company). The investor usually receives the funds from the sale within three business days. Investor Protection While not protected by the Canada Deposit Insurance Corporation (CDIC) the way bank deposits are, mutual fund assets are protected in several ways: Securities Law By law, unitholders own mutual fund assets. Therefore, the fund management company cannot co-mingle (mix) fund assets with any other assets that they own or administer. The fund management company also cannot use mutual fund assets for its own business purposes. To ensure this, the fund assets are held by a third party or custodian (either a chartered bank or trust company). The fund assets are protected by rigorous Canadian banking and trust company legislation. The fund assets are also kept in trust; that is, they are separate from the assets of the custodian, and must be managed for the benefit of the unitholders. Independent auditor Each mutual fund has an independent auditor who reports to the fund's directors or trustee(s). The auditor regularly reviews the operations of the fund and its manager, for items such as the following:

• unit pricing • compliance with generally accepted accounting principles • purchase and redemption practices


www.ifse.ca © 2007

2-9

Canadian Investor Protection Fund The Canadian Investor Protection Fund (CIPF) provides additional investor protection. The fund is sponsored by three entities: the Investment Dealers Association (IDA), the Montreal Exchange (ME) and the Toronto Stock Exchange (TSX) Group of companies.

The purpose of the CIPF is to protect investors from losses due to bankruptcy of IDA member firms. Eligible customers are covered to a maximum of $1 million for any combination of securities and cash balances in their general accounts. Only security dealers who are members of a stock exchange and/or the IDA can be members of the CIPF. MFDA Investor Protection Corporation (IPC) The Mutual Fund Dealers Association of Canada (MFDA) also has an investor protection fund that has been approved by the securities commissions of some provinces. The fund is meant to cover losses suffered by customers of insolvent MFDA members. Coverage is at the discretion of the Board of Directors of the MFDA IPC up to a maximum of $1 million. The MFDA IPC is funded by contributions from MFDA members. Other contingency funds Several provinces have also established contingency funds to protect mutual fund investors from non-market-related losses arising from dealer activities. However, the protection they offer is much smaller than that of the CIPF. To date, because the other protection measures are working, these funds have not been called upon to make any payments to investors. Administrative Services and Support Many mutual fund companies or dealers offer administrative services, such as the following:

• tax reporting • pre-authorized chequing plans • simplified statements • reinvestment of distributions

Exercise: Advantages of Mutual Funds

Lesson 3: Roles and Functions

www.ifse.ca © 2007

2-10

Lesson 3: Roles and Functions Welcome to the Roles and Functions lesson. In this lesson, you will learn about the participants in the mutual fund industry: from the custodians who safeguard funds' investment holdings, to the sales forces that distribute fund units to investors. This lesson enables you to have a good understanding of the behind-the-scenes structure. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following:

• explain how mutual funds are organized • describe the roles of the individuals involved in the day-to-day operations of

mutual funds


www.ifse.ca © 2007

2-11

Organizational Structure of Mutual Funds Behind every mutual fund is a series of organizations and individuals that are responsible for the day-to-day operations of the fund. Their duties range from investment strategy and selection, to the safekeeping of investor assets, to the sale and redemption of fund units.

This group of organizations and individuals is known as the mutual fund complex. A typical mutual fund complex consists of the following:

The Fund Itself The mutual fund is a separate entity from the company that manages the fund. Mutual funds may be structured either as a corporation or as a trust.

Mutual fund corporation A mutual fund corporation is subject to its Articles of Incorporation and governed by the Canada Business Corporations Act or similar provincial legislation. A mutual fund corporation has the following characteristics:

• Investors are referred to as shareholders. • A Board of Directors governs the fund. • The Board of Directors is elected by the shareholders at the fund's annual general

meeting.


www.ifse.ca © 2007

2-12

The Board of Directors is responsible for running the mutual fund corporation and has the authority to hire a management team or any others from whom services are required. Shareholders must be consulted before any major changes can be made to the structure of the fund. Originally, all mutual funds were organized as corporations. Certain income earned by mutual fund corporations is taxable first as income to the fund, and then again to the investors when paid to them. However, the taxes paid by the fund are recovered through a refund mechanism when the fund distributes its net income. Mutual fund trust Currently, the majority of mutual funds are structured as trusts. A mutual fund trust has the following characteristics:

• Investors are known as unitholders rather than shareholders.

• Trusts or trustees govern the fund. There is no board of directors.

• The trustee may be an individual or a corporate entity that has the authority to act in that role, such as a trust company.

• Investors or unitholders typically do not have the authority to appoint the trustee(s).

