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com Mutual Funds

Mutual funds are a very popular investment for retail investors. They package the investment management skills of professional money managers in an economical manner for smaller amounts. Their current popularity has increased to the point where they are starting to replace traditional savings instruments like bank and trust deposits and even direct investment in stocks and bonds.
A mutual fund is a pool of money that is managed by a professional money manager. Individual investors buy units of the fund which gives them a "pro rata" share of the value of the investments of the fund. The unit value of the fund is struck by adding up the values of all the investments at their market prices, subtracting amounts owed by the fund and dividing by the number of units held. The most popular type of mutual fund is an "open-ended" unit trust. This means that the fund sponsor has agreed to buy and sell units at the unit value established at certain times. Valuation used to be monthly or weekly, but now is almost universally done by major funds on a daily basis. A mutual fund is legally governed by its "trust indenture". This states how the fund will work. It establishes the role of the fund manager, who provides the investment management for the fund; the trustee and custodian, which holds the actual assets of the fund; and many other things such as investment policy for the fund, who values the fund and how this is done, and how the fund will make distributions of income.

What is a Mutual Fund?

A mutual fund is vehicle that enables a number of investors to pool their money and have it jointly managed by a professional money manager.
The fund is divided into units and each holder is entitled to a proportionate share of the fund. Each "unit holder" has the right to

their share of the assets of the fund and any income that the fund earns. Under tax law, the fund must distribute all of its income each year, to itself avoid taxation. These "distributions" of realized capital gains, interest and dividend income are made as frequently as monthly. Mutual funds are regulated by governments, which ensure that adequate information is available to prospective purchasers and unit holders about the fund characteristics and its performance. The major fund disclosure document is called the prospectus. Each fund is required to be audited and to provide statements to the unit holders. Major changes to the fund require unit holder approval. Mutual funds may invest in practically anything, according to what is provided for in the fund documents. Equity mutual funds invest in the common shares of corporations. Bond or income funds invest in the bonds of governments and corporations. Mortgage funds invest in residential and commercial mortgages. Money market or short-term funds invest in government treasury bills and the corporate commercial paper, all under one year in term. Balanced funds invest in a mixture of bonds, stocks and money market instruments and alter the proportion of these investments according to the manager's view of these investments.

Types of Mutual Funds

There are two basic types of mutual funds. "Openended" or "Open" mutual funds are the most common type of mutual funds. Investors may purchase units from the fund sponsor or redeem units at the valuation promised in the fund documents, usually on a daily basis. "Closedended" or "Closed" mutual funds are traded as financial securities, once they are issued, and holders must sell their units on the stock market to receive their funds back.

Open Mutual Funds

Open mutual funds are established by a fund sponsor, usually a mutual fund company. The sponsor has promised in the documents of the fund that it will issue and refund or units of the fund at the fund unit value. This type of fund is valued by the fund company or an outside valuation agent. This means that the investments of the fund are valued at "fair market" value, which is the closing market value for listed public securities. Essentially, the fund company prices all of the fund's holdings at the market close and adds up their value; it then subtracts amounts owing and adds amounts to be received by the

fund; and finally it divides this net amount by the number of units outstanding to "strike" the unit value for that day. Any participants withdrawing funds from the fund that day receive this unit value for their funds withdrawn. Any new purchases are made at the same unit value. Open mutual funds keep some portion of their assets in short-term and money market securities to provide available funds for redemptions. A large portion of most open mutual funds is invested in highly "liquid securities", which means that the fund can raise money by selling securities at prices very close to those used for valuations. Funds also have the ability to borrow money for short periods of time to fund redemptions. The documents of open mutual funds usually provide for the suspension of unit redemptions in "extraordinary conditions" such as major interruptions to the financial markets or total demands for redemptions forming a substantial portion of the fund assets in a short period of time. These clauses were invoked in October, 1987, when the stock market crashed 30% in a few days and the volume of stock transactions caused trading activity to be hours out date. Illiquid investments, those not actively traded on the public markets, are restricted by government regulators because they are difficult to dispose of in a short period of time. A fund holding an illiquid investment might not be able to sell it in a short period of time or would have to take a significant discount to the valuation level the fund was using. In Canada, most open real estate mutual funds suspended redemptions during the real estate debacle of the early 1990s. Fund participants did not obtain redeemed funds until these funds were restructured into closed-end funds in the mid 1990s and they could sell their units on the stock market. The valuation of investments that are less liquid and trade infrequently is an important issue for mutual funds.

Closed Mutual Funds

Closed mutual funds are really financial securities that are traded on the stock market. A sponsor, a mutual fund company or investment dealer, will create a "trust fund" that raises funds through an underwriting to be invested in a specific fashion. The fund retains an investment manager to manage the fund assets in the manner specified. A good example of this type of fund are the "country funds" that were underwritten during the international investment euphoria of the early 1990s. An investment dealer would decide that a "Germany" or "Portugal" or "Emerging Country" fund would sell given the popular consensus that these were "no lose" investments. It would then retain a well respected investment advisor to manage the fund assets for a fee and underwrite a public issue that it would sell through retail stock brokers to individual investors. It is interesting to note that many of these funds were caught in the sell-off of the stock market of 1994 and have languished ever since. This has led to the phrase "submerging

country" replacing "emerging market" for many of these funds. This is wry proof of the fickleness of investor fashion! Once underwritten, closed mutual funds trade on stock exchanges like stocks or bonds. Their value is what investors will pay for them. Usually closed mutual funds trade at discounts to their underlying asset value. For example, if the price of the fund assets less liabilities divided by the outstanding units is $10, the fund might trade on the stock market at $9. This fund would be said to be trading at a "10% discount to its net asset value". The reason for this discount is debated by academics, but is due in large part to the lack of liquidity of the fund units and the presence of the management fee.

