1. Chapter 14 Investing in Mutual Funds Copyright © 2012 Pearson Canada Inc. edited by Laura Lamb, TRU14-1

2. Chapter Objectives Describe the advantages and disadvantages of mutual funds Identify the types of mutual funds Explain how to choose among mutual funds Copyright © 2012 Pearson Canada Inc. 14-2

3. Chapter Objectives (cont’d) Describe quotations of mutual funds Explain the difference between ETFs and mutual funds Explain the difference between segregated funds and mutual funds Copyright © 2012 Pearson Canada Inc. 14-3

4. Background on Pooled Investment Funds Pooled investment fund: an investment vehicle that pools together money from many investors and invests that money in a variety of securities Copyright © 2012 Pearson Canada Inc. 14-4

5. Background on Pooled Investment Funds (cont’d) Marketability: refers to the ease with which an investor can convert an investment into cash Copyright © 2012 Pearson Canada Inc. 14-5

6. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-6 Equity mutual funds: funds that sell units, or shares, to individuals and use this money to invest in stocks Bond mutual funds: funds that sell units, or shares, to individuals and use this money to invest in bonds Balanced mutual funds: funds that sell units, or shares, to individuals and use this money to invest in a combination of stocks and bonds

7. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-7 Money market mutual funds: funds that sell units, or shares, to individuals and use this money to invest in cash and investments that can be converted to cash quickly

8. Background on Mutual Funds (cont’d) Advantages of Investing in Mutual Funds Provide professional money management Simplify the process of record keeping Mutual funds are available everywhere Allow diversification with a small investment Copyright © 2012 Pearson Canada Inc. 14-8

9. Background on Mutual Funds (cont’d) Disadvantages of Investing in Mutual Funds Management fees and other costs vary substantially among funds Investor has no control over the investments that are purchased and/or sold within the mutual fund Liquidity can be very low Liquidity: the ease with which the investor can convert the investment into cash without a loss of capital Copyright © 2012 Pearson Canada Inc. 14-9

10. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-10 Net Asset Value per Share Net asset value (NAV): the market value of the securities that a mutual fund has purchased minus any liabilities and fees owed Any liabilities, such as expenses owed to the mutual fund’s managers, are subtracted to determine the NAV NAV is commonly reported on a per share basis

11. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-11

12. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-12 Open-End versus Closed-End Funds Open-End Funds Open-end mutual funds: funds that sell shares directly to investors and will redeem those shares whenever investors wish to “cash” in

13. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-13 Closed-End Funds Closed-end mutual funds: funds that issue shares to investors but do not redeem those shares; instead, the fund’s shares are traded on a stock exchange Market price per share is determined by the demand for shares versus the supply of shares that are being sold

14. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-14 Premium: the amount by which a closed-end fund’s unit price in the secondary market is above the fund’s NAVPS Discount: the amount by which a closed-end fund’s unit price in the secondary market is below the fund’s NAVPS

15. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-15 Load versus No-Load Funds No-load mutual funds: funds that sell directly to investors and do not charge a fee Front-end load mutual fund: mutual funds that charge a fee at the time of purchase, which is paid to stockbrokers or other financial service advisers who execute transactions for investors

16. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-16 Back-end load mutual funds: mutual funds that charge a fee if shares are redeemed within a set period of time Declining redemption schedule: a fee schedule where the back-end load charge reduces with each year an investor holds the fund Fee may be based on the original amount purchased or the value of the fund when it is redeemed

17. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-17 Management Expense Ratio (MER) Management expense ratio: the annual expenses incurred by a fund on a percentage basis, calculated as annual expenses of the fund divided by the net asset value of the fund; the result of this calculation is then divided by the number of units outstanding

18. Background on Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-18 Reported Components of MERs Management expenses: investment research, portfolio management, marketing costs, and profit Dealer/adviser compensation: fees paid to advisers and salespeople Administrative costs: transaction processing, client reporting, and audit and legal fees Relationship between Expense Ratios and Performance

19. Types of Mutual Funds (cont’d) Types of Equity Mutual Funds Growth Funds Focus on stocks that have potential for above-average growth Small Capitalization (Small-Cap) Funds Focus on firms that tend to have more potential for growth relative to larger firms Mid-Size Capitalization (Mid-Cap) Funds: Focus on firms that are more established than small-cap firms Copyright © 2012 Pearson Canada Inc. 14-19

20. Types of Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-20 Dividend Funds Focus on firms that pay a high level of dividends Have less potential for high capital gains and exhibit less risk Balanced Growth and Income Funds: Contain both growth stocks and stocks that pay high dividends

21. Types of Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-21 Sector Funds Sector funds: mutual funds that focus on stocks in a specific industry or sector, such as technology stocks More risky, as they are less diversified Index Funds: Index funds: mutual funds that attempt to mirror the movements of an existing equity index May not contain every stock in the index

