Finance
Module 14
Investment Companies
Outline
Investment Companies
Closed-End Investment Companies
Open-End Investment Companies
Different Types of Investment Funds
Pricing of Investment Funds
Fee Structure of Investment Funds
Regulation
Growth in Investment Funds
Hedge Funds
Exchange-Traded Funds
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Investment Companies
Investment companies pool money from numerous individual investors and it to purchase securities.
This is a form of indirect investing.
The investors “own” the securities issued by IBM only indirectly through the investment company Windsor Funds.
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IBM
Windsor Funds
Investors
$
$
shares
securities
Investment Companies Organizational Structure
Directors or trustees
Represent shareholders and hire people to operate the fund
Fund managers
Decide how and when to invest based on fund objectives
Fund distributors
Help sell shares to investors
Other service providers
Internal parties (marketing, legal, reporting units)
External parties (custodian, transfer agent and independent public accountant)
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Investment Companies Organizational Structure
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Shareholders
(Owners)
Board of Directors
(oversee the fund’s activities)
Fund Manager
(handle investment)
Brokers or Dealers
(sell shares)
Internal Administrator
(follow rules)
Custodian
(collect/distribute cash)
Closed-End Investment Companies
Closed-end investment companies issue shares only at start-up to invest in the securities and assets of other firms.
Reinvest proceeds and borrowings in a portfolio to earn income and capital gains.
A fixed supply of outstanding shares are traded OTC or on stock exchanges.
In 2019, about $265 billion was managed by closed-end companies.
Example: RioCan Real Estate Investment Trust (REIT)
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Open-End Investment Companies
Open-end investment companies (mutual funds) constantly sell new shares to the public and use the proceeds to manage a portfolio of securities.
Right of redemption is the most distinguishing feature of open-end investment companies.
Number of shares in existence varies based on net sales and redemptions.
In 2019, about 140 open-end investment companies handled more than 4,000 funds.
Mutual fund investments rose to $1.71 trillion in 2020.
By setting up their subsidiaries, banks and insurance companies are major players in the industry.
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Open-End Investment Companies
| Mutual Fund Company | Parent Company |
| BMO Investments | Bank of Montreal |
| CIBC Securities | CIBC |
| Royal Mutual Funds | Royal Bank |
| Scotia Securities | Scotiabank |
| TD Investment Services | TD Canada Trust |
| Manulife Investment Management | Manulife Financial Group |
| Sun Life Capital SLC Management | Sun Life Financial Group |
| AGF Investments | Independent |
| Fidelity Investments Canada | Fidelity Investments, U.S. |
| Franklin Templeton Investments | Franklin Templeton Investments, U.S. |
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Different Types of Investment Funds
There are two basic types of investment funds available to investors.
Long-term funds
Bond funds, Equity funds, Balanced funds and Specialty funds
Short-term funds
Money market funds
Investment Funds Standards Committee (1998) provides a complete 35 categories listing for investors and industry standardization.
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Different Types of Investment Funds
IFSC mutual fund categories (partially selected classes):
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| Alternative Strategies | Global Equity |
| Asia/Pacific Rim Equity | Healthcare |
| Canadian Dividend | Labor Sponsored Venture Capital |
| Canadian Small Cap | Natural Resources |
| Emerging Markets Equity | Precious Metals |
| European Equity | High Yield Bond |
| Financial Services | US Equity |
| Foreign Bond | US Money Market |
Different Types of Investment Funds
A mutual fund typically focuses on specific types of investments.
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| Type | Investment Mix |
| Money market | Short-term fixed income securities (e.g., treasury bills) |
| Fixed income | Fixed income securities (e.g., government, corporate bonds) |
| Equity | Equity shares (e.g., stocks or income trust units) |
| Balanced | A mix of equities and fixed income securities |
| Global | Foreign equities or fixed income securities |
| Specialty | Aim at specific areas (e.g., Asia or information technology) |
| Index | Mimic a specific index (e.g., S&P/TSX Composite Index) |
| Fund of funds | Other mutual funds |
Pricing of Investment Funds Open-End Fund
Open-end fund: shares can be redeemed at any time at a price that is tied to the fund’s net asset value (NAV).
NAV is the total value of the fund’s assets minus any liabilities, divided by the number of shares outstanding.
NAV is the price investors get when selling shares back to the fund that day or buying any new shares in the fund that day.
