Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Mutual FundsMutual Funds

Mutual FundsMutual Funds

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Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Where can Mutual Funds be Purchased?Where can Mutual Funds be Purchased?• Who can sell mutual funds?Who can sell mutual funds?• What is a Mutual Fund?What is a Mutual Fund?• Legal Structures of Mutual FundsLegal Structures of Mutual Funds• The Mutual Fund ComplexThe Mutual Fund Complex• Management FeesManagement Fees• Advantages and Disadvantages of Mutual FundsAdvantages and Disadvantages of Mutual Funds• Segregated FundsSegregated Funds• SummarySummary• ConclusionsConclusions

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Learning ObjectivesLearning Objectives

1.1. To describe mutual fund organizationsTo describe mutual fund organizations2.2. To identify the advantages and disadvantage of investing To identify the advantages and disadvantage of investing

in mutual fundsin mutual funds3.3. To understand the costs associated with investing in To understand the costs associated with investing in

mutual fundsmutual funds4.4. To understand the differences between segregated funds To understand the differences between segregated funds

and mutual funds.and mutual funds.

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Important TermsImportant Terms

• Closed end FundClosed end Fund• Mutual FundMutual Fund• Management Expense Management Expense

Ratio (MER)Ratio (MER)• Net Asset Value per Net Asset Value per

Share (NAVPS)Share (NAVPS)• Open-end FundOpen-end Fund

• Segregated FundSegregated Fund

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Where can Mutual Funds Be Purchased?Where can Mutual Funds Be Purchased?

• Mutual funds are sold by most financial institutions:Mutual funds are sold by most financial institutions:• Credit unions (ethical funds)Credit unions (ethical funds)• BanksBanks• Insurance CompaniesInsurance Companies• Investment CompaniesInvestment Companies• Brokerage HousesBrokerage Houses• Trust CompaniesTrust Companies• Independent Mutual Fund DealersIndependent Mutual Fund Dealers

• You can usually set up a regular savings plan through You can usually set up a regular savings plan through your own financial institution…saving as little as $25.00 your own financial institution…saving as little as $25.00 per month.per month.

• You can invest in mutual funds outside or inside your You can invest in mutual funds outside or inside your RRSP.RRSP.

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Who Can Sell Mutual Funds?Who Can Sell Mutual Funds?

• The organization that markets (sells) mutual funds must be The organization that markets (sells) mutual funds must be licensed in the province where it offers these products.licensed in the province where it offers these products.

• In addition, the person working for the licensed organization must In addition, the person working for the licensed organization must also be licensed under either:also be licensed under either:– MFDAMFDA (Mutual Fund Dealers Association) (Mutual Fund Dealers Association)– IDAIDA (Investment Dealers Association) (Investment Dealers Association)

• In order to qualify for licensing, the individual must complete an In order to qualify for licensing, the individual must complete an accredited course of studies, have completed a supervised 90 day accredited course of studies, have completed a supervised 90 day training program and have satisfied the accrediting body of their training program and have satisfied the accrediting body of their personal integrity through a thorough background check. For personal integrity through a thorough background check. For example:example:– the MFDA will expect you to have completed the Canadian Investment the MFDA will expect you to have completed the Canadian Investment

Funds Course through the Investment Funds Institute of Canada, or the Funds Course through the Investment Funds Institute of Canada, or the Investment Funds in Canada Course Investment Funds in Canada Course through the through the Institute of Canadian Bankers Institute of Canadian Bankers or the Canadian Securities Course through or the Canadian Securities Course through the the Canadian Securities InstituteCanadian Securities Institute..

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What is a Mutual Fund?What is a Mutual Fund?

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

Mutual Fund

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What is a Mutual Fund?What is a Mutual Fund?

• It is a ‘pooled’ It is a ‘pooled’ investmentinvestment

• Pooled investments are Pooled investments are managed portfolios that managed portfolios that groups of investors groups of investors invest in.invest in.

• Other examples include Other examples include pension funds, labour pension funds, labour sponsored venture sponsored venture capital corporations, capital corporations, segregated funds, etc.segregated funds, etc.

Mutual Fund

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What is a Mutual Fund?What is a Mutual Fund?