Directors and trustees are responsible for supervising the fund's operations and ensuring that it adheres to its investment policies. They have the power to enter into contracts for services on behalf of the fund. One of those services is the selection of a fund management company to direct the fund's day-to-day affairs. Unitholders do not have the authority to appoint the trustees, but they must be consulted before any major changes are made to the fund, including its investment objectives or fee structure. Mutual fund trusts are "flow through entities", meaning that income earned by the trust is passed along to the investor and taxed as if the taxpayer invested in the securities directly instead of through a mutual fund. This is beneficial because most taxpayers are taxed at a lower marginal rate than trusts, which are taxed at the highest rate. Earnings are distributed in the same form as they are received: as interest, dividends, or capital gains. A mutual fund trust is organized under trust law and is subject to a Declaration of Trust rather than Articles of Incorporation. Trusts tend to be more tax efficient than corporations when flowing income through to investors. Fund Management Company Depending on how a fund is structured, either the board of directors (in a corporation) or the trustees (in a trust) are responsible for the management of the fund's investments, as well as the day-to-day operations of the fund. Some funds hire a separate fund management company rather than hiring staff in-house. The management company may be a wholly-owned subsidiary of a parent corporation. Banks often do this. For example, the Bank of Montreal offers its mutual funds through BMO Investments Inc.


www.ifse.ca © 2007

2-13

The name of the fund management company for a fund is disclosed in a document called the prospectus. The prospectus will be discussed in detail later in the course. Management services include some or all of the following:

• administrative services • research • portfolio management • legal services (regarding the prospectus) • audit services

Portfolio advisors and management companies are paid an annual management fee for their services. Portfolio Manager A portfolio manager is responsible for the investment decisions of a fund, including purchasing and selling securities and determining the mix of assets. In return, the portfolio manager receives management fees from the mutual fund family that he or she oversees.

Typically, the fund management company looks at the fund's investment objectives and selects a portfolio manager with related experience. Some fund management companies provide internal portfolio management based on similar criteria, while others use a combination of internal and external portfolio managers. Portfolio


www.ifse.ca © 2007

2-14

managers may also use specialists to help them make investment decisions. Portfolio managers are guided by the fund's investment objectives as stated in the prospectus. The aim of all portfolio managers is to generate the best rate of return for the fund's investors while operating within the fund's investment objectives. The name of the portfolio manager for a fund is disclosed in the prospectus. Custodian The custodian is responsible for safekeeping the cash and securities belonging to the fund. The custodian is also responsible for holding the income earned by the fund until it is reinvested or distributed to fund investors. The custodian makes payments and receives monies or securities as directed by the fund manager.

By law, to protect investors and ensure their peace of mind, custodial functions of a mutual fund must be kept separate from those of the fund manager. This way, the management company does not have access to the securities held by the mutual fund. They are not available for any purpose other than the investment objectives of the fund. The name of the custodian for a fund is disclosed in the prospectus. Under National Instrument 81-102, a mutual fund custodian must be one of the following:

• a Canadian chartered bank • a Canadian trust company with shareholder equity of not less than $10 million • a Canadian chartered bank or Trust company affiliate with shareholder equity of

not less than $10 million, and incorporated under Federal or Provincial law Custodial agreement A custodial agreement between the fund and the custodian outlines how the custodian holds the fund assets and how the two parties interact with each other. Custodians can appoint a sub-custodian to hold assets of the fund. This is more common for funds that have assets in other countries.


www.ifse.ca © 2007

2-15

Distributor The distributor is the sales and marketing arm of the mutual fund company responsible for bringing assets to the fund through sales to investors. The distributor sells units to investors and transmits redemption requests to the management company, at net asset value.

As a mutual fund salesperson, you are part of the distribution network. The actual distribution can be structured in different ways:

• Proprietary or in-house organizations that sell only their own mutual funds. They may also offer complementary products, such as insurance and GICs. Investors Group is an example.

• Independent mutual fund specialists employed by a mutual fund dealer that is not aligned with any particular mutual fund company.

• Stockbrokers employed by investment dealers.

• Employees of financial institutions such as banks, trust companies, credit unions, or caisses populaires. These people are licensed to sell mutual funds but likely perform other duties associated with their institution.

• Employees of mutual fund companies that deal directly with the public.

This graph illustrates the market share of mutual fund assets by distribution channel.


www.ifse.ca © 2007

2-16

Transfer Agent The role of the transfer agent is usually performed by a trust company, usually the fund's custodian. The name of the transfer agent for a fund is disclosed in the prospectus.