Other Types Of Investment Funds

There are many other types of investment funds that are quite similar to mutual funds. These look and act like mutual funds but differ in their legal status and nature of their investments. "Pooled funds", for large and sophisticated investors, are unit trusts like mutual funds but fall under prospectus exemptions from securities legislation. "Segregated funds" are really insurance contracts that depend on the value of a portfolio of investments and are legally "variable rate insurance annuity contracts". "Labour Venture Funds" are pools of capital that take advantage of special tax incentives for labour unions to establish investment funds that invest in smaller and start-up businesses. "Royalty Trusts" are closed-ended unit trusts which take the income from a pool of income producing assets and pass this through to investors. For more information on these investment vehicles, click "related articles" below.

Pooled Funds
A "pooled fund" is a unit trust in which investors contribute funds that are then invested, or managed, by a third party. A pooled fund operates like a mutual fund, but is not required to have a prospectus under securities law. Pooled funds are offered by trust companies, investment management firms, insurance companies, and other organizations.

Pooled funds and mutual funds are substantially the same, but differ in their legal form. Like a mutual fund, a pooled fund is a trust that is set up under a "trust indenture". This specifies how the pooled fund will operate and what the duties of the various parties to the trust indenture will be. The trust indenture specifies an investment policy for the pooled fund and how management fees will be charged. Substance Pooled funds, like mutual funds, are "unit trusts". This means that investors deposit funds into the trust in exchange for "units" of the fund, which reflect a pro-rata share of the fund's investments. The fund trust indenture will specify how units are issued and redeemed, as well as, the frequency and procedures for valuations. Pooled funds can be either "closed" or "open". An "open" pooled fund is the most common type of pooled fund, and allows units to be redeemed at scheduled valuations. A "closed" pooled fund does not allow redemptions, except in specific circumstances or at termination of the trust. Closed pooled funds are usually established to hold illiquid investments such as real estate or very specialized investment programs, such as hedge funds.

Form The major difference between pooled funds and mutual funds is their legal status under securities law. Pooled funds are not "public" investments, which means investment and trading in pooled funds is restricted. Securities legislation define the rules for a "public" security. Publicly issued securities must meet certain requirements before issue, particularly in information disclosure through their prospectus, or reporting by issuers. Pooled funds are exempt from prospectus requirements under securities law, usually under the "private placement", or "sophisticated investor", clauses in the Securities Act. This means that investments in pooled funds must be over $150,000. Financial institutions such as banks, trust companies or investment counselling firms are allowed to invest their clients in their own pooled funds, by specific exemptions granted under the Securities Act. Each pooled fund investment must be reported to the relevant Securities Commission. Fees Once a client is invested in a pool fund, the result is identical to being in a mutual fund with the same investment mandate. Fees for pooled funds can either be charged inside or outside the fund. Valuation of

pooled funds can be less frequent, as there tends to be less activity with fewer and more sophisticated pooled fund investors. Pooled fund fees are usually lower than mutual funds, as these funds are created to deal with larger investors. Pooled funds are allowed to charge their expenses from operations against the fund assets, and the trust indenture provides for the sponsor, or trustee, to hire outside agents to perform certain tasks, such as custody and unit recordkeeping.

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What are the types of mutual funds?

Mutual Funds are broadly classified into three categories viz. Equity Funds, Debt Funds and Balanced Funds.
EQUITY FUNDS

These funds invest a major part of their corpus in equities. The composition of the fund may vary from scheme to scheme and the fund managers outlook on various scrips. The Equity Funds are subclassified depending upon their investment objective, as follows:
Diversified Equity Funds Mid-Cap Funds Sector Specific Funds Tax Savings Funds (ELSS)

Equity investments are meant for a longer time horizon. Equity funds rank high on the risk-return matrix.
DEBT FUNDS

These Funds invest a major portion of their corpus in debt papers. Government authorities, private companies, banks and financial institutions are some of the major issuers of debt papers. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. Debt funds are further classified as:

Gilt Funds: Invest their corpus in securities issued by Government, popularly known as GoI debt papers. These Funds carry zero Default risk but are associated with Interest Rate risk. These schemes are safer as they invest in papers backed by Government. Income Funds: Invest a major portion into various debt instruments such as bonds, corporate debentures and Government securities. MIPs: Invests around 80% of their total corpus in debt instruments while the rest of the portion is invested in equities. It gets benefit of both equity and debt market. These scheme ranks slightly high on the riskreturn matrix when compared with other debt schemes. Short Term Plans (STPs): Meant for investors with an investment horizon of 3-6 months. These funds primarily invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of the corpus is also invested in corporate debentures. Liquid Funds: Also known as Money Market Schemes, These funds are meant to provide easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, interbank call money market, CPs and CDs. These funds are meant for short-term cash management of corporate houses and are meant for an investment horizon of 1day to 3 months. These schemes rank low on risk-return matrix and are considered to be the safest amongst all categories of mutual funds.

BALANCED FUNDS

These funds, as the name suggests, are a mix of both equity and debt funds. They invest in both equities and fixed income securities, which are in line with pre-defined investment objective of the scheme. These schemes aim to provide investors with the best of both the worlds. Equity part provides growth and the debt part provides stability in returns. Each category of funds is backed by an investment philosophy, which is pre-defined in the objectives of the fund. The investor can align his own investment needs with the funds objective and invest accordingly.

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