Canadian Securities Course Volume 2 - Chapter 17: Structure and Regulation of Mutual Funds

Chapter 17: Structure and Regulation of Mutual Funds

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 managed by an investment professional.
Management Styles: Can involve active or passive management in pooled or separately managed accounts.
Investment Restrictions:
- Types of securities permitted.
- Concentration limits.
- Leverage restrictions.

Examples of Managed Products

Types:
- 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: Access to the experience of management professionals.
Economies of Scale: Benefits from pooled investment funds leading to lower average costs.
Diversification: Provides exposure to a wide array of securities.
Liquidity: Easier to buy/sell than individual securities.
Flexibility: Greater ability to adjust to changing market conditions.
Tax Benefits: Potential tax advantages compared to other investment types.
Low-Cost Options: May provide cost-effective investment strategies.

Disadvantages of Managed Products

Transparency Issues: For example, hedge funds may not disclose portfolio holdings.
Liquidity Constraints: Investors may be required to remain invested for a set period.
High Fees: Fees can include 2% of assets managed and 20% of profits.
Volatility of Returns: Use of leverage can lead to amplified profits and losses.

Part 2: Overview of Mutual Funds

Definition: A mutual fund is an investment company that pools money from shareholders to invest in a variety of securities (stocks, bonds, Treasury bills).
Fund Facts Document: Contains information on:
- Investment objectives
- Risk degrees
- Types of securities involved
- Historical returns

Advantages of Mutual Funds

Cost-Effective Professional Management: Managed by specialists for specific asset categories (e.g., small-cap funds).
Diversification: Enables investors to trade a wider range of securities economically.
Flexibility in Transfer: Ability to switch from one fund type (e.g., bond to equity) with minimal fees.
Purchase and Redemption Plans: Includes options like lump-sum payments and Pre-authorized Contribution plans (PACs) at manageable amounts (e.g., $100/month).
Liquidity: Investors can redeem shares for cash based on net asset value (NAV).
Estate Planning Ease: Funds remain professionally managed through probate, which can last months.
Loan Collateral: Mutual funds can often be used as security for bank loans.
Eligibility for Margin: Aggressive investors can leverage their investments.
Record-Keeping Assistance: Facilitates income tax reporting.

Disadvantages of Mutual Funds

High Sales and Management Costs: Management Expense Ratio (MER) can exceed 3% annually.
Unsuitable as Emergency Reserve: NAVPS can be highly volatile, particularly in cyclical markets, making them unsuitable for short-term performance needs.
Professional Management Limitations: Studies show up to 75% of active funds underperform the market.
Tax Complications: Investors may incur capital gains taxes due to the fund's management activities, even if their share value has decreased throughout the year.

Structure of Mutual Funds

Open-End Trust: All interest, dividends, or capital gains, net of fees and expenses, are passed on directly to unitholders.
Trust Deed Contents:
- Investment objectives
- Investment policies
- Investment restrictions

Mutual Fund Companies

Purpose: Hold diversified investment portfolios; income derives from dividends, interest, and capital gains.
Tax Responsibilities: The fund is liable for taxes, not flow-through to investors; dividends equivalent to net income may be paid out post-expenses.

Organization of Mutual Funds

Directors and Trustees: Ensure that investments align with the fund's objectives.
Fund Manager: Responsible for the daily supervision of the portfolio, including:
- Preparing prospectus
- Calculating NAVPS
- Generating quarterly reports
Distributors: Retail investors purchase funds via distributors, often compensated via commission.
Custodian: A trust company tasked with managing cash transactions, acting as registrar, and transferring agent. Record-keeping for share ownership is maintained here.

Part 3: Pricing of Mutual Fund Units

Trading Mechanism: Mutual funds do not trade on exchanges; they are directly bought from and sold back to the fund.
Continuous Distribution: Investors buy/sell directly from the fund rather than through an exchange.
Offering Price: The cost an investor pays per fund unit.