• A mutual fund is a financial A mutual fund is a financial organization that accepts organization that accepts funds from numerous funds from numerous investors, pools these funds investors, pools these funds and invests them in bonds, and invests them in bonds, stocks, real estate precious stocks, real estate precious metals and other metals and other investments. It then issues investments. It then issues shares or units to investors shares or units to investors in proportion to the funds in proportion to the funds each investor contributes.each investor contributes.

• Conceptually, it is not a Conceptually, it is not a stock or bond, it’s a way of stock or bond, it’s a way of investing.investing.

Mutual Fund

Legal Structures of Canadian Mutual Legal Structures of Canadian Mutual FundsFunds

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The Mutual Fund ComplexThe Mutual Fund Complex

• A series of organizations and individuals A series of organizations and individuals responsible for the day to day administration responsible for the day to day administration of the mutual fund, its investment strategies, of the mutual fund, its investment strategies, the safe keeping of unit holders’ contributions the safe keeping of unit holders’ contributions and investments held by the fund and the and investments held by the fund and the selling and redemption of fund units.selling and redemption of fund units.

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Typical Mutual Fund ComplexTypical Mutual Fund Complex

• Consists of four things:Consists of four things:• The mutual fund itselfThe mutual fund itself• The mutual fund manager & portfolio advisorThe mutual fund manager & portfolio advisor• The custodianThe custodian• The distributorThe distributor

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About The Mutual FundAbout The Mutual Fund

• Can be organized in two waysCan be organized in two ways• As a corporationAs a corporation• As a unit trustAs a unit trust

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Mutual Fund ComplexMutual Fund Complex

FUNDTrustees

or(Board of Directors)

(Officers)

FUNDTrustees

or(Board of Directors)

(Officers)

ManagementCompany

and/orInvestment

Adviser

ManagementCompany

and/orInvestment

Adviser

GeneralDistributor

GeneralDistributor

Custodian

(Provides physical safekeeping of fund assets)

Custodian

(Provides physical safekeeping of fund assets)

Pays management fee to

Provides administration research and investment supervision

Contract

ContractContract

Sells shares/units to investors either through

investment dealers or through own direct sales organization/employees

Net asset value(price of shares/units)

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The Mutual Fund ComplexThe Mutual Fund Complex

• Behind every mutual fund is a series of organizations and Behind every mutual fund is a series of organizations and individuals that are responsible for the day-to-day individuals that are responsible for the day-to-day administration of the fund, its investment strategies, the administration of the fund, its investment strategies, the safekeeping of ‘unitholders’ contributions and investments safekeeping of ‘unitholders’ contributions and investments held by the fund, and the selling and redemption of fund units.held by the fund, and the selling and redemption of fund units.

• Together, we refer to this series of organizations and Together, we refer to this series of organizations and individuals as a mutual fund “complex.” A typical fund individuals as a mutual fund “complex.” A typical fund complex consists of:complex consists of:– the fund itselfthe fund itself

– the mutual fund manager and portfolio advisorthe mutual fund manager and portfolio advisor

– the custodianthe custodian

– the distributorthe distributor

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The Mutual Fund ComplexThe Mutual Fund Complex

The Fund OrganizationThe Fund Organization

• Mutual funds may be organized as either a Mutual funds may be organized as either a unit trustunit trust or as a or as a corporationcorporation..

• Some funds may operate in isolation, while others are part Some funds may operate in isolation, while others are part of a “family” of funds that includes a variety of mutual of a “family” of funds that includes a variety of mutual funds that specialize in different financial markets or have funds that specialize in different financial markets or have different investment objectives.different investment objectives.

• Corporate Form of OrganizationCorporate Form of Organization• an incorporated fund is subject to the Canada Business Corporations Act or an incorporated fund is subject to the Canada Business Corporations Act or

similar provincial legislation.similar provincial legislation.• Certain types of income (e.g. interest income) earned by an incorporated 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 fund may be taxable first as income to the fund, and then in the hands of investors in the fund.investors in the fund.