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Pricing of Investment Funds Example: NAV
Assets:
Stocks: $35m
Bonds: $15m
Cash: $3m
Total value of assets = $53m
Accrued fees: $0.8m
Total value of liabilities = $0.8m
Net worth = $52.2m = $53m − $0.8m
Outstanding shares: 15m
Thus, NAV = $52.2m/15m = $3.48 per share
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Pricing of Investment Funds Closed-End Fund
Closed-end fund: shares are non-redeemable and sold with an amount fixed at the initial offering.
Example: real estate investment trusts (REIT)
In Canada, closed-end funds are far less popular than their open-end counterpart.
Investors must trade among themselves in the market, just like with corporate stocks.
Price of the shares may be at either a premium or a discount to the fund’s NAV depending on supply and demand conditions.
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Fee Structure of Investment Funds
Investment funds are classified based on the types of sales commission (i.e., load) charged.
Load funds charge a commission on the purchase and/or sale of shares.
Front-end load fund: fee is paid at the time of purchase
Back-end load fund: fee is paid at the time of sale
Fees reduce return on the investment
No-load funds do not apply direct sales charges.
Funds sell directly to the public (bypassing brokers) with no sales fees.
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Fee Structure of Investment Funds Example: Loads
An investment fund has a NAV of $10 and a 3.75% front-end load.
As load is assessed as a percentage of premium paid into the fund, therefore purchase price = $10/(100% − 3.75%) = $10.39
$0.39 is 3.9% = $0.39/$10 of the net amount invested.
A fund has a NAV of $10 and a 5% back-end load with a selling price = $10 × (100% − 5%) = $9.50
$0.5 is 5.26% = $0.5/$9.5 of the net amount received.
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Fee Structure of Investment Funds
Other fees in addition to sales commissions may also be charged to investors.
Early redemption fees, switching fees and account activation fees
Some fees are not directly paid out by investors:
Management fee is paid to fund managers.
Operating expenses include all fees payable for overseeing the fund, in particular sales professionals.
Summarized by a management expense ratio (MER) and expressed as a percentage of NAV.
Trailer fee is paid to the selling organizations.
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Fee Structure of Investment Funds Example: Mutual Fund Operation
Total net assets = $4,000 (beginning) and $4,800 (ending).
Management fee and operating expenses (excluding brokerage fee) = $35.
Brokerage fee = $53
MER = [(Aggregate fees and expenses payable during the year)/(Average NAV for the year)] × 100%
MER = (35+53)/[(4,000+4,800)/2] = 88/4,400 = 2%
If a fund earns a gross return of 20%, with a MER of 2%, it will report an annual return of 18%.
Published rates of return are calculated after deducting the MER.
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Regulation
Most investment companies are regulated by the securities acts of the provinces within which they operate.
E.g., Ontario Securities Commissions in Ontario
Securities regulations are based on the principles of personal trust, disclosure and enforcement required by Canadian Securities Administrators (CSA):
Registration requirements
Prospectus requirements
Fund operations and sales conduct
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Regulation
Each investment company is a members of a self regulating organization (SRO):
Investment Industry Regulatory Organization of Canada (IIROC) is a national SRO.
Dealer/advisor must be a member to sell mutual funds.
Mutual Funds Dealer Association of Canada (MFDA) is the national SRO overseeing mutual dealers
Regulates its members’ distribution of investment funds, but not their management.
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Regulation
Investors must file a claim within 180 days after the firm declares bankruptcy.
Investment funds are covered by either of the following:
Canadian Investor Protection Fund (CIPF): provides protection of up to $1 million to eligible customers of a member of IIROC.
MFDA Investor Protection Corporation (IPC): provides protection of up to $1 million to eligible customers of MFDA members.
These funds do not cover losses from other causes (e.g., changing market values of securities, unsuitable investments the default of an issuer of securities).
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Regulation
Even though investment companies are closely regulated, investor abuses still occur.
Market timing: excessive buying/selling of securities to take advantage of arbitrage opportunities between different markets
Late trading: illegally buying/selling securities submitted after the closing time at that day’s price
Directed brokerage: paying brokerage firms to promote a fund not appropriate for clients
Improperly assessed fees: misrepresenting the fee structure
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Growth in Investment Funds
The barriers to entering the industry are low.
Banks and insurance companies have made their inroads starting from 2013.
Corporations have expanded into investment funds through the holding company structures owning them.
E.g., IGM Financial, Investors Group, Mackenzie Financial are under Power Corp. of Canada.
The retirement markets have fueled investment funds by introducing mutual funds into RRSPs.
Mutual funds account for 64% of RRSP portfolios.
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Growth in Investment Funds
Households hold the vast majority (89%) of investment fund assets.
Retail investors use funds for goals like retirements
This growth also attracts more participation from institutional investors.