Net Asset Value Per Share (NAVPS)

Definition: The theoretical amount a shareholder would receive if the fund liquidated its portfolio.
NAVPS = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Number of Units Outstanding}}
Calculation Frequency: Regularly calculated at day-end; real estate funds may calculate NAVPS quarterly.
Redemption Payment: Payments for redeemed securities are processed within three business days.

Sales Charges Associated with Mutual Funds

Types of Fees:
- 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 point of buying units in the fund; often negotiable.
Example Calculation: For a $10,000 investment with a 3.5% front-end load:
- Amount invested = $10,000 * (1 - 0.035) = $9,650
- Dealer compensation = $10,000 * 0.035 = $350
Disclosure Requirements: Must be shown as both
- Percentage of purchase amount
- Percentage of net amount invested (using example: \frac{350}{9650} = 3.63\%)
Offer Price Calculation:
\text{Offer Price} = \frac{\text{NAVPS}}{1 - \text{Sales Charge}} = \frac{25}{1 - 0.035} = 25.91

No-Load Funds

Description: Typically contain little to no direct sales charges; may have modest administrative fees or higher management fees.

Back-End Load

Definition: A deferred sales charge collected on unit redemption; often non-negotiable.
Impact: Banned as of June 1, 2022.
Example Calculation: For a fund purchased at $20, sold for $25 with a 4% charge:
- Sales price post-charge = $25 - (4% * $20) = $24.20
- NAVPS at redemption = $25 - (4% * $25) = $24.00

Trailer or Service Fees

Characteristics: Paid annually to salespersons as long as clients own the fund; they form part of the management fee.
Conflict of Interest: May incentivize advisors to keep clients in underperforming funds to receive these fees.

Switching Fees

Condition: Applied when exchanging units of one fund for another within the same company; typically waived.
Benefits: Allows transitions between asset classes with market changes; switching between front-end and back-end loads is often restricted.

Management Fees

Variation: Based on required service levels; range typically from under 1% (money markets) to nearly 3% (equity funds).
Potential Conflict: Managers are rewarded for asset levels rather than performance, which may lead to a lack of alignment with investors' best interests.

Management Expense Ratio (MER)

Definition: Includes all management fees and operational expenses charged to the fund.
Exclusions: Trading and brokerage costs not included as they are associated with portfolio asset transactions.
Formula:
\text{MER} = \frac{\text{Average Expenses Payable During Year}}{\text{Average Net Asset Value for the Year}}
Impact: Directly affects investor returns, as all expenses are deducted from the fund.
Example: Fund with a 7.5% annual return after a 2.5% MER indicates a gross return of 10% before MER application.

F-Class Funds

Purpose: Designed for fee-based advisors rather than commission-based.
Comparative Aspect: Charges reflect lower MER to reduce double charges for advisory fees while analogous to standard funds.

Part 4: Regulation of Mutual Funds

Ontario Securities Commission: Governing body for mutual fund regulation within the province.
Mutual Fund Dealers Association (MFDA): A self-regulatory organization (SRO) overseeing the sales practices of mutual funds.
National Instruments (Policy Statements):
- NI 81-101: Pertains to prospectus disclosures.
- NI 81-102: Concerns distribution and advertising practices.

Standards of Conduct

Duty of Care: Conduct due diligence in the advisement of clients.
Integrity: Perform with honesty and trustworthiness to avoid conflicts of interest.
Professionalism: Conduct business in a manner that reflects well on the industry and promotes constant personal knowledge enhancement.
Compliance: Adhere strictly to securities rules and regulations set forth by authorities.
Confidentiality: Maintain client information under strict confidentiality standards.

Mutual Fund Requirements

Disclosure: Essential information must be shared with investors for marketing purposes, including:
- Fund Facts document contents like the right to withdraw within 48 hours of confirmation, risk factors, suitability, past performances, and tax implications.

Simplified Prospectus Requirements

Contents Must Include:
- Business description of the issuer
- Identified risk factors
- Description of the offered securities
- Investment objectives and practices of the fund
- Applicable fees and dividends

Annual Information Form (AIF)

Contents: Includes similar disclosures as simplified prospectus but with more detailed information such as:
- Significant holdings in other issuers
- Tax status of issuers
- Remuneration details for directors and officers
- Interests of management in material transactions.