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The Mutual Fund ComplexThe Mutual Fund Complex

The Fund OrganizationThe Fund Organization

• Unit TrustsUnit Trusts• is the most common form of open-ended mutual fund organization today (largely 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 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.)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 lawsorganizational 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 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. 39under which the fund is created, through National Policy Statement No. 39

• a trustee or a number of trustees act as the governing body.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 Trustees may be individuals or a corporate entity that has the power to act as a trustee (such as a trust company)trustee (such as a trust company)

• Trustees are responsible for the supervision of the fund’s operations and adherence to Trustees are responsible for the supervision of the fund’s operations and adherence to its investment policies. They have the power to enter into contracts on behalf of the its investment policies. They have the power to enter into contracts on behalf of the fund for any required services.fund for any required services.

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The Mutual Fund ComplexThe Mutual Fund Complex

The Fund Manager and Portfolio AdvisorThe Fund Manager and Portfolio Advisor

• Regardless of organizational structure, directors and Regardless of organizational structure, directors and trustees are ultimately responsible for the management of trustees are ultimately responsible for the management of a mutual fund’s investment portfolio as well as the day-to-a mutual fund’s investment portfolio as well as the day-to-day operations of the fund.day operations of the fund.

• To assist with this latter task, the directors or trustees of To assist with this latter task, the directors or trustees of the fund may enter into a contract with a management the fund may enter into a contract with a management (investment) company to provide management services, (investment) company to provide management services, rather than hiring staff to perform day-to-day rather than hiring staff to perform day-to-day administration. A firm that provides these services is administration. A firm that provides these services is commonly known as an administrative manager. Trustees commonly known as an administrative manager. Trustees and managers are often the same company.and managers are often the same company.

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The Mutual Fund ComplexThe Mutual Fund Complex

The CustodianThe Custodian

• To protect investors and as a part of internal control mechanisms, the To protect investors and as a part of internal control mechanisms, the administrative and custodial functions of mutual funds are kept administrative and custodial functions of mutual funds are kept separate.separate.

• The custodian is responsible for the safekeeping of all the fund’s The custodian is responsible for the safekeeping of all the fund’s investments.investments.

• National Policy Statement No. 39 requires that a mutual fund’s cash National Policy Statement No. 39 requires that a mutual fund’s cash and securities be deposited with, and held by, a custodian.and securities be deposited with, and held by, a custodian.

• The custodian must be a Canadian chartered bank, a Canadian trust The custodian must be a Canadian chartered bank, a Canadian trust company having shareholder’s equity of not less than $10 million, or company having shareholder’s equity of not less than $10 million, or in some cases a subsidiary of a Canadian Chartered bank or trust in some cases a subsidiary of a Canadian Chartered bank or trust company that meets prescribed financial qualifications.company that meets prescribed financial qualifications.

• The custodian also holds all income earned by the fund until it is The custodian also holds all income earned by the fund until it is reinvested or distributed by the fund. The custodian makes all reinvested or distributed by the fund. The custodian makes all payments for the fund’s investments.payments for the fund’s investments.

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The Mutual Fund ComplexThe Mutual Fund Complex

The DistributorThe Distributor

• The distributor is the sales and marketing arm of the mutual fund The distributor is the sales and marketing arm of the mutual fund organization.organization.

• It is responsible for bringing in assets to the fund in the form of new It is responsible for bringing in assets to the fund in the form of new fund units.fund units.

• Securities laws require each mutual fund to designate a principal Securities laws require each mutual fund to designate a principal distributor to assume the distribution responsibilities, usually under distributor to assume the distribution responsibilities, usually under contract with the fund’s administrative manager.contract with the fund’s administrative manager.

• In many cases, the administrative manager will assume the role of In many cases, the administrative manager will assume the role of principal distributor, and will distribute or arrange for distribution by principal distributor, and will distribute or arrange for distribution by carrying out its distribution responsibilities through its employees or carrying out its distribution responsibilities through its employees or by subcontract with one or more of the following distribution by subcontract with one or more of the following distribution channels:channels:

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The Mutual Fund ComplexThe Mutual Fund Complex

The DistributorThe Distributor

• the following distribution channels:the following distribution channels:

– Proprietary (in-house) selling organizations that market only the funds Proprietary (in-house) selling organizations that market only the funds offered by one mutual fund group. (eg. Investors Group)offered by one mutual fund group. (eg. Investors Group)

– Mutual fund specialists employed by a mutual fund dealer who is not Mutual fund specialists employed by a mutual fund dealer who is not aligned or affiliated with any particular fund.aligned or affiliated with any particular fund.

