Vol 2 mutual funds ch 1718 PDF

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Vol 2 mutual funds CSC...

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CSC Volume Two – Mutual Funds (14%) Chapter 17: Mutual Funds: Structure and Regulations

1. Chapter Outline

2. Overview of Managed Products

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Managed products are available in various different types and formats, each with specific characteristics. The following types are some of the most common formats: • Mutual funds • Exchange traded funds (ETFs) • Segregated funds • Hedge funds • Listed private equity funds • Closed-end funds • Labour-sponsored venture capital corporations (LSVCC)

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3. What is a Mutual Fund? 

A mutual fund is a single investment vehicle operated by an investment company that pools contributions from investors and invests these proceeds into a variety of securities, including stocks, bonds and money market instruments.

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Individuals who contribute money become share or unitholders in the fund and share in the income, gains, losses and expenses the fund incurs in proportion to the number of units or shares that they own.

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Professional money managers manage the assets of the fund by investing the proceeds according to the fund‟s policies and objectives and based on a particular investing style.

Mutual fund shares/units are redeemable on demand at the fund‟s current price or net asset value per share (NAVPS), which depends on the market value of the fund‟s portfolio of securities at that time.

Advantages of Mutual Funds LOW-COST PROFESSIONAL MANAGEMENT The fund manager, an investment specialist, manages the fund‟s investment portfolio on a continuing basis. inexpensive way for the small investor to access professional management of their investments. DIVERSIFICATION A typical large fund might have a portfolio consisting of 60 to 100 or more different securities in 15 to 20 industries; fund ownership provides a low-cost way for small investors to acquire a diversified portfolio. VARIETY OF TYPES OF FUNDS AND TRANSFERABILITY Many fund families also permit investors to transfer between two or more different funds being managed by the same sponsor, usually at little or no added fee. VARIETY OF PURCHASE AND REDEMPTION PLANS There are many purchase plans, ranging from one-time, lump-sum purchases to regular purchases in small amounts under periodic accumulation plans (called pre-authorized contribution plans or PACs); low cost to invest (min $100 for PAC) LIQUIDITY Mutual fund shareholders have a continuing right to redeem shares for cash at net asset value be made within three business days in keeping with the securities industry settlement requirements.

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EASE OF ESTATE PLANNING Shares or units in a mutual fund continue to be professionally managed during the probate period until estate assets are distributed. LOAN COLLATERAL AND MARGIN ELIGIBILITY Fund shares or units are usually accepted as security for a bank loan; also acceptable for margin purposes VARIOUS SPECIAL OPTIONS consist of not only an underlying portfolio of securities, but also a package of customer services such as the reinvestment of dividend; record-keeping features; tax reporting

Disadvantages of Mutual Funds COSTS Historically, most mutual funds charged a front-end load or sales commission and a management fee that was typically higher than the cost to purchase individual stocks or bonds from a broker. UNSUITABLE AS A SHORT-TERM INVESTMENT OR EMERGENCY RESERVE Most funds emphasize long-term investment and thus are unsuitable for investors seeking short term performance, with the exception of money market funds, PROFESSIONAL INVESTMENT MANAGEMENT IS NOT INFALLIBLE Like equities, mutual fund shares or units can suffer in falling markets where unit values are subject to market swings (systematic risk). TAX COMPLICATIONS Buying and selling by the fund manager creates a series of taxable events that may not suit an individual unitholder‟s time horizon.

3. What is the Structure of Mutual Funds? An investment fund is a company or trust engaged in managing investments for other people. A mutual fund may be structured as either a trust or a corporation. Mutual Fund Trust Structure 

The most common structure is the unincorporated open-end trust (also referred to as „open-ended‟). 4

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The trust structure enables the fund itself to avoid taxation. Any interest, dividends or capital gains income, net of fees and expenses, flows-through directly to the unitholders.

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The trust deed establishing the open-ended mutual fund covers such things as the fund‟s principal investment objectives, investment policy, any restrictions on the fund‟s investments, who the fund‟s manager, distributor and custodian will be

Mutual Fund Corporation Structure 

Mutual funds may also be set up as federal or provincial corporations provided they meet certain conditions set out in the Income Tax Act

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The corporation can achieve a virtually tax-free status by declaring dividends and these dividends are then taxed in the hands of the shareholder.

Organization of a Mutual Fund

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Pricing Mutual Fund Units or Shares 

Mutual fund shares or units are purchased directly from the fund (often through a distributor) and are sold back to the fund when the investor redeems his or her units.

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The price an investor pays for a share or unit is known as its offering price. In the financial press the offering price is expressed as the net asset value per share or NAVPS.

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This price will be based on the NAVPS at the close of business the day the order was placed.

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Charges Associated with Mutual Funds Mutual funds can be categorized on the basis of the type of sales commission or load that is levied. Most load funds have optional sales charges that let the investor choose between front-end or back-end charges. NO-LOAD FUNDS Many mutual funds, primarily those offered by direct distribution companies, banks and trust companies, are sold to the public on a no-load basis, with little or no direct selling charges. FRONT-END LOADS A front-end load is payable to the distributor at the time of purchase. It is usually expressed as a percentage of the purchase price or NAVPS. Investors should be aware that the front-end load effectively increases the purchase price of the units, thereby reducing the actual amount invested.

