Canadian Investments II: FIN 2062 - Fall 2025

Chapter 17: Structure and Regulation of Mutual Funds

• Overview of Chapter Contents:

  • Part 1: Overview of Managed Products

  • Part 2: Overview of Mutual Funds

  • Part 3: Pricing Mutual Fund Units

  • Part 4: Mutual Fund Regulation

  • Part 5: Other Forms and Requirements

  • Part 6: The Know Your Client Rule

  • Part 7: Requirements for Opening and Updating an Account

Part 1: Overview of Managed Products

• Definition:

  • A managed product is a pool of capital gathered to buy securities according to a specific investment mandate.

• Management:

  • The pool seeds a fund which is managed by an investment professional.

• Management Style:

  • The fund may be subject to active or passive management in pooled or separately managed accounts.

• Investment Restrictions:

  • There may be restrictions on the types of securities, concentration, and leverage that the fund can employ.

Examples of Managed Products

• Types of Managed Products:

  • Mutual Funds

  • Hedge Funds

  • Segregated Funds

  • Exchange Traded Funds (ETFs)

  • Private Equity Funds

  • Closed-End Funds

  • Labour Sponsored Venture Capital Corporations (LSVCCs)

Advantages of Managed Products

• Professional Management:

  • Managed by experienced investment professionals.

• Economies of Scale:

  • Pooled investment funds can achieve lower costs compared to individual investments.

• Diversification:

  • Access to a more extensive range of securities, reducing risk.

• Liquidity and Flexibility:

  • Easier to buy and sell units compared to direct security holdings.

• Tax Benefits:

  • Various tax advantages may be available.

• Low-Cost Options:

  • Offers cheaper investment alternatives.

Disadvantages of Managed Products

• Lack of Transparency:

  • Hedge funds are not required to disclose their portfolio holdings.

• Liquidity Constraints:

  • Investors may need to remain invested for a specific period.

• High Fees:

  • Management fees typically around 2% of assets managed plus 20% of profits.

• Volatility of Returns:

  • Use of leverage can enhance both profits and losses.

Part 2: Overview of Mutual Funds

• Definition of Mutual Fund:

  • An investment company that pools money from shareholders and invests it in a variety of securities, including stocks, bonds, and Treasury bills.

• Fund Facts Document:

  • Contains essential information about the fund's investment objectives, degree of risks, types of securities, and historical returns.

Advantages of Mutual Funds

• Professional Management:

  • Continuous management by investment specialists, tailored for specific asset categories such as small-cap funds.

• Diversification:

  • Easier access to a range of securities, allowing for a balanced investment portfolio.

• Flexibility in Fund Types:

  • Investors can switch types (e.g., from a bond fund to an equity fund) with minimal fees.

• Variety of Plans:

  • Options such as lump-sum investments or pre-authorized contribution plans (PACs).

• Liquidity:

  • Ability to redeem shares for cash based on net asset value (NAV).

• Estate Planning Ease:

  • Fund managers continue to manage during the probate process.

• Loan Collateral:

  • Mutual funds are often accepted as collateral by banks.

• Margin Eligibility:

  • Allows aggressive investors to use leverage.

• Record-Keeping:

  • Helps with income tax documentation and reporting.

Disadvantages of Mutual Funds

• High Costs:

  • Management expense ratios (MER) may exceed 3% annually.

• Emergency Reserve Issues:

  • NAVPS can be volatile during market fluctuations, unsuitable for short-term needs.

• Underperformance of Management:

  • Studies show that up to 75% of actively managed funds underperform the market.

• Tax Complications:

  • Tax liabilities may arise due to fund managers selling profitable shares, resulting in capital gains tax for investors even if the NAV declines.

Structure of Mutual Funds

• Open-End Trust:

  • All interest, dividends, and capital gains (net of fees) are distributed directly to unitholders.

• Trust Deed Components:

  • Investment objectives, investment policy, and any investment restrictions outlined.

Organization of Mutual Funds

• Directors and Trustees:

  • Ensure investments align with the fund’s objectives.

• Fund Manager:

  • Oversees daily management of the investment portfolio, prepares prospectus, calculates NAVPS, and provides reports.

• Distributors:

  • Sell funds to retail investors, typically earning commission.

• Custodian:

  • A trust company that handles cash and records of fund shares and transactions.