The transfer agent maintains the register of unitholders and records all transfers of ownership. This register changes daily as fund units are purchased and redeemed. The transfer agent may also offer a dividend distribution service. The role of transfer agent is often performed by the management company or the custodian. Exercise: Who is Who?


www.ifse.ca © 2007

2-17

Lesson 4: Purchases and Redemptions Welcome to the Purchases and Redemptions lesson. In this lesson, you will learn about the methods for purchasing and redeeming mutual funds. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following:

• calculate the NAVPS • list the methods of purchasing mutual funds • list the methods of redeeming mutual funds

Lesson 4: Purchases and Redemptions

www.ifse.ca © 2007

2-18

Net Asset Value Per Share (NAVPS) The net asset value per share (NAVPS) is critical to a fund because it represents the price at which units are bought and sold on any particular day. The NAVPS is equally important for investors, because it has a direct bearing on how many units their money purchases, or how much cash they receive when they redeem their fund units. Investors may also use the NAVPS to help them calculate the value of their mutual fund investment at any given time and to monitor the performance of their securities. The fund manager has the responsibility of calculating the NAVPS, usually daily. It involves assessing the value of all the fund's assets and liabilities, as well as the number of shares or units outstanding at the close of business on each valuation day. Calculating the Net Asset Value Per Share (NAVPS) The NAVPS is calculated using the following formula:

Assets Liabilities

Market value of fund's investment portfolio

expenses incurred for the valuation period

cash dividends payable to investors

near-cash investments (those that can be quickly converted to cash)

redemption amounts owed to investors

accounts receivable (owed) from dealers

Accurate market values for securities are obtained by doing the following:

• Recording the closing price of a security on the financial market where most of its trading activity takes place.

• Setting reliable bid and ask quotations if a security is not traded, in accordance with the stated policies of the fund.

• In the case of mortgages, setting a price that reflects the current rates for equivalent mortgages.

All costs are accrued and expensed in accordance with generally accepted accounting principles. The auditor of the fund is required to confirm annually that proper valuation techniques were employed. Mutual funds, like public corporations, must be audited by an independent auditor. Methods of Purchasing Mutual Funds One of the main advantages of mutual funds is ease of investment. Fund units can be purchased easily on any business day. Mutual funds are available through banks, investment dealers, fund companies, and a variety of other sources.


www.ifse.ca © 2007

2-19

The fund prospectus must describe how units can be purchased and how the fund is valued. It must also indicate that the purchase price will be the next NAVPS calculated after receipt of the purchase order. Funds that publish the NAVPS in the press have to ensure that the current NAVPS is provided on a timely basis (Part.13.1 (4), National Instrument 81-102). There are two common methods for purchasing mutual funds: single lump-sum purchases and regular investment plans. Single lump-sum purchases A single purchase can generally consist of any lump-sum amount, subject to the minimum purchase requirements established by individual funds. Minimum initial investments range from $1,000 for most funds to $150,000 for premium funds. Lower limits often apply to purchases for RRSPs and other tax-deferral plans. Once an account has been opened, subsequent purchase requirements are generally much lower. Regular investment plans Many mutual fund sales organizations offer regular investment plans whereby an investor can make regular automatic purchases of mutual fund units. A minimum purchase is generally required ($1,000 is common) and additional contributions can often be made for as little as $25. Minimum amounts vary from fund to fund. There are two types of regular investment plans: Voluntary accumulation plans: With a voluntary accumulation plan, an investor agrees to invest a pre-determined amount on a regular basis (usually weekly, monthly, or quarterly). The amount of contributions can be changed at any time, and the investor can withdraw from the plan at any time. To encourage continuing participation, these plans try to make contributing as easy as possible through postdated cheques or pre-authorized payments from bank accounts. Acquisition charges are deducted at the time of each contribution. These plans are commonly known as pre-authorized chequing (PAC) plans. Contractual plans: Under a contractual plan, the investor commits to make regular monthly payments for a fixed period of time. For example, the investor may agree to invest $100 each month for five years. Under the terms of the contractual plan, most of the sales charges for purchases are levied in the early years of the plan. Consequently, it is in the interests of the investor to continue until the end of the plan. The Canadian Securities Administrators (under National Instrument 81-102) has provided that no new contractual plans will be permitted, but existing plans can continue. Dollar-cost Averaging Investors with pre-authorized chequing (PAC) plans can take advantage of a wealth accumulation strategy called dollar-cost averaging. With dollar-cost averaging, investors purchase the same amount of money in the same mutual fund at regular intervals, such as monthly or quarterly. When unit prices are low, more units are purchased. Consequently, when unit prices are high, fewer units are


www.ifse.ca © 2007

2-20

purchased. Over the long term, the average cost per share of the investment should be lower because of this strategy. Dollar-cost averaging encourages a disciplined investing approach. After purchasers set the amount and frequency of the plan, payments can be automatically withdrawn from their bank accounts. Dollar-cost averaging also helps investors avoid the temptation of market timing. Some investors attempt the impossible task of timing the top or the bottom of the market. With dollar-cost averaging, purchases are made on a regular basis despite market conditions. Mutual Fund Redemptions Mutual funds also provide liquidity for investors. Mutual funds can be redeemed easily and investors can receive their money quickly. Redemption requests must be in good order as stated in the prospectus. Following are some items that would constitute an acceptable redemption request:

