Besides mutual funds, there are several investment options available in the financial market. Some products have similar features to mutual funds.
It is important to understand that some of these products are exempt from the prospectus requirement which means they will not have the same level of disclosure, transparency, or reporting requirements as mutual funds. Your access to reliable, accurate, or up-to-date information may be limited. Therefore, some of these products may pose a higher risk.
Furthermore, securities regulation or your mutual fund dealer may impose additional requirements or restrictions on these products. For instance, clients may have to qualify for an exemption before they can invest. A common exemption is the accredited investor exemption where individual investors have to meet financial thresholds to qualify. Another example is your dealer may restrict the concentration of the investment to 5% of the investor’s overall holdings. This prevents the investor from holding too much of a potentially higher-risk investment.
Exchange-Traded Funds (ETFs)
Similar to mutual funds, exchange-traded funds (ETFs) are open-end investment funds that hold a basket of securities. There are a variety of investment options. ETFs can engage in active management and alternative investment strategies but for our purposes, we will focus on the more traditional style ETFs that are designed to copy the performance of a specific index.
Similar to index funds, ETFs are considered passive investments because the portfolio manager invests in the same basket of securities as those in a specific index. ETFs can track broad-based market indexes such as the TSX or S&P, where most business sectors are represented. There are also ETFs that track niche markets that are invested in a specific sector or industry, such as commodities or agriculture.
Since ETFs are traded on a stock exchange, they can be bought and sold throughout the day. Transactions must be made through an investment dealer or broker. The market price is determined by supply and demand conditions and varies continuously during the day. The market price may also differ from the net asset value of the ETF.
Like stocks, trades are placed using the bid-ask price process. Buyers of ETFs place a “bid” on a price and the seller will “ask” for a specific price. When the bid and ask prices are matched the ETFs are sold.
An attractive feature of ETFs is their low management expense ratios (MERs). However because ETFs trade on the stock exchange, broker commissions are charged when an investor buys or sells an ETF.
The return of ETFs will not be perfectly identical to the indexes they track, since the ETFs may not have exactly the same securities as the index at all times. Also, management fees will affect the return of the fund.
Principal Protected Notes (PPNs)
Principal protected notes (PPNs) are debt instruments issued by creditworthy financial institutions that provide two main features:
- the repayment of the original principal upon maturity of the instrument
- performance linked to that of an underlying asset (e.g. market index, investment fund, foreign currency)
Since PPNs are debt instruments, the issuer is obligated to repay the principal at maturity. However, it does not offer a fixed coupon rate. Instead, its return is linked to the underlying asset that is specified. If the return from the underlying asset is positive, this is what the investor will receive when the PPN matures. If the return of the underlying asset is negative, the investor receives only the principal back.
PPNs offer investors the opportunity to participate in the upside of an underlying asset without the downside risk since their principal is guaranteed at maturity.
Pooled funds and mutual funds share many similarities. They both pool together investor monies, are structured as unit trusts, have professional portfolio managers make investment decisions, offer a variety of investment options, and provide liquidity through redemptions.
However, pooled funds have some distinct differences:
- they do not have to file prospectuses with the provincial securities commissions
- they are only available to accredited investors (i.e. sophisticated and high-net-worth investors)
- they have high minimum investments requirements
- they benefit from economies of scale which lowers the management fees
Hedge funds are investment funds with the following characteristics:
- they are privately distributed, which means they do not have to file a prospectus
- their objective is typically to generate positive returns in all market conditions
- they have broad investment mandates
Hedge funds are only available to accredited investors who must deposit a minimum amount into the fund.
In contrast to mutual funds where portfolio managers are judged relative to a benchmark, hedge fund managers strive for positive absolute returns. In other words, their objective is to perform independently of market conditions.
They are free to invest in any type of security (e.g. gold, currencies, distressed securities) and are able to employ alternative strategies such as leverage and short selling to achieve high returns. Leverage is using borrowed money to amplify returns and short selling is selling a security that is borrowed from another investor.
In addition to the management fee, hedge funds charge a performance fee that applies if they achieve superior fund performance.
Generally, these funds can be an extremely high risk especially if they involve speculative trading and leverage (which can magnify investment losses).
Income trusts are trusts that invest exclusively in one or more operating companies, with the objective of distributing cash flow to their investors (unitholders). Unitholders have a right to the income and capital of the trust. The underlying operating company usually has a consistent cash flow of interest, royalties, or lease payments, and these are passed along to unitholders. These units are traded on the stock exchange.
Prior to 2006, income trusts were very popular because of their favorable tax treatment since they were not subject to corporate tax. However, since that time the Federal government now requires all income trusts to pay corporate tax before any distributions are made.
Segregated funds are the life insurance industry’s equivalent to mutual funds. They are variable annuities, which are investment products offered through life insurers and that can only be sold by licensed life agents.
The technical term for a segregated fund is individual variable insurance contract (IVIC). The value of the contract is linked to that of an underlying investment fund selected by the investor. The insurer may hedge its investment risk by investing the proceeds of the sale of the segregated fund in units of the underlying fund.
Segregated funds have some key distinctions from mutual funds:
- Investors do not own the units of the underlying fund. Instead, investors own an insurance contract whose value is linked to that of the underlying fund. The insurer owns the units of the underlying fund.
- In addition to interest, dividends, and capital gains, segregated funds can flow capital losses to investors.
- Segregated funds guarantee the return of at least 75% (sometimes 100%) of the capital invested to the investor at maturity of the contract (usually ten years) or the death of the contract holder. Redemption of the segregated fund at any other time is subject to the current market value.
- Some segregated funds allow investors to reset the principal amount at periodic intervals. Resets lock-in increases the value of the segregated fund.
- Segregated funds charge higher management fees to cover the cost of the guarantees.
- Investors can designate a beneficiary to the contract.
- Investor monies may be protected from creditors.
These funds are suited for investors who want the benefit of investing in the equity market, but also some protection of their principal from market volatility.
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