CSC Volume 2 (ch 17) 2022

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Sep 19, 2023
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CSC Volume Two Chapter 17 MUTUAL FUNDS: STRUCTURE AND REGULATION Introduction Managed products have been around since the first modern mutual fund was created in the 1920s. Over the past 35 years, there has been tremendous growth in the number of managed products on the market and in the amount of assets under management. Although they may seem simple and are nearly universally available, mutual funds are, in fact, a complex investment vehicle. They are available in many forms and through many distribution channels. They may ne one of the most visible vehicles for investors, from the smallest retail client to the largest institutional investor. The funds themselves are subject to a range of unique structures, provisions, and regulations. Overview of Managed Products A managed product is a pool of capital gathered to buy securities according to a specific investment mandate. The fund is managed by an investment professional that is paid a management fee to carry out the mandate. The mandate of a fund can specify either active management or passive management . Active Management o Active fund managers make investment decisions based on their outlook for the markets and securities in which they invest, which should be clearly identified in the fund's investment mandate. o In almost all cases, active fund managers intend to outperform the return on a specific benchmark index. Passive Management o Managers of passively managed funds do not make security selections; they assume only the systematic risk associated with investing in a particular asset class. o The most common type of passively managed fund is one that attempts to replicate the returns of a market index. Managed products are available in various types and formats and includes: o Mutual Funds A pooled open-end investment fund in which units are continually issued and redeemed and invests according to its type (equity, fixed-income, money market). o Hedge Funds Use alternative investment strategies to generate returns These strategies include long and short positions, derivatives, leverage, speculation, and arbitrage They are a "fund structure" rather than a specific investment strategy, since strategies can be conservative, aggressive, and may or may not involve hedge positions o Segregated Funds An insurance contract that combines life insurance with investment funds and provides investor guarantees o Exchange-traded Funds (ETFs) An investment fund that tracks an index but trades like a stock o Closed-end Funds An investment fund in which shares are issued and derivatives can be used o Labour-Sponsored Venture Capital Corporations (LSVCCs) A fund invested in small to mid-sized Canadian companies o Private-equity Funds An investment fund that buys shares in private companies 1
Advantages of Managed Products Professional Management o Investors benefit from the experience and specialized knowledge of investment professionals. Economies of Scale o The asset size of the pooled investment funds allows for negotiation of lower fees and transaction costs. Liquidity and Flexibility o Some managed products, such as mutual funds, can be bought and sold at their net asset value at any time. Low-Cost Diversification o Investors with relatively small sums to invest have access to diversification, which they could not otherwise achieve.. Tax Benefits o Products such as LSVCCs can provide tax benefits, including provincial and federal tax credits. Low-Cost Investment Options o Products such as exchange-traded funds (ETFs) have some of the lowest management costs in the fund universe.. Disadvantages of Managed Products Lack of Transparency o Because of the largely unregulated and competitive nature of their business, products such as hedge funds rarely discloses their portfolio holdings on a timely basis. Liquidity Constraints o Some managed products prevent investors from accessing their funds until a specified time, or only when certain conditions are met. High Fees o Active fixed-income and foreign equity mutual funds can charge 2% to 5% in management fees. o Some private equity funds and hedge funds typically charge a 20% performance fee. Volatility of Returns o Some mutual funds and hedge funds can be subject to market instability, as well as volatility associated with their underlying securities. Overview of Mutual Funds A mutual fund is a single investment vehicle sponsored by an investment management company on behalf of many investors. By selling shares or units to a pool of investors, the fund raises capital, which is then invested according to the fund's investment policies and objectives. The fund makes money from the dividends and interest it receives on the securities it holds. It may also earn capital gains from trading its investment portfolio. Thousands of mutual funds exist in the Canadian market and globally that cater to many different investment objectives. Some funds take a passive approach by simply replicating a stock or bond index (Index funds). Others offer moderate risk and moderate return by balancing investments between fixed income and equities. Still others may be very active by constantly trying to beat the market. Mutual funds' investment objectives are stated in a document called the Fund Facts document. o This document generally discloses the degree of risk the fund is exposed to, the main types of securities held in its portfolio, and the historical returns it earned, among other things. Investors in a mutual fund becomes unitholders or shareholders in the fund. As such, they share in the income, gains, losses and expenses the fund incurs in proportion to the number of units or shares they own. 2
Overview of Mutual Funds (continued) Professional money managers manage the assets of the fund by investing the proceeds according to the fund's policies and objectives, and based on a particular investing style. Mutual funds are sold in units or shares, depending on the structure, which are redeemable on demand at the fund's current offering price. In the financial press, they offering price is expressed as the net asset value per share (NAVPS) or unit. The NAVPS depends on the market value of the fund's portfolio of securities at the time of redemption.. This number is determined by the market value of the securities held by the mutual fund at the time of redemption. (example: ABC fund has $13M in assets, $1M in liabilities, and 1M units outstanding) Total Assets - Total Liabilities 13,000,000 - 1,000,000 --------------------------------------- ----------------------------- = $12 NAVPS # of Units Outstanding 1,000,000 The mutual funds in Canada has experienced tremendous growth since 1980, and in that year, mutual fund net assets totalled $3.6 Billion in Canada. By March 2020 mutual fund net assets under management was more than $1.45 Trillion. Advantages of Mutual Funds Low-Cost Professional Management o Mutual fund managers study available investments, analyze the market, and select securities that match the objectives of the fund. o This is a very inexpensive way for the small investor to have access to professional investment management. o To optimize the return for investors, managers track performance and change the investments as conditions warrant. o The skill of these professional managers is especially valuable when it comes to specialty funds (e.g., overseas regional funds, sector funds, or small-cap funds). Diversification o A mutual fund allows an investor to acquire holdings in a large number of company stocks in a wide variety of industries. Variety of Types of Funds and Transferability o Every client has different has different and changing investment objectives that can be fulfilled by the variety of funds available. o Shareholders can convert units of one fund to units of another if both funds are managed by the same sponsor. o Investors may also transfer between different purchase plans under the same fund. Variety of Purchase and Redemption Plans o There are numerous purchase and redemption plans to choose from, making mutual fund investment accessible to a variety of investors. o The low initial investment ($100) is another feature of mutual funds for the small investor. Liquidity o National Instrument 81-102 requires payment be made for a redemption of shares within 2 business days Ease of Estate Planning o When estate capital is invested in a mutual fund, the portfolio receives continual portfolio management during the estate probate period, until the assets of the estate are distributed o Individual securities cannot trade during the probate period. Loan Collateral and Margin Eligibility o Investments in mutual funds are normally acceptable as collateral for bank loans. Various Special Options o Compounding of investment return o Inclusive record keeping and custodial services 3
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