Canadian Investments II - Study Notes
Canadian Securities Course - Volume 2 (FIN 2062, Fall 2025)
Instructor: Robert Symmons, Professor at School of Accounting and Finance
Chapter 18: Types and Features of Mutual Funds
Part 1: Types of Mutual Funds
Main Groups of Mutual Funds:
Money Market Funds:
Invest in cash and near-cash securities.
Fixed-Income Funds:
Invest in bonds and mortgage securities.
Balanced Funds:
Invest in both stocks and bonds to provide growth and income.
Equity Funds:
Invest mainly in common stocks for long-term capital growth.
Commodity Funds:
Invest in physical commodities or derivatives.
Specialty Funds:
Focus on a specific industry or region.
Alternative Funds:
Focus on short selling or leverage.
Money Market Funds
Liquidity Maintenance:
Hold Treasury bills, commercial paper, and short-term bonds.
Very low-risk: Safety of principal and liquidity, but earn a very low rate of return.
Must maintain minimum weighting of 95% of assets in cash or cash-equivalent securities.
Interest Rate Risk:
Rapid increase in interest rates can reduce the value of shares.
Net Asset Value per Share (NAVPS):
To keep NAVPS constant (e.g., $10), the net income of the fund is recalculated daily and credited to unitholders.
Earned interest can be either paid out as cash or reinvested in additional shares.
Distributions taxed as interest income if held outside of registered plans (e.g., RRSP).
Fixed-Income Funds
Investment Focus:
Generate income and provide safety of principal rather than capital appreciation.
Must invest 95% of their non-cash assets in fixed-income securities, primarily high-quality government and corporate debt.
High-Yield Funds:
Invest in bonds with a non-investment-grade credit rating.
Volatility:
Related to fluctuations in interest rates; managers adjust portfolio duration and bond mix based on this.
Main risks include interest rate volatility and default risk.
Returns:
Interest income and capital gains if the fund sells bonds at a profit.
Balanced Funds
Portfolio Composition:
Provides safety, income, and capital appreciation by holding both stocks and bonds.
Managers adjust the percentage of each based on current market conditions and future expectations.
Typical Weighting:
60% equity, 40% bonds; range from 5% to 90% equity and 10% to 95% fixed-income.
Asset Allocation Funds:
Similar objectives but without minimum amounts in specific asset classes.
Managers shift portfolio weighting among equity, money market, and fixed-income securities based on market conditions.
Equity Funds
Objective:
Generate long-term capital growth by holding common shares, requiring a minimum of 90% of non-cash assets in equities.
Volatility:
Higher than fixed-income funds and subject to market and foreign exchange risk (if investing outside of Canada).
Types of Equity Funds:
Conservative: Blue-chip stocks.
Aggressive: Emerging markets.
Speculative: Biotechnology.
Small and Mid-Cap Equity:
Focus on higher growth but with higher risk.
Small caps: Market capitalization under $1 billion.
Mid-caps: Market capitalization under $9 billion.
Distributions typically in the form of capital gains due to reinvestment by firms into expansion.
Dividend Funds:
Provide tax-advantaged income with potential for capital growth.
Invest in preferred shares and high-quality common shares.
Interest changes impact preferred shares while market risk affects common shares.
Index Funds:
Designed to match the performance of a market index.
Invest in stocks in proportion to their weighting in the index, associated with low fees and market risk.
Commodity Funds:
Invest in physical commodities or derivatives.
Exposure limited to less than or equal to 100% through leverage.
Specialty Funds:
Focus on specific areas to achieve above-average returns (e.g., real estate funds, ethical funds).
Alternative Funds:
Employ strategies such as short selling, high leverage, and hedging.
Target-Date Funds
Based on a life-cycle approach, assuming risk tolerance declines with age.
Investors select maturity dates aligned with specific life goals, e.g., retirement funding for 40 years.
Asset allocation changes to reduce risk approaching maturity (“glide path”): Starts at 70% equity and 30% fixed income, ending at 20% equity and 80% fixed income.
Part 2: Fund Management Styles
Categories:
Passive: Involves indexing to a market or benchmark.
Active: Aims to outperform market benchmarks.
Passive Fund Manager Styles:
Indexing:
Passive investment style replicating a market benchmark (e.g., S&P 500), characterized by low costs and a long-term buy-and-hold strategy.
Closet Indexing:
Strives to stay close to market weighting without fully replicating strategies.
Part 3: Redeeming Fund Units
Mutual funds generate taxable income through distributions of interest, dividends, and capital gains realized by the fund.
Capital Gains Tax:
May apply even without selling mutual funds due to realized profits in fund assets.
Capital losses not passed on to unitholders can offset future capital gains.
Example of Tax Trigger:
Buy fund unit for $30, receive $6 capital gain at year-end, and NAVPS drops to $24.
Tax Calculation:
$24 NAVPS + $6 gain = $30; thus, capital gain tax of $1.20 if in 40% bracket.
Adjusted Cost Base (ACB):
Reinvesting dividends changes average cost.
Example of selling fund units: If bought for $10,000, reinvested income reflects on actual capital gains when sold at $18,000.
Total capital gain calculated as: $18,000 - ($10,000 + amount reinvested).
Withdrawal Plans:
Ratio Plan: Redeems a specified percentage (e.g., 10%) annually.
Fixed-Dollar Plan: Redeems a fixed amount (e.g., $10,000) each year.
Fixed-Period Plan: Collapses over several years (e.g., 25% in year 1, up to 100% in year 4).
Life Expectancy Plan: Adjusts withdrawals based on remaining capital and revised life expectancy.
Suspension of Redemptions:
Possible in cases of market-wide trading suspensions or issues with securities held by the fund.
Part 4: Measuring Performance
Types of Performance Measurement:
Absolute Performance: Gain in NAVPS from beginning to end of the period.
Comparative Performance: Relative performance against an appropriate benchmark index (e.g., TSX).
Time-Weighted Return: Average return for each sub-period with cash flows.
Performance Calculations:
Daily Valuation Method: Incremental value changes assessed daily.
Modified Dietz Method: Assumes constant rate of return through the period:
MV{End} - MV{Beg} - Cash ext{ }Flows = MV_{Beg} - (Sum ext{ }of ext{ }CF imes Weight)
Standard Performance Data:
Compounded annual returns tracked for 1, 3, 5, and 10 years, including inception returns.
Money market funds’ current yield and effective yield included.
Comparison Guidelines:
Ensure that comparison frames match (e.g., 1-year vs. 5-year).
Do not compare dissimilar funds (e.g., bond vs. equity fund).
Assess funds with similar risk profiles (e.g., high volatility growth vs. conservative income).
Be aware of asset allocation despite fund names (e.g., Canadian equity fund with foreign investments).
Volatility Indicators:
Standard Deviation: Indicates future potential volatility.
Beta: Correlates change in fund price with overall market changes.
Track historical data on years of negative performance, and best/worst periods for clearer understanding.
Pitfalls to Avoid:
Past performance not indicative of future performance.
Historical performance should be viewed critically if fund management changes.
Beware of survivorship bias in average returns, which may artificially inflate results due to discontinuation of poor-performing funds.
Summary of Key Points
Types of Mutual Funds:
Cash, fixed income, balanced, and equity funds.
Management Styles:
Value vs. growth; passive vs. active management.
Tax Consequences:
Calculate adjusted cost base for capital gains impacts.
Withdrawal Plans:
Options include ratio, fixed-dollar, and fixed-period plans.