Part 3: Pricing of Mutual Fund Units

• Trading Structure:

  • Mutual funds do not trade on exchanges like stocks or bonds. They are bought and sold directly from the fund.

• Offering Price:

  • The price an investor pays for a unit in the fund.

Net Asset Value Per Share (NAVPS)

• NAVPS Calculation:

  • NAVPS = ( rac{\text{Total Assets} - \text{Total Liabilities}}{\text{Number of Units Outstanding}})

• NAVPS Calculation Timing:

  • Typically calculated at the close of each business day; real estate funds often calculate quarterly.

• Redemption Payments:

  • Payments for redeemed securities must be completed within three business days.

Sales Charges

• Types of Sales Charges:

  • Front-end load funds

  • No-load funds

  • Back-end load funds

  • Trailer fees

  • Switching fees

  • Management fees

  • F-class shares

Front-End Load

• Definition:

  • Charged at the time of purchase; often negotiable.

• Example Calculation:

  • If an investor pays $10,000 with a charge of 3.5%, the investment would be:

  • 10,000 (1 - 0.035) = 9,650.00

  • Dealer's commission: 10,000 imes 0.035 = 350.00

• Disclosure Required:

  • Front-end loads must be disclosed as a percentage of the purchase amount and the net amount invested.

No-Load Funds

• Description:

  • May involve minimal direct sales charges, though administrative fees may apply.

• Fee Structure:

  • Often have higher management fees compared to load funds to compensate sales representatives.

Back-End Load

• Definition:

  • A deferred sales charge applied upon the redemption of units.

• Set by Dealer:

  • Usually non-negotiable and may depend on the original purchase price or NAVPS at redemption.

• Regulatory Change:

  • Such practices banned as of June 1, 2022.

• Example Calculation:

  • If an investor buys a fund for $20 and sells it for $25 after three years with a 4% charge:

  • Selling price = 25 - (20 imes 0.04) = 24.20

  • NAVPS = 25 - (25 imes 0.04) = 24.00

Trailer or Service Fees

• Payment Structure:

  • Annual fees paid to the salesperson as long as the investor holds the fund.

• Conflict of Interest:

  • Distributors may incentivize clients to remain invested in underperforming funds to receive fees.

Switching Fees

• Application:

  • May apply when exchanging units of one fund for another within the same company; usually waived.

• Restrictions:

  • Clients typically cannot switch between front-end and back-end load funds.

Management Fees

• Fee Variability:

  • Fees differ based on service levels, ranging from under 1% for money market funds to nearly 3% for equity funds.

• Potential Issues:

  • Conflicts may arise as managers are rewarded for asset levels rather than performance.

Management Expense Ratio (MER)

• Definition:

  • Includes all management and operational expenses charged to the fund, excluding trading and brokerage costs.

• Formula:

  • \text{MER} = \frac{\text{Average Expenses Payable During Year}}{\text{Average Net Asset Value for the Year}}

• Impact on Returns:

  • All expenses deducted from the fund decrease returns.

• Example:

  • A fund reporting a 7.5% compound annual return after a 2.5% MER has a gross return of 10%.

  • 25\%\text{ of gross return allocated to MER}

F-Class Funds

• Purpose:

  • Created for fee-based advisors, originally included payments to advisors and additional fees.

• New Structure:

  • Designed to offer lower MER and eliminate the double charge.

Part 4: Regulation of Mutual Funds

• Key Regulatory Bodies:

  • Ontario Securities Commission regulates mutual funds in Ontario.

  • Mutual Fund Dealers Association regulates sales practices of funds.

• National Instruments:

  • NI 81-101: Outlines prospectus disclosure.

  • NI 81-102: Covers distribution and advertising protocols.

Standards of Conduct

• Duty of Care:

  • Conduct thorough due diligence before advising clients.

• Integrity:

  • Conduct business in an honest and fair manner; avoid conflicts of interest.

• Professionalism:

  • Maintain a professional demeanor and continually enhance knowledge.

• Compliance:

  • Adhere to all relevant securities and industry regulations.

• Confidentiality:

  • Safeguard client information meticulously.

Mutual Fund Requirements

• Information Disclosure:

  • Required to provide investors with adequate marketing information.

• Fund Facts Document:

  • Investors have the right to withdraw within 48 hours of purchase confirmation; right to rescind purchases due to misrepresentation; detail on risk factors, suitability, past performance, taxes, and costs.