Particularly controversial in recent years has been a type of institutional investor called sovereign wealth funds (SWF), state-owned investment funds investing in foreign assets.
Have non-transparent operations.
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Growth in Investment Funds
| Sovereign Wealth Fund Company | Country | Assets |
| Norway Government Pension Funds (1990) | Norway | $922 billion |
| Abu Dhabi Investment Authority (1976) | UAE | $828 billion |
| China Investment Corporation (2007) | China | $814 billion |
| Kuwait Investment Authority (1953) | Kuwait | $592 billion |
| SAMA Foreign Holdings | Saudi-Arabia | $514 billion |
| HK Monetary Authority Investment Portfolio (1993) | Hong Kong – SAR | $457 billion |
| SAFE Investment Company (1997) | China | $441 billion |
| Government of Singapore Investment Corp. (1981) | Singapore | $350 billion |
| Qatar Investment Authority (2005) | Qatar | $335 billion |
| China’s National Social Security Fund (2000) | China | $295 billion |
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Hedge Funds
No legal definition exists.
Limited partnerships targeting small number of “sophisticated” individuals whose wealth exceeds $1 million or corporations of $5 million net assets.
Not subject to regulatory requirement, generally sold without prospectus, only through offering memo.
Fund managers have great flexibility in managing their assets with alternative investment strategies.
Charge both an asset management fee (e.g., 2%) and a performance fee (e.g., 20%).
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Hedge Funds
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| Top Ten Canadian Hedge Funds Honoured by Alternative IQ |
| Agilith North American Diversified Fund |
| Blair Franklin Global Credit Fund |
| CC&L Absolute Return Fund |
| Exemplar Canadian Focus Portfolio |
| JM Catalyst Fund |
| King & Victoria Fund LP |
| PH&N Absolute Return Fund |
| ROMC Fund |
| Vertex Managed Value Portfolio |
| Vision Opportunity Fund LP |
Hedge Funds Investment Strategy
Unlike mutual funds, a hedge fund's investment universe is only limited by its mandate.
A hedge fund can basically invest in anything, including land, real estate, stocks, derivatives, and currencies.
More risky because of the investing style.
Non-directional: bet only on relative performance
Event driven: seek to profit from price imbalances
Opportunistic: take advantage of special situations
Leverage: use borrowed money to amplify returns
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Hedge Funds
Comparing mutual funds (MF) to hedge funds (HF):
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| Characteristic | MF | HF |
| Sales charges | Yes | Yes |
| Sold by licensed dealers | Yes | Yes |
| Use of derivatives | Limited | Yes |
| Sold through prospectus | Yes | No |
| Liquidity | High | Low |
| Performance fee | No | Yes |
| Return measurement | Relative | Absolute |
| Regulatory Oversight | Heavy | Light |
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Exchange-Traded Funds
Exchange-traded funds (ETFs) are investment funds traded on stock exchanges.
Like mutual funds, an ETF is a collection of bonds or stocks. Unlike open-end funds, ETFs have a fixed number of shares.
Like a stock, buy/sell on the markets.
Margin purchase and short sales are allowed.
As ETF share price changes throughout the day, ETF share values stay pretty close to their NAVs.
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Exchange-Traded Funds
ETFs are designed for active traders.
ETFs differ from mutual funds in several ways:
They are traded throughout the day on exchanges.
They have lower management fees.
They allow short selling.
They may be purchased on margin varying among dealers.
They have lower portfolio turnover with restricted capital gains, in turn reducing taxes.
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Exchange-Traded Funds
The first ETF was created and traded on TSX in April 1990 with a simple design of tracking the major stock indexes.
Mutual fund dealers are legally permitted to sell ETFs in Canada.
ETFs used to be a microscopic share of the dealers' client assets, but fast-forward developed in the last 10 years.
Today, investors are no longer confined to using broad-market index funds.
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Exchange-Traded Funds
The strong growth of ETFs lies in the specialty or sector funds.
Rather than passively tracking a benchmark, specialty ETFs use strategies to select stocks with certain characteristics (e.g., high dividend yields).
Higher cost is the drawback, as ETFs are typically inactively managed, keeping a low MER
Of the $40 billion invested in Canadian ETFs, only about $1 billion is in actively managed ETFs.
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Exchange-Traded Funds Canadian Example
BMO 2020 Corporate Bond Target Maturity ETF
Ticket: ZXC
Company Name: BMO Asset Management
Strategy: Active
Category: Fixed income
CIFSC Category: 2020 target date portfolio
Inverse: No
Leverage: No
Trailers Paid: No
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