• Was the order received before the time stipulated in the prospectus? For example, requests must be received before 4 p.m. Eastern Standard Time if the investor wants to receive that day's NAVPS.

• Was the order placed by the rightful owner of the units or shares to be redeemed? For example, a unitholder signs a redemption form and an authorized employee or agent of the fund manager guarantees the signature.

• Where registered unit or share certificates are involved, the signature of the registered holder must be guaranteed. (Signature guarantees may be required for large redemptions, regardless of whether certificates are involved.)

The fund manager must provide to investors on an annual basis the requirements to redeem fund units. This information is usually set out in the prospectus and/or annual report along with the following:

• how units can be redeemed • how often the fund is valued • the fact that the redemption price is the next NAVPS calculated after a request is

received Valuation Day and Settlement Purchases and redemptions are based on the valuation date following the receipt by the fund of a purchase or redemption request. For redemptions, the request must be in good order. Some investors expect the price they receive to be based on the daily fund unit values reported in the press. You need to make your clients aware that there may be a difference between their valuation date and the one published. The calculation of the NAVPS could be delayed because of an administrative problem or valuing securities in a different time zone. There is no common practice for reporting the NAVPS for funds holding international securities.


www.ifse.ca © 2007

2-21

Settlement is the actual clearing of the transaction, in essence the payment of the funds and the delivery of the securities. Nowadays, settlement for most securities is almost exclusively performed on an electronic basis. For purchases, you have until the settlement date to provide payment. In the case of redemptions, you will not receive your proceeds until the settlement date. Settlement for most funds is T+3 or trade date plus three business days. For money market funds, settlement is usually the next business day (or sooner, if chequing privileges are available). Exercise: Purchases and Redemptions

Systematic Withdrawal Plans (SWP) Systematic withdrawal plans are redemption programs that allow investors to receive a regular cash flow from their holdings. These plans provide investors with three advantages:

• Withdrawals can be tailored to the client, providing assets are sufficient to support the payout level.

• Investments remaining in the fund continue to generate returns.

• Depending on the type of funds held, income may be eligible for preferential income tax treatment.

A fund that offers systematic withdrawal plans must describe them in its prospectus. As well, the prospectus must specify if there is a minimum level of holdings, such as $50,000 or $100,000, before investors can take advantage of these plans. There are four basic types of systematic withdrawal plans:

• ratio withdrawal plan • fixed-dollar withdrawal plan • fixed-period withdrawal plan • life expectancy adjusted

withdrawal plan


www.ifse.ca © 2007

2-22

Ratio Withdrawal Plan In this type of plan, the investor receives a cash flow based on a percentage of his or her portfolio's value (such as 8% or 12%). The amount paid is calculated as a fixed percentage of the average daily NAVPS during the previous payment period, or the value of the account on the last day of the previous payment period. Investors can specify the frequency of withdrawals, such as monthly or quarterly. The withdrawal ratio is flexible, which is ideal for the investor who has immediate cash needs but whose income needs may change in the future. If an investor's withdrawals are less than the growth of the portfolio, the investments continue to grow and the investor can withdraw more in later years without depleting the investment. However, if an investor's withdrawals exceed the fund's return or the investor increases the withdrawal percentage, then the portfolio's growth is adversely affected and begins to deplete the capital. Fixed-dollar Withdrawal Plan With this type of plan, the investor chooses to receive a fixed amount at specified intervals, such as monthly or quarterly. Investors who have financial commitments that are relatively stable may choose this type of plan. The fund sells enough units, depending on the price to produce the payment. Since the price may vary for each payment, it is possible to experience the reverse effect of dollar-cost averaging. (In other words, as prices fall, more units are redeemed and when prices rise, fewer units are redeemed.) For example, assume an investor owns 1,000 units of a fund and sets up a fixed-dollar withdrawal plan to receive $80 per month.