Part 5: Registration Requirements

Mandatory Registration: All mutual fund managers, distributors, and sales personnel must be registered with the respective provincial securities commissions.
Application Information: Includes details such as:
- Licensing actions or approvals
- Relevant past bankruptcies or judgments.

Prohibited Management Practices

Stock Ownership Restrictions: Cannot hold more than 10% of a company's stocks or voting shares.
Self-Purchase Restrictions: Funds cannot buy shares in their own company.
Leverage Restrictions: Prohibits borrowing for leverage, buying on margin, or engaging in short selling.

Use of Derivatives by Mutual Funds

Allowed Uses: Derivatives such as calls, puts, futures, etc., can reduce portfolio risk but cannot be used for speculative purposes.
Usage Example: Buying put options as insurance against market downturns.

Prohibited Selling Practices

Improprieties Include:
- Backdating orders for previous day’s pricing.
- Offering to repurchase units to buffer investors from price drops.
- Selling without proper registration.

Prohibited Practices (continued)

Advertizing Prohibitions:
- Misleading claims regarding registration or performance.
- Promises of specific future value for a fund.

Sales Communications Guidelines

Advertising Requirements: Must present accurate fund characteristics and fee structures while ensuring no omission of relevant facts.

Distribution by Financial Institutions

Sales Personnel Requirements: Only registered employees may sell mutual funds, meeting proficiency requirements.
Conflict Management: Institutions must set up supervisory rules to mitigate conflicts of interest based on compensation plans.
Loan Recalls: Loans extended to buy mutual funds must be repaid even if fund values drop.

Part 6: Know Your Client Rule (KYC)

Client Information Gathering: Essential for ensuring the suitability of mutual fund purchases; includes client information on:
- Investment objectives
- Net worth and earnings
Recommendation Suitability: Advisements must be appropriate to the client's financial situation.
Record Maintenance: Client account information must be updated regularly.
Regulatory Requirement: If clients do not provide necessary info, transaction processing is halted.

KYC Rule (continued)

Suitability Assessment: Assess each investment's appropriateness for the client’s account.
Documentation Requirements: Maintain comprehensive records of client orders and relevant follow-up actions.
Product Knowledge: Advisors must understand recommended products' features, risk levels, and investment aims.

KYC Role in New Account Opening

Account Structure: Understand roles of joint holders, beneficiaries, and trading authorities.
Changes in Client Circumstances: Must adapt to any material changes affecting the client's situation.
AML and ATF Compliance: Protocol for verification and reporting processes on suspicious transactions exceeding $10,000.

Part 7: Account Opening and Updating Requirements

Client Account Nature: Dependence on representative advice.
Product Offering Types: Proprietary versus third-party products.
Dealer Obligations: Investigate order acceptance and recommendation suitability.
Compensation Structures: Involves commissions and specific fees for services rendered.

New Account Application Form (NAAF)

Completion Requirement: NAAF must be filled out for all new clients, capturing KYC details like personal, financial information, risk tolerance, and investment objectives.
Updating Protocols: Track significant changes, including alterations in risk tolerance, time horizons, objectives, assets, or income.

Distribution by Financial Institutions Overview

Institutional Sellers: Includes banks, trust companies, loan organizations, and insurance firms.
Dual Employment Issues: Engage in financial services while licensed for mutual fund sales.
Conflict of Interest Escalations: Recommend suitability assessments ensuring the client does not receive unfavorable fund suggestions.

Summary

Overview of advantages and disadvantages of mutual fund investments.
Organizational structuring of funds and director, fund manager roles.
Pricing calculation and significance of NAVPS.
Variations in sales charge types including front-end, back-end, and no-load funds.
Comprehensive regulation policies and summary of simplified prospectus requirements.
Awareness and mitigation of prohibited sales practices and guidelines for communication in sales.