1. INVESTMENTS: Analysis and Management Third Canadian Edition
W. Sean Cleary
Charles P. Jones
Prepared by
Khalil Torabzadeh
University of Lethbridge

2. Chapter 3
Investments Funds

3. Learning Objectives Distinguish between direct and indirect investing.
Define open-end and closed-end investment funds.
State the major types of mutual funds and give their features.
Define exchange-traded funds (ETFs).
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 2

4. Learning Objectives
Explain the transactions behind indirect investments.
Understand how the performance of investment funds is measured.
Discuss the opportunities for investing indirectly internationally.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 2

5. Indirect Investing
Alternative to direct investment in or ownership of securities
Refers to buying and selling the shares of intermediaries that hold a portfolio of securities
Shares are ownership interest in the underlying portfolio
Shareholders are entitled to portfolio income
Shareholders also pay expenses
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 2

6. Figure 3-1Total Net Assets-Canadian Mutual Funds ($billions) 1989 to 2007
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

7. Investment Fund
Financial company or trust fund that sells shares to the public and uses the proceeds to invest in marketable securities
Acts as conduit for distribution of dividends, interest, and realized gains
Offers the benefits of diversification
Offers professional management
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 3

8. Fund Types Unit Investment Trusts Closed – End Investment Funds
Open – End Investment Funds (Mutual Funds)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 5

9. Unit Investment Trust
Unit Investment Trust: an unmanaged, fixed-income security portfolio put together by a sponsor and handled by an independent trustee
Passive investments designed to be bought and held with capital preservation as a major objective
Currently represent a very small part of total investment company assets
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

10. Closed – End Investment Funds
Closed-end investment fund: No additional shares sold after initial public offering
Share prices determined and traded in a secondary market
Price may not equal Net Asset Value of the shares
Net Asset Value (NAV): Total market value of the security portfolio divided by total shares
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

11. Open – End Investment Funds
Open-end investment fund: Shares (units) continue to be sold to the public at NAV after initial sale that capitalizes the company
Shares may be sold back (“redeemed”) to the company at NAV
Capitalization constantly changes
Popularly called mutual funds
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 6

12. Types of Mutual Funds Money Market Funds (a) Mortgage Funds
Objectives of income and liquidity
Investments include short-term money market instruments
Attractive to investors seeking low risk and high liquidity
(a) Mortgage Funds
Investment terms may be  5 years
Riskier than money market (more interest rate risk), but less risky than bond funds (shorter maturities)
(b) Bond Funds
Objectives of income and safety
Subject to capital gains/losses due to interest rate risk
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

13. Types of Mutual Funds (cont’d)
(a) Balanced Funds
Objectives of safety, income and capital appreciation
Min./max. rules apply for percentage invested in each asset class.
(b) Asset Allocation Funds
Similar objectives as balanced funds, but typically not restricted by asset class percentage rules
Equity/Common Stock Funds
Objective of capital gains
Bulk of assets are in equity, but other assets held for liquidity, income and diversification purposes
May vary greatly in degree of risk and growth objectives
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

14. Types of Mutual Funds (cont’d)
Growth Funds
Tend to invest in small-cap stocks, i.e. small companies with growth potential
Riskier than equity funds (small firms pay no dividends)
Specialty Funds
Objective of superior capital gains (through minimal diversification)
Tend to focus on one industry, market, or segment
International/Global Funds, for example, invest in foreign securities (and carry the risk of foreign exchange exposure)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

15. Types of Mutual Funds (cont’d)
(a) Real Estate Funds
Invest in income-generating properties for long-term growth and capital gains
Portfolio valuation is based on infrequent external appraisal
Less liquid than other funds – investors may need to give advance notice when selling
(b) Ethical Funds
Relatively new type of fund
Investments are guided by moral criteria (e.g., not investing in tobacco-related firms)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

16. Types of Mutual Funds (cont’d)
Index Funds
Objective is to mirror the performance of a market index (e.g., S&P/TSX 60)
Generally lower management fees than other funds.
Dividend Funds
Objective of tax reduction through favourable treatment of dividend
Inappropriate for RRSPs or RRIFs
Price changes are driven by interest rates and market trends
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

17. Types of Mutual Funds (cont’d)
Each type of fund has different risk-return characteristics. In general, they can be ranked from lowest risk/return to highest risk/return as follows:
Money market
Mortgage
Bond
Balanced
Dividend
Equity
Real estate
Specialty
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