On if the NAVPS is the fund will sell

January 15 $20 4.000 units

February 15 $16 5.000 units

March 15 $22 3.636 units

As you can see, the number of units sold varies depending on the fund's price at redemption. Fixed-period Withdrawal Plan The aim of this type of plan is to fully deplete the investor's fund holdings (capital and accrued income) through regular withdrawals over a set period of time. Withdrawals are adjusted periodically to compensate for dividends so that the portfolio is exhausted at the end of the specified period. These plans are appropriate for investors with a specific need, such as a student using the portfolio for education expenses.


www.ifse.ca © 2007

2-23

For example, assume a student wants to deplete his or her education fund in four years using a fixed-period withdrawal plan. The student would withdraw 1/4 of the investments in the first year, 1/3 in the second year, 1/2 in the third year and all the investments in the last year. After four years, the student would deplete the entire investment. Life Expectancy Adjusted Withdrawal Plan The purpose of this plan is to deplete the entire amount of an investor's holdings, while providing maximum periodic income over the investor's lifetime. These plans are ideal for individuals who want an income and are not concerned with providing an estate for their heirs. In this type of plan, withdrawals are continually adjusted to the life expectancy of the investor, as predicted using mortality tables. For example, someone at age 70 with a life expectancy of 15 years receives 1/15 of the plan in the first year. At age 80 (when life expectancy is 10 years), he or she receives 1/10 of the plan. Taxation of Systematic Withdrawal Plans With a systematic withdrawal plan (SWP), all distributions are taxed in the year received. Taxation also occurs each time a payment is made under the plan. In this case, there may be a capital gain or loss, which is taxable in the same year the payments are received. To calculate the capital gain or loss, the investor needs to know his or her average cost per unit (ACB). The ACB is based on purchases and any distributions. The prospectus must disclose the tax consequences from mutual fund dispositions. In most cases, the fund company provides tax reporting to the investor that includes the following:

• the average cost of units held • the number of units redeemed during the year • the total dollar value of payments made during the year

Withholding Tax Mutual fund companies are required by law to withhold tax on redemptions made from tax-sheltered registered plans (for example, RRSPs). The tax rates depend on the total dollar amount of the redemption. In compliance with the Canada Revenue Agency, fund companies apply the appropriate withholding tax rate on the basis of the full or aggregate amount (minus fees and charges). The rate is based on the total amount of the transactions per request in an account, not on the individual transactions.


www.ifse.ca © 2007

2-24

Exercise: Comparing Systematic Withdrawal Plans

Switching Between Funds Most fund companies allow you to sell units in one mutual fund to purchase units in another mutual fund among its own offerings. This transaction is called switching. A fund's prospectus outlines whether this service is available and whether a switch fee can be charged. If your client purchased a mutual fund with a deferred sales charge, there are no redemption fees charged if the client switches to another fund. In general, your client maintains the same deferred sales charge schedule as if he or she had not made the transaction. As well, if your client had purchased the mutual fund with a front-end load, there is no sales charge applicable at the time of the switch. However, there may be an early redemption charge for redemptions or switches made within a certain time period, often 90 days. If your client purchased a mutual fund with an early redemption fee and decided to switch to another fund within the early redemption period, he or she would be subject to that early redemption charge.


www.ifse.ca © 2007

2-25

Lesson 5: Mutual Fund Fee Structure Welcome to the Mutual Fund Fee Structure lesson. In this lesson, you will learn about the fees associated with the purchase of mutual funds and how to price mutual funds. This lesson prepares you to explain to your clients the fees associated with the purchase of mutual funds, their purpose, and the importance of comparison. As a salesperson, you will often be asked to explain the various fees associated with mutual funds to your clients. Differences in fees and the ways in which they are calculated can be significant and investors should be made aware of these differences. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following:

• discuss the importance of and the calculation of management fees and management expense ratios (MERs)

• understand the commission fee structures • discuss the costs associated with no-load funds • understand trailer fees • calculate front-end charges and deferred/contingent charges • understand fees for tax deferral plans

Lesson 5: Mutual Fund Fee Structure

www.ifse.ca © 2007

2-26

Three Important Costs There are three important costs that are incurred when you hold mutual funds:

• management fees and operating expenses, paid by the fund for professional portfolio management, marketing, accounting, record keeping, and legal advice

• loads or commissions, paid by investors when they buy and sell mutual funds • trailer fees, fees paid to mutual fund dealers

