Chapter 5 - Mutual Funds: Overview
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 manager, who is compensated for the
Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.
One of the reasons for the proliferation of mutual funds and fund types is that mutual funds have become
Created and marketed to the public in ways that are intended to promote buyer appeals
5.1 – Advantages and Drawbacks of Mutual Fund Investing
o When investing in a mutual fund, you are investing in a portfolio, or basket of securities
o Diversification of mutual funds = reduced risk but doesn’t eliminate risk
o Because a mutual fund might invest in hundreds (or thousands) of securities
o If the value falls to zero, the decline will have a small impact on the mutual fund value
o The mutual fund manager makes the decision of when to add or remove particular securities from the
o As the investor holding the mutual fund, do not have to make these crucial decisions
Minimum Initial Investment
o Most funds have a minimum initial purchase of $2500, but some are as low as $1000
o After initial purchase, subsequent purchases are sometimes as low as $50
o Amounts vary from fund to fund
o Value of you mutual fund investment, unlike bank deposit, could fall and be worth less than your initial
o No gov’t or private agency guarantees the value of a mutual fund
o Due to diversification, one limits their chances for large returns if one of these securities increases
dramatically in value
o Investing in mutual funds entails fees and expenses that do not usually accrue when purchasing
individual securities directly
5.2 - Investment Companies and Fund Types
An Investment company is business that specializes in pooling funds (managing financial assets) from
individual investors and making investments.
All mutual funds are investment companies but not all investment companies are mutual funds
Open-End vs. Closed-End Funds An Open-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at
A Closed-end fund is an investment company with a fixed number of shares that are bought and sold by
investors, only in the open market.
Difference between open vs. close – end
Closed-end fund, the fund itself does not buy or sell shares – 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 then closed-end funds
Mutual fund = open-end funds (strictly)
Sometimes, if an open-end fund gets too big, it will not take in new investors.
It will, however, take more money from its current investors.
Of course, current investors can withdraw money from the fund.
Net Asset Value
Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares.
Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any
In contrast, share value of closed-end funds may differ from their NAV.
The NAV of a mutual fund will change essentially every day simply because the value of the assets held by the
The price you will receive for shares you sell is the NAV
The RBC Canadian Equity Fund has 5365.1 million net assets. It has about 213749 shares outstanding. What is the
5365.1 M/213749 = $25.10
5.3 - Mutual Fund Operations
Organization and Creation
A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors.
Most mutual funds are created by investment advisory firms (say Fidelity Investments) or brokerage firms with
investment advisory operations (say Merrill Lynch).
Investment advisory firms earn fees for managing mutual funds.
Taxation of investment companies
• Treated as ‘flow-through entity’ for tax purposes as long as all CRA rules are met
o Important because mutual fund does not pay taxes on its investment income
o The fund passes through all realized investment income to fund shareholders, who then pay taxes on
these distributions as thought they owned the securities directly
The Fund Prospectus and Annual Report
Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares.
Mutual funds must also provide an annual report to their shareholders.
5.4 – Mutual Fund Costs and Fees
Types of Expenses and Fees
Sales charges or “loads”
Front-end loads are charges levied on purchases.
Can range as high as 8.5% typically it would be 5%
2% - 3% low-load funds
A sales charge levied on purchases of shares in some mutual funds. When you purchase shares
in a load fund, you pay a price in excess of the NAV, called the offering price. The difference
between the offering price and the NAV is the load. Shares in no-load funds are sold at NAV.
Funds that charge loads are called load funds
Back-end loads are charges levied on redemptions.
Often called deferred sales charges (DSC)
Declines through time Special Fees
Charged for certain funds and under certain conditions like
Annual RRSP, RRIF, or RESP trustee fee
Account set-up fee
Short-Term trading fee
Usually range from 0.25% to 1.00% of the funds total assets each year.
Are usually based on fund size and/or performance.
Not reported directly
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
Funds must report "turnover," which is related to the amount of trading.
The higher the turnover, the more trading has occurred in the fund.
The more trading, the higher the trading costs.
Mutual funds are required to report expenses in a fairly standardized way in their prospectus.
Shareholder transaction expenses - loads and deferred sales charges.
Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director
Funds report a hypothetical example showing total expenses paid by investors per $10,000 invested.
Why Pay Loads and Fees?
After all, many good no-load funds exist.
But, you may want a fund run by a particular manager. All such funds are load funds.
Or, you may want a specialized type of fund.
Perhaps one that specialized in Italian companies
Loads and fees for specialized funds tend to be higher, because there is little competition among
5.5 - Short-Term Funds
Short-term funds are collectively known as money market mutual funds.
Money Market Mutual Funds
Money market mutual funds (MMMFs) are mutual funds specializing in money market instruments.
MMMFs maintain a $1.00 net asset value to make them resemble bank accounts.
There is no guarantee that the net asset value will be $1.00 or more.
A Net Asset Value for a MMMF under $1.00 results in the term, “breaking the buck.”
Following the Crash of 2008, a few MMMF “broke the buck.”
Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.
The distinction is that a bank money market account is a bank deposit and offers CDIC protection.
5.6 - Long-Term Funds
There are many different types of long-term funds, i.e., funds that invest in long-term securities.
Historically, mutual funds were classified as stock funds, bond funds, or balanced funds.
Today, the investment objective of the fund is the major determinant of the fund type.
Some stock funds trade off capital appreciation and dividend income.
Capital appreciation – invest in companies that have, in the opinion of the fund manager, the nest
prospects for share price appreciation without regard to dividends, company size, or, for some funds,
country Main goal
Investing in unproven companies or perceived out-of-favour companies
Growth – tend to invest in larger, more established companies
Somewhat less volatile as a result
Dividends are not an important consideration
Growth and Income – with capital appreciation being the main goal, dividend –paying companies are part
of the focus
Equity income – funds focus exclusively on stocks with relatively high dividend yields which maximizes
the current income on the portfolio
Some stock funds focus on companies in a particular size range.
Small company -
Some stock fund invest internationally.
Sector funds specialize in specific sectors of the economy, such as:
Other fund types include:
Social conscience, or “green,” funds
“Sin” funds (i.e., tobacco, liquor, gaming)
Bond funds may be distinguished by their
Bond fund types include:
Short-term and intermediate-term funds
Stock and Bond Funds
Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid”
Asset allocation funds
Convertible funds Income funds
Target Date Funds (also known as Lifecycle Funds)
The asset allocation chosen by target date funds is based on the anticipated retirement date of the
investors holding the fund.
If a company offers a Target Date 2040 Fund, the fund is for people planning to retire in about 2040.
In 2011, say, this fund would have a large equity exposure.
In 2039, say, this fund would have a large bond exposure.
5.7 - Mutual Fund Performance