– Stockbrokers employed by investment dealers.Stockbrokers employed by investment dealers.

– Employees of financial institutions such as banks, trust companies, Employees of financial institutions such as banks, trust companies, credit unions, and caisses populaires or their securities subsidiaries.credit unions, and caisses populaires or their securities subsidiaries.

– Employees of mutual fund groups that deal directly with the public and Employees of mutual fund groups that deal directly with the public and exclusively market their proprietary funds.exclusively market their proprietary funds.

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The Mutual Fund ComplexThe Mutual Fund Complex

The Registrar and Transfer AgentThe Registrar and Transfer Agent

• This entity carries out two duties:This entity carries out two duties:– RegistrarRegistrar: the role of the Registrar is to safeguard against excess distribution of : 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 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 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 or unit certificates is now the exception rather than the rule, the role of the registrar is decreasing in importance.registrar is decreasing in importance.

– Transfer Agent:Transfer Agent: maintains the register of owners of units or shares of the fund maintains the register of owners of units or shares of the fund and records all transfers of ownership of units. This register is constantly and records all transfers of ownership of units. This register is constantly changing as investors buy and redeem units. The transfer agent may also changing as investors buy and redeem units. The transfer agent may also provide dividend distribution services.provide dividend distribution services.

• These functions are usually provided by a trust company or other These functions are usually provided by a trust company or other third-party service provider. In many cases, the same trust company third-party service provider. In many cases, the same trust company that acts as the fund’s custodian will perform these duties.that acts as the fund’s custodian will perform these duties.

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Management FeesManagement Fees

• The costs of managing the fund are borne by the fund itself.The costs of managing the fund are borne by the fund itself.• These include:These include:

– Bank chargesBank charges– CommissionsCommissions– Investment analysis costsInvestment analysis costs– Salary and bonuses for the portfolio managerSalary and bonuses for the portfolio manager

• Investors need to be advised of the management feesInvestors need to be advised of the management fees• Easiest way to compare management expenses is by using Easiest way to compare management expenses is by using

the management expense ratio (MER)the management expense ratio (MER)

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MERMER

• The Management Expense Ratio is reported in annual The Management Expense Ratio is reported in annual percentage terms.percentage terms.

• For example:For example:• 2.5% or 250 bps (basis points)2.5% or 250 bps (basis points)

• If the fund earned a gross return of 10% and it If the fund earned a gross return of 10% and it incurred an MER of 2.5%, then the net return to the incurred an MER of 2.5%, then the net return to the unitholder is 7.5%unitholder is 7.5%

• If the fund earned a gross return of 0% and it incurred If the fund earned a gross return of 0% and it incurred an MER of 2.5%, then the net return to the unitholder an MER of 2.5%, then the net return to the unitholder is -2.5%is -2.5%

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Standard Costs - MERsStandard Costs - MERs

• Range from .2% to > 3%, depending upon the type of Range from .2% to > 3%, depending upon the type of fund.fund.– The lowest MERs are for money market mutual fundsThe lowest MERs are for money market mutual funds– The highest MERs are typically for balanced mutual fundsThe highest MERs are typically for balanced mutual funds

• Consists of management salaries and administrative Consists of management salaries and administrative expensesexpenses

• May contain a 12B-1 fee to cover the funds advertising May contain a 12B-1 fee to cover the funds advertising expenseexpense

• High MERs don’t necessarily translate to above average High MERs don’t necessarily translate to above average returnsreturns

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Standard Costs - LoadsStandard Costs - Loads

• There are no-load funds…but remember, there will still There are no-load funds…but remember, there will still be MER expenses borne by such a fund and be MER expenses borne by such a fund and potentially, back-end fees…be sure to check the fine potentially, back-end fees…be sure to check the fine print!print!