Mechanics of Management Fees A management fee is the sum a mutual fund pays its management company for supervising the portfolio and administering its operations. Management fees are paid by the fund, not by the investor. Investors should be concerned about management fees because they reduce the rate of return for a fund. For example, if a fund earns a 10% return over a year before management fees, and then pays out a 1.5% management fee to its management company, the return to investors will be only 8.5%. The higher the management fee, the larger the reduction and the lower the investors' return. When the net asset value per share (NAVPS) or rates of return are given for a fund, management fees have already been deducted. For instance, the unit values and rates of return printed in financial publications or advertisements have already taken management fees into account. Despite these practices, investors must be advised that returns will be affected by management fees. In fact, when choosing investments for your clients, it would be prudent to compare management fees of similar funds that share the same financial objectives. A very useful tool to help you compare fees is the Ontario Securities Commission mutual fund fee calculator. Click here to view the calculator. Management Expense Ratio (MER) To help investors compare management expenses for different funds, the Management Expense Ratio (MER) provides a standardized measure that expresses the costs of a fund as a percentage of its average net asset value during the fiscal year. To look at it another way, the MER allows you to calculate what percentage of each dollar of fund assets is being used to pay for management services.

Regulators require a fund to disclose the MERs for the last five years in its prospectus, and annual and semi-annual financial statements.


www.ifse.ca © 2007

2-27

Expenses included in the MER The MER includes the total expenses paid by a fund to a management company and other service providers including the following:

• the management fee • interest charges and taxes (GST and sales tax) • audit fees • legal fees • accounting fees • fees to maintain investor records

Brokerage fees paid on the purchase and sale of securities in the fund's investment portfolio are not included in the calculation. National Instrument 81-102 (NI 81-102) also requires disclosure of any fees or expenses absorbed or waived by the fund manager, as well as the impact of such actions on the MER. The MER calculation must also include management fee rebates to investors. How fund assets affect fees Because fees are based on assets under management, portfolio managers have a strong incentive to increase fund assets. The more successful they are, the more they earn in fees. For example, the manager of a fund with $100 million in net assets and a management fee of 1.5% earns $1.5 million in a year. If those assets are doubled to $200 million, the fund manager earns $3 million. This growth in assets can take place in two ways:

• capital appreciation of the existing assets or

• an increase in the sales of fund units A fund manager can also increase profits by controlling the costs associated with operating a fund, although these controls have less of an impact on profitability than increasing assets. When costs are lower, there are more assets available for investing against which management fees can be charged. MERs and Performance The MER is used to express what it costs to manage mutual funds. Funds that are actively managed, such as equity funds and asset allocation funds, tend to have MERs ranging from 2.5% to 4%. Money market funds and passively managed funds designed to replicate a particular market index tend to have MERs at or below 1%. When mutual fund performance data is published, the rates of return reflect the funds' returns after the MERs have been deducted. Therefore, two funds with the same returns before expenses, but with different MERs, will have different returns after the MER has been deducted. The fund with the higher MER will have lower net returns. The MER is charged whether or not the fund is performing well, even if it is going down in value. To the mutual fund investor, it is the net rate of return that determines how much his or her investment will be worth, while staying invested in a fund.


www.ifse.ca © 2007

2-28

Let's look at the impact a small difference in MERs can have on the future growth of mutual funds. Although the numbers are made up, they reflect realistic performance and realistic expenses from May 2005. The Funds' Past Performance We have data for two Canadian Equity mutual funds called Blueberry and Strawberry. The funds' rates of return over the past ten years before the deduction of their MERs (Gross Return) and after the deduction of their MERs (Net Return) are shown in the following table:

Blueberry Fund Strawberry Fund

Year Gross Return

% MER %

Net Return

%

Gross Return

% MER %

Net Return %

1 13.7 2.7 11 12.9 3.7 9.2 2 11.8 2.7 9.1 10.2 3.7 6.5 3 12.7 2.7 10 13.4 3.7 9.7 4 13.2 2.7 10.5 12.8 3.7 9.1 5 14.6 2.7 11.9 15.5 3.7 11.8 6 11.1 2.7 8.4 12.7 3.7 9 7 9.3 2.7 6.6 8.7 3.7 5 8 7.2 2.7 4.5 8.4 3.7 4.7 9 11.8 2.7 9.1 11.6 3.7 7.9 10 13.6 2.7 10.9 12.8 3.7 9.1

