Mutual fund

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A mutual fund is a type of professionally-managed collective investment arrangement that pools money from many investors to purchase securities[1]. While there is no legal definition of mutual fund, the term is most commonly applied only to those collective investment arrangements that are regulated, available to the general public and open-ended in nature.

Investopedia defines a mutual fund as:

An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.[2]

Hedge funds are not considered a type of mutual fund. Index funds are a type of mutual fund.

In Canada, mutual funds are generally structured as either a unit trust (which generally qualifies as a mutual fund trust) or a corporation qualifying as a mutual fund corporation.[3] The regulatory framework that governs mutual funds falls under the jurisdiction of the provinces of Canada and there is no federal framework. Each province and territory has its own securities regulatory standards. A fund must be separately registered in each province or territory in which it wishes to market.[4] Although the legislation varies as between provinces, national policies (instruments) have been established which are applied in all provinces. The standards relate to the marketing and administration of mutual funds as well as the permitted investment activities. In addition, the Investment Funds Institute of Canada (IFIC) publishes guidelines and rules to which its members are expected to adhere.

Mutual funds allows small investors to purchase large blocks of investments at a modest purchase price. Many different investment styles are available. Filters to aid in mutual fund selection can be obtained from Globefund and Morningstar.

At the end of 2011, the mutual fund industry managed $762 billion in assets on behalf of Canadians.[5] By the end of January 2014, the assets under management surpassed the one trillion dollars mark.[6]

Mutual fund investors should be aware of the impact of fees on long-term performance. Mutual fund investors in Canada primarily incur two kinds of fees and expenses to invest in and own mutual funds: sales charges and ongoing fund fees. Sales charges are transaction-based fees that investors pay directly either when they buy the fund or when they sell or redeem from the fund. Ongoing fund fees, which include the management fees and fund expenses (expressed together as the management expense ratio or MER), are paid from fund assets, which means that investors pay these fees indirectly. Embedded within the management fees of most Canadian mutual funds are ongoing trailing commissions paid to advisors.[5] The MERs of ETFs and index funds is typically much lower than those of actively managed funds.[7]

Types of mutual funds

Open-end funds

Open-end mutual funds must be willing to buy back their shares from their investors at the end of every business day at the net asset value computed that day. Most open-end funds also sell shares to the public every business day; these shares are also priced at net asset value. A professional investment manager oversees the portfolio, buying and selling securities as appropriate. The total investment in the fund will vary based on share purchases, share redemptions and fluctuation in market valuation. There is no legal limit on the number of shares that can be issued.[1]

Closed-end funds

Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.[1]

Categorization

Main article: Asset classes

Mutual funds are categorized according to their investment objective. Since 1998 this role has been undertaken by the Canadian Investment Funds Standards Committee (CIFSC) with the self-imposed mandate to standardize the classifications of Canadian-domiciled retail mutual funds.[8]

The CIFSC tracks investment funds on a comprehensive security-by-security holdings basis. For purposes of the category assignment, security types will be grouped into four broad asset classes: Cash, Fixed Income, Equity, and Other.[9]

Fees structure

Surveys show that consumer/investors are generally not aware of the fees, charges and expenses that they pay with respect to investing in investment funds. Part of the reason why consumer/investors are not aware of the fees, charges and expenses that they pay is because the amount they pay is “deducted at source” and all returns are stated on a net basis.[10]

Mutual fund investors should be aware of the impact of fees on long-term performance, which can be examined with the Investor Education Fund's[note 1] Mutual fund fee calculator. A lower-cost alternative to mutual funds can often be obtained with an exchange-traded fund.

All of the fees and charges should be detailed in the mutual fund's prospectus, which a prudent investor should review before making an investment decision. In 2011, the Global Fund Investor Experience 2011[11] study gave Canadian funds an overall score of C, but on Fees and Expenses the score was F, the lowest of all countries.

Sales charges

Mutual funds sales charges typically are one of no-load, front-end load or deferred sales charge (DSC) (also known as back-end load), but there are other classifications, low-load, fee-based and high net worth/institutional.

No-load

A mutual fund that does not charge a fee for buying or selling its units.

Front-end load

A sales charge is levied on the purchase of mutual fund units. The charge is generally a fixed percentage of the gross dollars invested. This charge can be as high as 9%, although most fund companies recommend a maximum of 5% or 6%. The amount is negotiable with your mutual fund representative.

Deferred sales charge

A DSC fund is a mutual fund series that has no commission to purchase but is subject to a fund company charge upon redemption. Typically DSC charges start at around 5% to 7% in the first year, and will decline towards 0% over the next 5 to 7 years. Investors are generally allowed to redeem up to 10% of their DSC funds annually without charge. Investors should also note that although they don't pay a sales commission, their advisor typically receives a commission of 5% of the amount purchased.

Mutual fund assets by purchase option[5]
Sales charge  % of assets
No-load 31
Front-end load 23
Back-end load 19
Institutional 19
Fee-based 3
Low-load 5

Management fees

A Management Expense Ratio (MER) is the percentage of a mutual fund’s average net assets paid out of the fund each year to cover the day-to-day and fixed costs of managing the fund.

