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Chapter 5

FIN 501 Chapter Notes - Chapter 5: Net Asset Value, Defined Contribution Plan, Investment Advisory

Course Code
FIN 501
Edward Blinder

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Chapter 5: Mutual Funds
Mutual funds are simply a means of combining or pooling the funds of a large group of investors
The buy and sell decisions for the resulting pool are then made by a fund managers, who is compensated for the
service provided
Since mutual funds provide indirect access to financial markets for individual investors, they are a form of
financial intermediary
One of the reasons for proliferation of mutual funds and fund types is that mutual funds have become consumer
They are created and marketed to the public in ways that are intended to promote buyer appeal
Defined benefit plans are rapidly being replaced by “defined contribution” plans
With a defined contribution plan, your employer will contribute money each pay period to a retirement
account on your behalf, but you have to select where the funds go
With this, the benefit you ultimately receive depends entirely on how your investments do; your
employer only makes contribution
You must choose from a group of mutual funds for your investments, so it is very important that you
understand the different types of mutual funds, as well as their risk and returns
5.1 Investment Companies and Fund Types:
Investment Company: a business that specializes in pooling funds from individual investors and
investing them (specializes in managing financial assets for individual investors)
All mutual funds are investment companies but not all investment companies are mutual funds
Open-End versus Closed-End Funds:
- Whenever you invest in a mutual fund, you do so by buying shares in the fund
- Open-End Fund: an investment company that stands ready to buy and sell shares at any time
o When an investor wishes to buy open-end fund shares, the fund simply issues them and then
invests the money received
o When someone wishes to sell open-end fund shares, the fund sells some of its assets and
uses the cash to redeem the shares
o With an open-end fund, the number of shares outstanding fluctuates through time
- Closed-End Fund: an investment company with a fixed number of shares that are bought and sold
only in the open stock market
o Number of shares is fixed and never changes
o If you want to buy shares, you must buy them from another investor
o If you wish to sell shares that you own, you must sell them to another investor
- Key difference is that, with a closed-end fund, the fund itself does not buy or sell shares
- Shares in closed-end funds are listed on stock exchanges just like ordinary shares of stock, where
their shares are bought and sold in the same way
- Open-end funds are more popular among individual investors than closed-end funds
- The term “mutual fund” actually refers only to an open-end investment company
- The term “investment company” has all but disappeared from common use, and investment
companies are now generally called mutual funds
Net Asset Value (NAV): the value of assets less liabilities held by a mutual fund, divided by the number
of shares outstanding
- With one important exception (money market mutual funds), the net asset value of a mutual fund
will change essentially every day simply because the value of the assets held by the fund fluctuates
- An open-end fund will generally redeem or buy back shares at any time. The price you receive for
shares you sell is the net asset value
- Because the shares of closed-end funds are bought and sold in the stock markets, their share prices
at any point in time may or may not be equal to their net asset values

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5.2 Mutual Fund Operations:
Mutual Fund Organization and Creation:
- A mutual fund is simply a corporation
- Like a corporation, a mutual fund is owned by its shareholders, the shareholders elect a board of
directors; the board of directors is responsible for hiring a manager to oversee the fund’s operation
- Although mutual funds often belong to a larger “family” of funds, every fund is a separate company
owned by its shareholders
- Most mutual funds are created by banks or by investment advisory firms, which are businesses that
specialize in managing mutual funds
- Investment advisory firms are also called mutual fund companies
- Increasingly, such firms have additional operations such as discount brokerages and other financial
- In Canada, different mutual funds are offered by banks, insurance companies, and investment
advisory firms
- The largest provided is the RBC Asset Management Inc. with more than 50 million different mutual
funds and $80 billion in assets under management
- Investment advisory firms create mutual funds because they wish to manage them to earn fees
- A typical management fee might be 1.5% of the total assets in the fund per year
- Example: A fund with a $200 million in assets would not be large but nonetheless generate
management fees of $3 million per year
- The significant economic incentive to create funds and attract investors to them
- An investment advisory firm such as RBC can (and often will) create new funds from time to time
- Through time, this process leads to family of funds all managed by the same advisory firm
- Each fund in the family will have its own fund manager, but the advisory firm will generally handle
the record keeping, marketing, and much of the research that underlies the fund’s investment
- In principle, the directors a mutual fund in a particular family, acting on behalf of the fund
shareholders, could vote to fire the investment advisory firm and hire a different one (rarely occurs)
- Unhappy shareholders generally “vote with their feet”- that is, sell their shares and invest elsewhere
Taxation of Investment Companies:
- As long as an Investment Company meets certain rules set by the Canada Revenue Agency, it is
treated as a “flow-through entity” for tax purposes
- This is important because a mutual fund does not pay taxes on its investment income
Funds Bond
Funds Blended
End Funds

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- Instead, the mutual fund passes through all realized investment income to fund shareholders, who
then pay taxes on these distributions as though they owned the securities directly
- The fund simply acts as a conduit, funneling gains and losses to fund owners
The Fund Prospectus and Annual Report:
- Mutual funds are required by law to produce a document known as a prospectus
- The prospectus must be supplied to any investor wishing to purchase shares
- Mutual funds must also provide an annual report to their shareholders
- The annual report and the prospectus, which are sometimes combined, contain financial statements
along with specific information concerning the fund’s expenses, gains and losses, holdings,
objectives, and management
5.3 Mutual Fund Costs and Fees:
All mutual funds have expenses that are paid by the fund’s shareholders
Type of Expenses and Fees: 4 types of expenses/ fees
1. Sales charges or “loads”:
o Front-end load: a sales charge levied on purchases of shares in some mutual funds
o Funds that charge loads are called load funds
o Funds that have no such charges are called no-load funds
o Offering price: when you purchase shares in a load fund, you pay a price in excess of the
net asset value
o Load: the difference between the offering price and the net asset value
o Shares in no-load funds are sold at net asset value
o Front-end loads can range as high as 8.5% but 5% is more typical
o Low-load funds: some funds, with front-end loads in the 2%- 3% range
o Front-end loads are expressed as a percentage of the offering price, not the net asset value
o Some funds have “back-end” loads, which are charges levied on redemptions (these loads
are often called deferred sales charges (DSC) which usually declines over time)
2. Special fees: are charged for certain funds and under certain conditions. These fees include:
1. Annual RRSP, RRIF, or RESP trustee fee
2. Account set-up fee
3. Short-term trading fee
4. Processing fees
3. Management fees:
o Fees are usually based first on the size of the fund
o There is often an incentive provision that increases the fee if the fund outperforms some
benchmark, often the S&P/TSX
o Generally range from 1%- 2% of total fund assets every year
4. Trading costs:
o Mutual funds have brokerage expenses from trading just like individuals do
o Mutual funds that do a lot of trading will have relatively high trading costs
o Trading costs can be difficult to get a handle on because they are not reported directly
o Funds are required to report something known as turnover
o Turnover: a measure of how much trading a fund does, calculated as the lesser of total
purchases or sales during a year divided by average daily assets
o A fund’s turnover is a measure of how much trading a fund does
o A higher turnover indicates more frequent and higher trading costs
Expense Reporting:
- Mutual funds are required to report expenses in a fairly standardized way in the prospectus
- The exact format varies, but the information reported is generally the same
- Figure 5.2: shows the policies and expense statements of the BMO Equity Index Fund (page 133)
Why Pay Loads and Fees?
- Today there are many good no-load funds, and competition among funds is forcing many funds to
lower or do away with loads and other fees
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