Average 11.9 2.7 9.2 11.9 3.7 8.2

The two funds' rates of return show some variation from year to year. However, the funds have the same ten-year average annual rate of return before expenses (11.9%). The funds' MERs Blueberry fund has a MER of 2.7% while Strawberry fund's MER is 3.7%. The difference of one percentage point means that Blueberry's ten-year net average rate of return is 9.2%, calculated as (11.9% - 2.7%), while Strawberry's ten-year net average rate of return is 8.2%, calculated as (11.9% - 3.7%). If the returns for Blueberry and Strawberry funds were made public, their ten-year average annual rate of return would be displayed as 9.2% and 8.2%, respectively. In May 2005, Canadian Equity funds as a group had a ten-year average rate of return of 9.2% (Source: Morningstar Canada). Our Blueberry fund, therefore, has the same ten-year average performance as the average Canadian Equity mutual fund, while our Strawberry fund's performance is a little below that of the average fund over the past ten years. Impact of MERs on the Growth of a Lump-sum Investment A difference of one percentage point in the rate of return may not sound like very much to the individual investor (in our example, 9.2% versus 8.2%). As shown below, however, over time such a difference may translate into a substantial amount of money. To illustrate this point, look at the growth of $10,000 invested today in each of the Blueberry and Strawberry mutual funds. Assume that their future performance will be the same as their performance over the past ten years, and that their MERs will remain unchanged at 2.7% and 3.7%, respectively.


www.ifse.ca © 2007

2-29

The following table and graph show how a $10,000 investment in our two funds will grow under these assumptions. The amount of capital is measured at the end of each year.

Blueberry Fund Strawberry Fund Year Net Return

% Capital $

Net Return % Capital $

Difference in Capital $

1 9.2 10,920 8.2 10,820 100 7 9.2 18,516 8.2 17,362 1,154 10 9.2 24,112 8.2 21,992 2,120 20 9.2 58,137 8.2 48,367 9,770 30 9.2 140,178 8.2 106,370 33,808

Under our assumptions, investors in the Blueberry fund will have $1,154 more than investors in the Strawberry fund after seven years. After ten years, the difference between them is $2,120, and after twenty years, it is $9,770. At the end of thirty years, investors in the Blueberry fund will have accumulated $140,178, while investors in the Strawberry fund will have accumulated $106,370 - a difference of $33,808. This means that after thirty years, the Blueberry fund will be worth about 32 percent more than the Strawberry fund. Impact of MERs on the Growth of Annual Contributions When money is invested regularly through annual contributions to the funds, the accumulated capital amounts after a number of years show significant differences. The following table and graph illustrate how $10,000 invested at the beginning of each year grows when invested in the Blueberry fund and the Strawberry fund, respectively.


www.ifse.ca © 2007

2-30

Blueberry Strawberry

Year Net Return

%

Contribution $

Capital $ Net

Return %

Contribution $

Capital $

Difference in Capital

$

1 9.2 10,000 10,920 8.2 10,000 10,820 100 7 9.2 10,000 101,087 8.2 10,000 97,138 3,949 10 9.2 10,000 167,499 8.2 10,000 158,241 9,258 20 9.2 10,000 571,365 8.2 10,000 506,251 65,114 30 9.2 10,000 1,545,154 8.2 10,000 1,271,610 273,544

Under our assumptions, the value of the capital in the Blueberry fund will after seven years be $3,949 greater than the value of the capital in the Strawberry fund. After ten years, the difference between the two capital values is $9,258, and after twenty years, the difference has grown to $65,114. At the end of thirty years, the Blueberry fund investors will have $273,544 more than the Strawberry fund investors just because of the one percentage point difference in the funds' MERs.

MER and Investment Decisions It is important to make sure clients invest in the mutual funds that have the lowest possible MERs, provided the funds otherwise are equal. Even a difference in MER of one percentage point may in the long run lead to significantly different financial results. This is not to say that investors should only buy mutual funds that have low MERs. Funds that have higher MERs may be more actively managed, which may lead to higher returns that more than compensate for the higher MER. If so, the retail investor will be better off with the high-MER fund, because its after-expenses rate of return would be higher.

If Strawberry fund's one percentage point higher MER means more active management and an increase in its gross (before-expenses) ten-year average rate of return from 11.9% to 13.4%, its net ten-year average rate of return would increase from 8.2% to 9.7% - a rate that is half a percentage point higher than Blueberry fund's 9.2%. If the two funds are otherwise equal, investors would be better off buying Strawberry fund securities, even though they pay more for management services in that fund, compared to the Blueberry fund.


www.ifse.ca © 2007

2-31

Ultimately, the selection of mutual funds should be based on several factors, including the investor's risk tolerance and investment objectives. The funds' MER is only one factor that should be taken into consideration. Exercise: MERs and Performance

Commission Fees Commissions, also known as loads, are fees that are paid directly by the client. Since loads can take a number of forms, the client decides at the time of purchase how he or she wants to pay this fee. Click each type of commission for a description.