• Front-end loadFront-end load• Back-end load (often decreasing)Back-end load (often decreasing)

– These ‘loads’ or fees equate to a sales commission paid to the These ‘loads’ or fees equate to a sales commission paid to the financial intermediaryfinancial intermediary

– They reduce/inhibit the investment’s liquidityThey reduce/inhibit the investment’s liquidity

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NAVPSNAVPS

• Net asset value per share Net asset value per share is the ‘price’ of the mutual is the ‘price’ of the mutual fund.fund.

• It is calculated at the end It is calculated at the end of each business day on a of each business day on a unit basis and then unit basis and then reported in the press.reported in the press.

• It is like the ‘share price’ It is like the ‘share price’ that you see reported for a that you see reported for a common stock.common stock.

57.1$000,500,6

000,180$000,350,10$

gOutstandin UnitsofNumber

sLiabilitie Fund - Assets of ValueMarket Total

NAVPS

NAVPS

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Advantages of Mutual Funds Over Direct Advantages of Mutual Funds Over Direct InvestmentInvestment

• Professional ManagementProfessional Management• Broad DiversificationBroad Diversification• More Reliable Estimates of Risk and ReturnMore Reliable Estimates of Risk and Return• Past Performance RecordPast Performance Record• Record Keeping and SafekeepingRecord Keeping and Safekeeping• Flexibility of Purchase and SaleFlexibility of Purchase and Sale• Automatic Reinvestment PlanAutomatic Reinvestment Plan

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Disadvantages of Mutual Funds Over Direct Disadvantages of Mutual Funds Over Direct InvestmentInvestment

• Management FeesManagement Fees• High Cost for Short-term InvestmentHigh Cost for Short-term Investment• Vulnerable to Massive RedemptionVulnerable to Massive Redemption• Professional Management is Not InfallibleProfessional Management is Not Infallible• Tax ImplicationsTax Implications

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Mutual Fund TypesMutual Fund Types

• Open-ended vs. Closed-endedOpen-ended vs. Closed-ended• Vary by: Asset Classes, Investment Strategy, Vary by: Asset Classes, Investment Strategy,

etc.etc.– Examples include: Sector, Index, Regional, Growth, Examples include: Sector, Index, Regional, Growth,

Balanced, Socially-Responsible Balanced, Socially-Responsible

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Fund LinksFund Links

• TalvestTalvest Mutual Funds Mutual Funds• CI FundsCI Funds• Investors GroupInvestors Group• Franklin Templeton InvestmentsFranklin Templeton Investments• MorningstarMorningstar – an organization dedicated to following – an organization dedicated to following

and reporting on mutual fund performanceand reporting on mutual fund performance

Please note – these are just samples of organizations – there are thousand of others like these Please note – these are just samples of organizations – there are thousand of others like these organizations.organizations.

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Segregated FundsSegregated Funds

• Segregated funds are often viewed as mutual Segregated funds are often viewed as mutual funds…however, they do have special funds…however, they do have special features that distinguish them from a features that distinguish them from a common mutual fund.common mutual fund.

• Nevertheless they are pooled investments Nevertheless they are pooled investments offered by Insurance companies.offered by Insurance companies.

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Segregated FundsSegregated Funds

• Segregated Funds are an insurance product, Segregated Funds are an insurance product, combining a mutual fund-like investment with the combining a mutual fund-like investment with the protection of an insurance policy. As with mutual protection of an insurance policy. As with mutual funds, an investor's money is pooled with the funds, an investor's money is pooled with the contributions of other investors to purchase a portfolio contributions of other investors to purchase a portfolio of securities. The value of the units purchased is of securities. The value of the units purchased is based on the value of the underlying securities and based on the value of the underlying securities and will change in response to market conditions. will change in response to market conditions.

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SummarySummary

In this chapter you have developed:In this chapter you have developed:– An understanding of the managed financial An understanding of the managed financial

product known as a mutual fundproduct known as a mutual fund

– An understanding of how mutual fund An understanding of how mutual fund organizations are organized and the channels organizations are organized and the channels that are used to distribute their products and the that are used to distribute their products and the parties involved in mutual fund organizationsparties involved in mutual fund organizations

– An understanding of the advantages and An understanding of the advantages and disadvantages of mutual funds.disadvantages of mutual funds.

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CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.