BACK-END LOADS OR DEFERRED SALES CHARGES A back-end load or deferred sales charge is payable to the distributor at the time of redemption or sale of the fund. The fee may be based on the original contribution to the fund or on the net asset value at the time of redemption. Deferred sales charges (DSC) on a back-end load fund decrease the longer the investor holds the fund.

TRAILER FEES 

Another kind of fee is the trailer fee, sometimes called a service fee. This is a fee that a mutual fund manager may pay to the distributor that sold the fund.

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The justification for paying a fee is that the representative provides ongoing services to investors such as investment advice, tax guidance and financial statements.

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OTHER FEES A small number of funds charge a set-up fee, on top of a front-end load or back-end load. A variation of the redemption fee is the early redemption fee. (90 days) SWITCHING FEES Switching fees may apply when an investor exchanges units of one fund for another in the same family or fund company. MANAGEMENT FEES The level of management fees varies widely depending on the type of fund. In general, fees will vary depending on the level of service required to manage the fund. Management fees are generally expressed as a straight percentage of the net assets under management. 

The management fees associated with money market funds are low, in the range of 0.50% to 1%.

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The management of equity funds (with the exception of index funds) requires ongoing research and therefore the management fees are higher, ranging from 2% to 3% (or higher).

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Index funds try to mirror the market with occasional rebalancing. Since this strategy is largely a passive buy-and-hold strategy, management fees are usually lower. In all cases, the management fees charged would be outlined in the prospectus.

The management fee compensates the fund manager, but it does not cover all the expenses of a fund. For instance, other operating expenses like: • Interest charges • All taxes, audit and legal fees • Safekeeping and custodial fees • Provision of information to share or unitholders are charged directly to the fund. The management expense ratio (MER) represents the total of all management fees and other expenses charged to a fund, expressed as a percentage of the fund‟s average net asset value for the year.

Published rates of return are calculated after deducting the management expense ratio, while the NAVPS of investment funds are calculated after the management fee has been deducted.

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F–CLASS FUNDS 

An F-class fund is a type of fee-based fund with a lower MER. With a fee-based account, the client is charged a percentage of the assets under management, rather than a commission or fee for each transaction.

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These funds reduce or eliminate the double charge. As a result, many more financial advisors now provide fee-based, rather than commission-based, accounts.

4. What are Labour-Sponsored Venture Capital Corporations? Labour-sponsored venture capital corporations (LSVCCs) or Labour-Sponsored Investment Funds (LSIFs) are managed investment funds sponsored by labour organizations to provide capital for small to medium-sized and emerging companies. Advantages of Labour-Sponsored Funds 

Federal tax credits that individuals receive for investing in them combined with the provincial tax credits that some provinces may offer.

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LSVCC shares are purchased with money contributed to an RRSP, the contributor to the RRSP will receive the RRSP tax deduction as well as any available LSVCC tax credits

Disadvantages of Labour-Sponsored Funds 

Because of the nature of the companies in which they invest, LSVCCs are considered a high-risk or speculative investment suitable only for investors who have a high risk tolerance.

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The redemption of LSVCC shares is more complicated than the redemption of conventional mutual fund shares

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The costs of administering these funds, as reflected in management expense ratios, tend to be much higher

5. How are Mutual Funds Regulated? Securities regulations related to mutual funds are based upon three broad principles: personal trust, disclosure and regulation. Mutual Fund Regulatory Organizations 

Investment firms that are members of one or more of the Canadian self-regulatory organizations (SROs), and the registered employees of such dealer members, are subject to the rules and regulation of these SROs

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The Mutual Fund Dealers Association (MFDA) is the mutual fund industry‟s SRO for the distribution side of the mutual fund industry.

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The MFDA is not responsible for regulating the activities of mutual fund dealers who are already members of another SRO. For example, IIROC members.

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In Québec, the mutual fund industry is under the responsibility of the Autorité des marches financiers (AMF)

General Mutual Fund Requirements 

With certain exceptions, the funds must annually file a full or simplified prospectus (described below) which must be acceptable to the provincial securities administrator.

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It is important, therefore, that mutual fund representatives deal only in those funds registered in their own jurisdiction.

Mutual fund disclosure documents include: • A fund facts document • A simplified prospectus • The annual information form • The annual audited statements or interim unaudited financial statements • Other information required by the province or territory where the fund is distributed, such as material change reports and information circulars. The Fund Facts Document The Fund Facts document is part of a modified point of sale disclosure regime designed to give investors key information about a mutual fund, in an easily understood format and described in plain language. DISCLOSURE COMPONENTS OF FUND FACTS

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The Simplified Prospectus 

A mutual fund prospectus is normally shorter and simpler than a typical prospectus for a new issue of common shares.

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The simplified prospectus must be filed with the securities commission annually, but need not be updated annually unless there is a change in the affairs of the mutual fund.

