INVESTMENTS:

AnalysisandManagement
ThirdCanadianEdition

W. Sean Cleary
Charles P. Jones
Prepared by
Khalil Torabzadeh
University of Lethbridge

Chapter 3
Investments
Funds

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

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

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

Figure 3-1Total Net Assets-Canadian Mutual

Funds ($billions) 1989 to 2007

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

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

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

Unit Investment Trust

Unit Investment Trust: an unmanaged, fixedincome 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

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

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

Types of Mutual Funds

1. Money Market Funds

Objectives of income and liquidity

Investments include short-term money market
instruments
Attractive to investors seeking low risk and high liquidity

2. (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

Types of Mutual Funds (contd)

3. (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

4. 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

Types of Mutual Funds (contd)

5. 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)

6. 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

Types of Mutual Funds (contd)

7. (a) Real Estate Funds

Invest in income-generating properties for longterm 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

Types of Mutual Funds (contd)

8. 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.

9. 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

Types of Mutual Funds (contd)

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:
1.Money market
2.Mortgage
3.Bond
4.Balanced
5.Dividend
6.Equity
7.Real estate
8.Specialty
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

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

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 funds board

Disclosure of objectives to investors through
a prospectus

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

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

Figure 3-3 Mutual Funds Assets

(October 2007)

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

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

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

Canadian-Based ETFs

I-60s

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

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

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

Differences between ETFs and Mutual

Funds
ETFs

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

Other Funds
Segregated funds

Provide death benefits

Must guarantee a minimum percentage (75% is
required, 100% is usually offered) of investors
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 owners death, assets may be transferred to
beneficiaries without being subject to probate fees

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 3

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

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

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

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

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

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