No-load Funds Some funds, known as no-load funds, charge no commission or service fees. A mutual fund is considered to be a no-load fund if an investor does not have to pay any fee or charge to buy or redeem securities of the fund. However, some fees and charges that may be levied when an investor buys units of a no-load fund include the following:

• optional fees or charges for specific services • redemption fees for funds that are not money market funds if redemption

occurs within 90 days after purchasing the fund • an account set-up or closing fee to cover the initial administrative costs of

opening or closing the account No-load funds are generally sold by banks and trust companies, although some independent mutual fund firms now offer no-load funds. Exercise: Fees


www.ifse.ca © 2007

2-32

Calculating the Front-end Charge Now that we have described the various types of sales charges, let's take a look at how the front-end sales charge is calculated. This is one of the most common options. Let's assume an investor invests $10,000 in a fund whose NAVPS is $10, and that levies a front-end sales charge of 4%. In this case, the $10,000 investment is used to pay for fund units, as well as the sales charge. The transaction is calculated as follows:

NAVPS purchase price per share =

1-sales charge

10 =

1-0.04

= $10.42

gross investment number of shares purchased =

purchase price per share

$10,000 =

$10.42

= 959.69 units If there were no sales charge, the $10,000 would purchase 1,000 units. Calculating the Deferred Sales Charge (DSC) Now let's assume our investor invests $10,000 in a fund that has the following Deferred Sales Charge (DSC) schedule:

Time Charges within the first year 7% 1 to 2 years 6% 2 to 3 years 5% 3 to 4 years 4% 4 to 5 years 3% 5 to 6 years 2% 6 to 7 years 1% After 7 years 0%

Three and half years later, our investor wants to redeem the investment that has grown to $15,500. How much would the investor receive? If the fund calculates the DSC based on market value, then the investor would receive $14,880 after fees. The calculation is as follows:

net amount after DSC = market value - (market value x % DSC) = $15,500 - ($15,500 x 0.04) = $15,500 - $620 = $14,880


www.ifse.ca © 2007

2-33

If the fund calculates the DSC based on the original value, then the investor would receive $15,100 after fees. The calculation is as follows:

net amount after DSC = market value - (original value x % DSC) = $15,500 - ($10,000 x 0.04) = $15,500 - $400 = $15,100 The method of calculation used by a fund is clearly indicated in its prospectus. Note: Most fund companies allow an investor to redeem 10% of the value of his or her holding per year without any charges. Trailer Fees Trailer fees are designed as an incentive to salespeople and mutual fund dealers to continue servicing fund clients after sales have been made. Trailer fees should not be confused with direct costs to investors such as commissions, or with indirect costs such as management fees. Trailer fees are paid by the management company to its distributors. All or part of these funds then flow to the mutual fund dealer and ultimately to the salesperson responsible for the sale of the units or shares. The amount paid is a percentage of the total assets held by all the clients of the mutual fund dealer. These fees normally fall in the range of 0.25% to 1% per year of the market value of eligible assets (sometimes subject to minimums) and are paid out of the revenues of the fund manager. Note: See Part 3 of National Instrument 81-105 for details on payment of commissions, rebating commissions, and trailing commissions, as well as the rules on disclosing commissions to investors. Click here to visit the Ontario Securities Commission if you would like to view the National Instrument in more detail. Fees for Tax-deferral Plans In addition to sales charges, an investor who holds fund units in a tax-deferral plan such as an RRSP, RRIF, or RESP may be required to pay a trustee fee. Because of the highly specialized functions that trustees of such plans are required to perform under the provisions of the Income Tax Act (Canada), these trustees generally levy an annual fee. Services performed by the trustee include obtaining the necessary registration for the tax-deferral plan, maintaining an account in each investor's name, receiving contributions to the account, refunding contributions, and issuing tax receipts and other forms required by the Canada Revenue Agency (CRA). Trustee fees are charged directly to the investor. Payment can be made out of the assets of the plan, or they can be paid directly by the investor. Fees vary, depending on the type of tax-deferral plan. For example, fees may be $25 to $50 for a conventional RRSP, or $75 to $125 for a self-directed RRSP.


www.ifse.ca © 2007

2-34

Exercise: Calculations

Review Let's look at the concepts covered in this unit:

• Mutual Fund History • Benefits of Mutual Funds • Roles and Functions • Purchases and Redemptions • Mutual Fund Fee Structure

You now have a good understanding of the basics of mutual funds. At this point in the course you can explain the history and benefits of investing in mutual funds. You also understand how mutual funds are purchased and redeemed, and the fees associated with mutual funds. Click Assessment on the table of contents to test your understanding. Assessment Now that you have completed Unit 2: Mutual Fund Basics you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.

Documents

Unit 2: Mutual Fund Basics