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The prospectus must be amended concurrently with the fund facts document when material changes occur, and investors must receive a copy of the amendment.

The simplified prospectus must contain the following information: • Introductory statement describing the purpose of the prospectus and identifying the other information documents which the fund must make available to investors • Name and formation of the issuer, including a description of the issuer‟s business • Risk factors and description of the securities being offered • Method used to set the price of the securities being sold or redeemed, and disclosure of any sales charges • Statement of who has the responsibility for management, distribution and portfolio management • Fees paid to dealers • Statement of management fees and other expenses, including the annual management expense ratio for the past five years • The fund‟s investment objectives and practices • Information on the amount of dividends or other distributions paid by the issuer • In general terms, the income tax consequences to individuals holding an investment in the fund

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THE ANNUAL INFORMATION FORM Delivery of the annual information form (AIF) is available to investors on request. Much of the disclosure required in the AIF is similar to that provided in the simplified prospectus. The AIF contains, in addition to the above, information concerning: • Significant holdings in other issuers • The tax status of the issuer • Directors, officers and trustees of the fund and their indebtedness and remuneration • Associated persons, the principal holders of securities, the interest of management and others in material transactions • The particulars of any material contracts entered into by the issuer

6. What other forms are requirements are necessary？ Registration Requirements for the Mutual Fund Industry Mutual fund managers, distributors and mutual fund representatives must all be registered securities administrators in all provinces in which they operate.

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Education qualifications: Mutual fund representatives must have successfully passed a mutual course such as the Canadian Securities Course (CSC),

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Registration requirements: An application for registration is filed electronically with the National Registration Database (NRD) Notices of changes: The mutual fund representative has the obligation to notify the provincial administrator within five business days of any changes in the information required in provincial application Transfer of registration: As soon as a mutual fund representative ceases to work for a registered registration is automatically suspended.

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Mutual Fund Restrictions PROHIBITED MUTUAL FUND MANAGEMENT PRACTICES   

Purchases of no more than 10% of the total securities of a single issuer or more than 10% of a company‟s voting stock Funds cannot buy shares in their own company (for example, a fund owned by a bank cannot buy shares in that bank) Purchases of no more than 10% of the net assets in the securities of a single issuer or 20% of net assets in companies engaged in the same industry (specialty funds excepted)

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No purchases of the shares of other mutual funds, except in certain cases where no management fees occurs No borrowing for leverage purposes No margin buying or short selling

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USE OF DERIVATIVES BY MUTUAL FUNDS 

Subject to strict regulatory controls, mutual fund managers are allowed to incorporate specific “permitted” derivatives as part of their portfolios.

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The most prominent applications of derivatives among mutual fund managers are to hedge against risk and to facilitate market entry and exit

PROHIBITED SELLING PRACTICES

GUIDELINES AND RESTRICTIONS There are also guidelines and restrictions with respect to what distributor firms and fund managers are permitted to do. These guidelines obviously have an impact on the representative. Prohibited sales practices include:  

The provision by fund managers of money or goods to a distributor firm or its representatives in support of client appreciation A fund manager may not provide co-operative funds for practices which are considered general marketing expenses, such as general client mailings.

SALES COMMUNICATIONS COMMUNICATING RATES OF RETURN TO CLIENTS

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Sales communications can include: • A description of the fund‟s characteristics • Comparisons between funds under common management, funds with similar investment objectives or a comparison of the fund to an index COMMUNICATING RATES OF RETURN TO CLIENTS As with any communication delivered to the client, the expectation is that the client will be provided with “full, true and plain disclosure”. CLIENT ACCOUNT PERFORMANCE REPORTING clients must also be provided with information regarding the performance of their investments. mutual fund representative must ensure that on an annual basis, clients are provided with a performance report that covers at a minimum, a 12-month period

7. What is the “Know Your Client （KYC） ）” Rule? Prior to accepting a client account, securities regulations require that dealers and their mutual fund representatives obtain information about their client to ensure that the purchase of mutual funds is suitable. It is the responsibility of every mutual fund representative to use due diligence to: • learn the essential facts relative to a client (i.e. age, net worth and earnings, investment knowledge, investment objectives, etc.) before opening an account and maintain this knowledge on an ongoing basis; • learn the essential facts relevant to every order accepted and ensure that the order is within the bounds of good business practice; • learn the circumstances behind each transaction, and ensure that the recommendations made for an account are appropriate for the client based on factors including the client‟s financial situation, investment knowledge, investment objectives and risk tolerance.

Suitability and Know Your Product 

mutual fund representatives shall use due diligence to, among other things, ensure that the suitability of investments within each client account is assessed

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mutual fund representatives also have an on-going responsibility to assess that the investments in the client account continue to be suitable

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Unsolicited Orders (i.e., orders for mutual funds that have not been recommended by the representative but instead come from the clients).

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In the case of unsolicited orders to be accepted, the purchase must be reasonable given the client‟s investment objectives, risk tolerance, investment horizon and investment knowledge.

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The Role of KYC Information in Opening an Account 

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