18. Mutual Fund Categories
Money market mutual funds invest in a portfolio of money market securities
Treasury bills
Commercial paper
Short-term government bonds
Low risk
Not insured by the federal government
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 7

19. Mutual Fund Categories
Equity, bond, and income funds invest in portfolios of securities consistent with the objectives of the particular fund
Objectives set by the fund’s board
Disclosure of objectives to investors through a prospectus
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 8

20. Equity Funds
Most mutual fund assets are in equity funds rather than bond or income funds
Most equity funds are either:
Value funds, which invest in undervalued stocks as determined by fundamental financial analysis
Growth funds, which invest in stocks of firms expected to show future rapid earnings growth
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 9

21. Figure 3-3 Mutual Funds Assets (October 2007)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

22. Equity Funds Closed-End Funds
NAV > market price, selling at a discount
NAV < market price, selling at a premium
If the value of the portfolio remains unchanged, an investor can gain or lose if the discount narrows or widens over time
Trade at premiums and discounts across time, and variance is great
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

23. Exchange-Traded Funds (ETFs)
Units of these trusts hold shares of firms in market indices in proportion to their weights in the index
Differences from traditional mutual funds:
Traded throughout the day on exchanges
Lower management fees (e.g., 0.08% to 0.25% versus 2.5% average for active equity funds versus 0.75% average for Index funds)
Lower portfolio turnover – reduces capital gains income and taxes payable
Permit short-selling
May be purchased on margin
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

24. Canadian-Based ETFs I-60s DJ40s
Represent units in the S&P/TSX 60 Index
Trade on the TSX (ticker: XIU).; units are valued at 1/10th the value of the S&P/TSX 60 Index; for example, if index is valued at 450, each unit is valued at $45
Dividends are paid every quarter; MER is 0.17%
DJ40s
Represent units in the Dow Jones Canada Index Participation Fund, which hold stocks that mimic those of the Dow 40 Index; MER is 0.08%
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

25. Canadian-Based ETFs TD S&P/TSX Index Fund
The S&P/TSX Composite Index is the underlying index; MER is 0.25%
There are now a growing number of small-cap, mid-cap, industry-based, style-based, and bond ETFs available
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

26. Differences between ETFs and Mutual Funds
Trade all day on exchanges, can be bought on margin, and can be shorted
Currently passive in nature
Can be traded at discount or premiums.
Offer an important advantage over funds with regard to flexibility on taxes
Mutual Funds
Bought and sold at the end of the trading day when the NAV is calculated
Most are actively managed
Trade at NAV
Mutual fund mangers may have to sell shares to pay those who want to leave the fund, thereby generating capital gains
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

27. Other Funds Segregated funds Provide death benefits
Must guarantee a minimum percentage (75% is required, 100% is usually offered) of investor’s payments will be returned at fund maturity (or at death of owner)
Structured to prevent fund assets from being seized by creditors if investor declares bankruptcy
Upon owner’s death, assets may be transferred to beneficiaries without being subject to probate fees
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 9

28. Other Funds Labour Sponsored Venture Capital Corporations (LSVCCs)
No 10% maximum ownership restriction
Restrictions on transferability and redemption
Valuation may not be based exclusively on market prices
Tax advantages – federal & provincial tax credits offered
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

29. Mutual Funds Performance
Reported on a regular basis (usually daily) in the popular press
Measured over a given time period as a percentage of initial investment
Total returns include reinvested dividends and capital gains
Average annual return reflects the mean compound growth rate of investment over a given time period
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 12

30. Mutual Funds Performance
Investors relate the performance to some benchmark to judge relative performance
An important issue is expenses: funds with low MERs provide better returns in the long run
Mutual fund ratings: best known rating system is provided by Morningstar
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

31. International Funds
Some mutual funds specialize in international securities
Canadian investors can participate in emerging market economies
International diversification
International funds or global funds emphasize international stocks
Single-country funds concentrate assets
Actively or passively managed
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 13

32. New Directions in Funds
Mutual fund “supermarkets”
Various mutual fund families can be purchased through a single source
Brokerage account may provide access
“Supermarket” managers earn fee
On-line investment services
Internet used to provide mutual fund information and to make transactions
Hedge Funds
Unregulated companies that seek to exploit various market opportunities.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3 14

33. Copyright
Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.