Specifically, the MER represents the combined costs of two main services: investment management services provided to the fund and its investors by the fund company; and financial advice and planning services provided by the investor’s advisor. Management fees comprise approximately 40 percent of the total MER, while the dealer advisor compensation (also known as trailer fees) comprises another 40 percent. The fund company’s administrative costs--including legal and accounting fees, brokerage fees and interest expenses--as well as HST/GST costs comprise the remaining 20 percent of MER fees.

MERs range from less than one per cent per year (usually for certain low risk investments such as some money market funds) to more than three per cent (usually involving equity funds primarily comprising Canadian and international stocks).[12]

Typical Management Fee[5]
Asset class Median fee Average fee (asset-weighted)
Money market 1.00 0.89
Fixed income 1.50 1.38
Balanced 1.95 1.82
Equity 2.00 1.91

Chasing performance

Investors often select actively managed funds based on past performance. In doing so, they hope that good performance of the selected funds will continue in the future. Unfortunately this is rarely the case over the long term. For example, in one Vanguard study, Canadian equity funds were ranked in terms of excess returns versus their stated benchmarks, over five years to 2008. Then the fate of the funds in the top quintile (the "best" 20%) was examined over the next five years (to 2013). Only 23% remained in the top quintile, whereas 17% fell to the bottom quintile (i.e. the worse 20%). [7]

Impact of dividends on NAV (net asset value)

What happens to the dividends paid to the mutual fund by companies whose shares the mutual fund holds? Those dividends form part of the income of the mutual fund, and increase the fund's net asset value (NAV). They are usually aggregated, the fund is paid its MER, and the remainder is then paid out to holders of the mutual fund in the form of dividends from the mutual fund.

Distributions

Mutual funds distribute their capital gains at year end, typically in December. The exact date varies by fund company and year-over-year. The Income Tax Act (Canada) states that mutual funds must distribute their net income and any net realized capital gains earned within the fund to unitholders in order to prevent the fund itself from incurring a tax liability.[13]

If you buy the fund shortly before the distribution is declared, you’ll be required to pay the taxman, even though you didn’t own the fund while it was earning those gains during the year. Keep in mind, this is only an issue if you’re investing in a taxable account; if you hold your funds inside a Registered Retirement Savings Plan or Tax-Free Savings Account, the question is moot.[14] By deferring your investment decision until after the distribution, you may be missing out on the market movement while not invested.[15]

What happens to the distributions paid out by the mutual fund to its unit holders? The NAV of the fund decreases by the amount of the distribution paid out. Some unit-holders choose to DRIP, i.e. use the distributions to buy more units. The extra number of units just cancels out the drop in NAV, and the unit holder is left as before, except for some accounting.

Regulation

Currently, each province and territory in Canada regulates the distribution and sale of mutual funds and other securities in its jurisdiction through a government agency, usually known as a securities commission.

It is important to remember that securities law may differ among jurisdictions.[16]

Size of the industry

There are approximately 117 fund companies and 2946 available funds, with total assets under management of over one trillion dollars as of January 31, 2014.[6]

See also

Notes

  1. Investor Education Fund develops and promotes unbiased, independent financial information, programs and tools to help consumers make better financial and investing decisions. It was established as a non-profit organization by the Ontario Securities Commission (OSC) and is funded by settlements and fines from OSC enforcement proceedings.

References

  1. 1.0 1.1 1.2 Wikipedia, Mutual fund, viewed July 27, 2012.
  2. Investopedia, Mutual Fund Definition, viewed July 27, 2012.
  3. KPMG Canada Taxation FUNDS AND FUND MANAGEMENT 2010, viewed December 15, 2013.
  4. KPMG Survey Report, [Fund management survey: Canada – Regulation | KPMG | GLOBAL, dated 6/25/2013, viewed December 15, 2013.
  5. 5.0 5.1 5.2 5.3 CANADIAN SECURITIES ADMINISTRATORS DISCUSSION PAPER AND REQUEST FOR COMMENT 81-407 MUTUAL FUND FEES. Viewed December 13, 2012.
  6. 6.0 6.1 Canadians build financial security with one trillion dollars in mutual funds | IFIC.ca, viewed February 20, 2014.
  7. 7.0 7.1 Philips et al., The case for index-fund investing for Canadian investors, Vanguard Research, July 2014, viewed February 3, 2015
  8. Canadian Investment Funds Standards Committee, About CIFSC, viewed July 27, 2012.
  9. Canadian Investment Funds Standards Committee, www.cifsc.org/en/CIFSC 2012 Category Definitions_Revisions.pdf, viewed July 27, 2012.
  10. Glorianne Stromberg, Investment Funds in Canada and Consumer Protection: Strategies for the Millennium., viewed July 30, 2012.
  11. Morningstar, Global Fund Investor Experience 2011, viewed July 27, 2012.
  12. IFIC, IFIC - Media Backgrounder on Management Expense Ratios, viewed July 30, 2012.
  13. Phillips, Hager and North, Understanding the Mysteries of Mutual Fund Taxation, published August 14, 2006. Viewed December 15, 2013.
  14. The Globe and Mail, Hidden pitfalls of that year-end gift from your mutual fund, viewed July 30, 2012.
  15. The December dilemma: Should you buy funds before or after the year-end distribution? from National Post by Jamie Golombek, viewed July 30, 2012.
  16. Investment Funds Institute of Canada, IFIC - Regulation of Mutual Funds, viewed July 27, 2012.

External links