chapter 14 investing in mutual funds copyright © 2012 pearson canada inc. 14-1
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Chapter 14
Investing in Mutual Funds
Copyright © 2012 Pearson Canada Inc. 14-1
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
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
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
Background on Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-5
• 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
Background on Mutual Funds (cont’d)
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• 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
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. 14-7
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. 14-8
Background on Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-9
• 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
Background on Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-10
• 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
Background on Mutual Funds (cont’d)
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• 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
Background on Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-12
• 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
Background on Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-13
• 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
Background on Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-14
• 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
Background on Mutual Funds (cont’d)
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• 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
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. 14-16
Types of Mutual Funds (cont’d)
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• 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
Types of Mutual Funds (cont’d)
Copyright © 2012 Pearson Canada Inc. 14-18
• 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
Types of Mutual Funds (cont’d)
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• 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
Types of Mutual Funds (cont’d)
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• Types of Bond Mutual Funds• Canadian Bond Funds
• High-Yield Bond Fund
• Global Bond Funds
• Index Bond Funds
Return and Risk of a Mutual Fund
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• Return from Investing in a Mutual Fund
1. Interest income distributions
2. Dividend distributions
3. Capital gains distributions
Return and Risk of a Mutual Fund (cont’d)
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• Trade-off between Expected Return and Risk of Equity Funds
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. 14-23
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. 14-24
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. 14-25
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. 14-26
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. 14-27
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