22. Types of Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-22 International Equity Funds Focus on firms that are based outside Canada Expenses associated with managing an international equity fund are higher “Global mutual funds” invest in stocks of both foreign firms and Canadian firms Ethical Funds Screen out firms viewed as offensive by some Other Types of Equity Funds

23. Types of Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-23 Types of Bond Mutual Funds Canadian Bond Funds Focus on investment in Canadian bonds Types of investments held within a Canadian bond fund vary significantly High-Yield Bond Fund Focus on relatively risky bonds issued by firms that may have a higher default risk

24. Types of Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-24 Index Bond Funds Intended to mimic performance of a specified bond index Global Bond Funds Global bond funds: mutual funds that focus on bonds issued by non-Canadian firms or governments May offer higher yields than Canadian bonds

25. Types of Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-25 Maturity Classifications Each type of bond fund can be segmented further by the range of maturities held in the fund

26. Return and Risk of a Mutual Fund Copyright © 2012 Pearson Canada Inc. 14-26 Return from Investing in a Mutual Fund 1.Interest income distributions 2.Dividend distributions 3.Capital gains distributions

27. Return and Risk of a Mutual Fund (cont’d) Copyright © 2012 Pearson Canada Inc. 14-27 4.Capital Gain from Redeeming Shares Occurs when you redeem shares of a mutual fund when the price exceeds the price at which you purchased the shares For example, purchase 200 shares at a price of $25 per share and sell them for $30 per share

28. Return and Risk of a Mutual Fund (cont’d) Copyright © 2012 Pearson Canada Inc. 14-28 Focus on Ethics: Risk From Investing In Hedge Funds Hedge funds: limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions Investor must be classified as either an accredited investor or a sophisticated investor to invest in a hedge fund Not regulated by a securities commission May invest in a wide variety of investments May engage in short selling and/or buying stocks on margin

29. Return and Risk of a Mutual Fund (cont’d) Copyright © 2012 Pearson Canada Inc. 14-29 Trade-off between Expected Return and Risk of Equity Funds

30. Deciding among Mutual Funds Copyright © 2012 Pearson Canada Inc. 14-30 Determining Your Preferred Mutual Fund Characteristics Minimum Initial Investment Investment Objective (Type of Fund) Investment Company Assess the past performance of the type of mutual funds you are considering Compare fees and expenses along with returns and risks Fund Profiles

31. Deciding among Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-31 Reviewing a Mutual Fund’s Simplified Prospectus Simplified Prospectus: a document that provides financial information about a mutual fund, including expenses and past performance Investment Objective Investment objective: in a prospectus, a brief statement about the general goal of the mutual fund

32. Deciding among Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-32 Investment Strategy Investment strategy: in a prospectus, a summary of the types of securities that are purchased by the mutual fund to achieve its objective Past Performance Prospectus will include the return on the fund over recent periods (previous year, three years, five years) Past performance will not necessarily persist in the future

33. Deciding among Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-33 Fees and Expenses Maximum front-end load Redemption fee or back-end load Expenses, including management fees, distribution fees, and marketing costs Management expense ratio

34. Deciding among Mutual Funds (cont’d) Copyright © 2012 Pearson Canada Inc. 14-34 Risk Mentions the numerous risks that the investments in mutual funds are exposed to Distribution of Interest Income, Dividends and Capital Gains Explains how frequently the mutual fund makes distributions to investors Minimum investment and minimum balance How to Buy or Redeem Shares

35. Exchange-Traded Funds Share may of the same benefits of a mutual fund Diversification, economies of scale, and marketability Differences: Do not have a net asset value per share Trade on the stock exchange and have a share price Purchased in real time, whereas mutual funds are purchased at the end of the day Copyright © 2012 Pearson Canada Inc. 14-35

36. Exchange-Traded Funds (cont’d) Fee Structure Do not have a load structure Initial fee you pay is the brokerage commission for completing the transaction There is an ongoing MER Copyright © 2012 Pearson Canada Inc. 14-36

37. Exchange-Traded Funds (cont’d) Tax Efficiency Tend to be more tax efficient since there is not as much active trading in an ETF There are many types of ETFs Copyright © 2012 Pearson Canada Inc. 14-37

38. Segregated Funds Insurance products that are regulated through the insurance legislation of the province in which they are sold Principal Protection Offer a guarantee on your deposits when the contract matures Usually matures 10 years after the date of purchase Deposit guarantee will be between 75 and 100 percent of deposits Copyright © 2012 Pearson Canada Inc. 14-38

39. Segregated Funds (cont’d) Death Benefit Guarantee Creditor Protection Assessing the Value of Protection Any segregated fund will underperform its mutual fund equivalent as a result of the difference in MERs Up to the individual investor to determine whether the benefits of owning a segregated fund outweigh the added costs Copyright © 2012 Pearson Canada Inc. 14-39