Simplified Prospectus

• Contents Required:

  • Description of the issuer’s business, risk factors, securities description, distribution method, investment objectives, fees to dealers, dividends, and charges to investors.

Annual Information Form (AIF)

• Similar to Simplified Prospectus:

  • Provides significant holdings, tax status, and key personnel's remuneration and indebtedness.

Part 5: Registration Requirements

• Person Registration:

  • All mutual fund managers, distributors, and sales personnel must register with relevant provincial securities commissions.

• Application Information Needed:

  • Background on license requirements, bankruptcies, civil judgments, or criminal convictions.

Prohibited Management Practices

• Restrictions:

  • Funds cannot hold over 10% of any company's stock or voting shares.

  • Funds cannot buy shares in their own management company.

  • Using leverage, margin purchases, or short selling is prohibited.

Use of Derivatives by Mutual Funds

• Allowed Uses:

  • Can use options and warrants for risk reduction, market entry/exit facilitation, or to clone fund performance (e.g., buying put options for insurance).

Prohibited Selling Practices

• Banned Activities:

  • Backdating trade orders, offering to buy back units to protect against price downturns, or selling without registration.

• Misleading Advertising:

  • Claiming registration with OSC implies regulatory approval; promising specific future fund prices; selling unregistered securities or out of province.

Sales Communications

• Advertising Guidelines:

  • Must be truthful and not omit important facts.

  • Can include fund characteristics description, comparative performance with similar funds, and fee structures.

Distribution by Financial Institutions

• Industry Regulations:

  • Only registered representatives can sell funds and must meet proficiency requirements.

• Conflict Prevention:

  • Supervisory rules should minimize conflicts arising from compensation for mutual fund sales.

• Loan Payment Requirement:

  • Clients must repay any loans used to purchase mutual funds, even if values decline.

Part 6: Know Your Client (KYC) Rule

• KYC Definition:

  • Aim to gather necessary information ensuring mutual fund purchases suit the client’s needs, considering investment goals, net worth, and earnings.

• Client Suitability Assessment:

  • Recommendations must align with financial situations and risk tolerances. Regular updates to client records are mandatory, especially after significant changes.

• Legal Requirement:

  • Failure to provide requested KYC information prohibits transaction processing.

KYC Rule (continued)

• Investment Suitability Assessments:

  • Maintaining accurate records of orders, client instructions, and reviewing transactions.

• Know Your Product:

  • Advisers must understand fund characteristics, risk levels, and investment objectives.

KYC Rule (continued)

• Account Management Needs:

  • Identify who has trading authority in the account; recognize material changes in clients.

  • Adhere to anti-money laundering (AML) and anti-terrorist financing (ATF) laws, especially regarding transactions over $10,000.

Part 7: Requirements for Opening and Updating an Account

• Account Type Considerations:

  • The dealer must assess the nature and type of the client account based on the representative's advice.

• Products Offered:

  • Include proprietary or third-party funds awareness.

• Dealer's Obligations:

  • Ensure suitable acceptance of orders or recommendations.

• Compensation Structure:

  • Includes commissions and specific fees for financial services.

New Account Application Form (NAAF)

• Information Required:

  • KYC data covering personal and financial details, risk tolerance, and investment objectives.

• Updating Client Information:

  • Material changes should include shifts in risk tolerance, investment horizons, objectives, assets, or income.

Distribution of Mutual Funds by Financial Institutions

• Participants in Distribution:

  • Banks, trusts, loan companies, and insurance firms may distribute mutual funds.

• Conflicts and Compliance:

  • If employees are dual-employees in both fund sales and other financial services, there is a risk of conflicts.

• In-House Fund Regulation:

  • Firms must consult regulators before selling third-party funds.

Summary

• Key Highlights:

  • Advantages and disadvantages of investing in mutual funds.

  • Organizational structure of mutual funds and the responsibilities of directors and managers.

  • Pricing mechanisms of mutual funds, specifically regarding NAVPS calculations.

  • Types of sales charges applicable to mutual funds including front-end, back-end, and no-load fees.

  • Overview of mutual funds regulation and related simplified prospectus requirements.

  • Identification of prohibited selling practices and guidelines for sales communications.

Next Week

• Upcoming Chapter:

  • Chapter 18: Types and Features of Mutual Funds