Ifc TXT-2021 12 en V01

THE CANADIAN SECURITIES INSTITUTE
The Canadian Securities Institute (CSI) has been setting the

standard for excellence in life-long education for financial
professionals for more than 45 years. CSI is part of M oody’s
Analytics Training and Certification Services, which offers education
programs and credentials throughout the world.
Our experience training over 800,000 global professionals makes
us the preferred partner for individuals, financial institutions, and
regulators internationally. Our expertise extends across the
financial services spectrum to include securities and portfolio
management, banking, trust, and insurance, financial planning and
high-net-worth wealth management.
• CSI is a thought leader offering real world training that sets

professionals apart in their chosen fields and helps them
develop into leaders who excel in their careers. Our focus on
exemplary education and high ethical standards ensures that
they have met the highest level of proficiency and certification.
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ensure that our programs meet the evolving needs of the
marketplace. In Canada, we are the primary provider of
regulatory courses and examinations for the Investment
Industry Regulatory Organization of Canada (IIROC). Our
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© 2021 Canadian Securities Institute

All rights reserved. No part of this publication may be reproduced, stored in a retriev al
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recording, or otherwise, without the prior written permission of CSI.
Identifiers: ISBN 978-1-77176-487-2 (print)

ISBN 978-1-77176-488-9 (ebook)
First printing: 1997

Rev ised and reprinted: 2009, 2010, 2011, 2012, 2014, 2016, 2019, 2021
Copyright © 2021 by Canadian Securities Institute

Introduction
The information in the chapters to follow is designed to help you
serve your clients in a professional, confident and knowledgeable
manner. As you prepare by taking this course and become more
confident, the role of the mutual fund sales representative
becomes one of guidance. Helping clients through the maze and
variety of investment products and choices in today’s financial
marketplace is a valued service that many clients are seeking.
Uncovering client needs and choosing the right product to meet
those needs is the foundation of giving quality advice. By correctly
understanding the financial objectives and impact of constraints on
the client, you can build strong relationships with your clients. A
mutual fund sales representative must also thoroughly know the
investment products that are available for meeting client needs. If
either one of these key elements is weak or lacking, there is a risk
that clients will feel poorly served and wrongly advised, and will
look to take their business elsewhere.
LEARNING OUTCOME
M any financial services professionals advance their careers by
acquiring a license to sell mutual funds, which is a $1.983 trillion
industry in Canada as of July 2021. This course will give you the
skills you need to work in this exciting investment area.
After taking this course, you will be able to:
• guide clients in their selection of mutual funds and related
investment products
• confidently describe and discuss with clients the risk/return
characteristics of the different mutual fund classes
• ensure product suitability, the underlying principle of consumer
protection regulations
• provide superior client service with respect to mutual fund
investments
LEARNING SECTIONS
The course is organized around six learning sections:
SECTION 1: INTRODUCTION TO THE MUTUAL FUND

MARKETPLACE
Clearly explains the role of the mutual fund sales representative
within the context of client service. It also provides an overview of
the financial marketplace, economy, and mutual fund industry.
SECTION 2: THE KNOW YOUR CLIENT

COMMUNICATION PROCESS
Outlines and illustrates, through the use of examples, what
information is required to know your clients and your products. We
also address the process of analyzing this information to ensure
investment suitability.
SECTION 3: UNDERSTANDING INVESTMENT

PRODUCTS AND PORTFOLIOS
Details the features and risk/return characteristics of the various
financial assets, as well as the process of creating and managing
investment portfolios.
SECTION 4: UNDERSTANDING MUTUAL FUNDS AND

MANAGED PRODUCTS
Thoroughly describes the nature of many mutual fund types, their
portfolio risk/return characteristics, and their performance over time.
The section also introduces the many types of alternative
managed products available in the marketplace.
SECTION 5: EVALUATING MUTUAL FUNDS

Describes the techniques used to measure and evaluate mutual
fund performance so that you can make better decisions when
selecting a mutual fund for a client.
SECTION 6: ETHICS, COMPLIANCE AND MUTUAL

FUND REGULATIONS
Lists and explains the rules and ethical principles you must adhere
to as a mutual fund sales representative. The section also
illustrates, via a series of case studies, how mutual fund sales
persons integrate client and product knowledge to meet their legal,
ethical and professional responsibilities.
COURSE FEATURES
This edition of the Investment Funds in Canada (IFC) textbook
was prepared in early 2019. The IFC textbook is updated and
revised on a regular basis to better reflect the rapidly changing
financial services industry.
The following learning features are included in this edition of the
course:
Chapter Outlines: The chapter outline lets you know what content
will be covered in the chapter and will prepare you for the material
you are about to read.
Learning Objectives: The learning objectives help you to focus
your studies on important topic areas. Be sure to read each
objective before you begin a chapter; the objectives specify
precisely what you are expected to know after reading the chapter
and studying the material. To highlight their importance, we have
linked each objective directly to the chapter’s major headings.
Key Terms: A list of key terms is provided at the start of each
chapter. Understanding the terminology and jargon of the mutual
fund industry is an important part of your success in this course.
Each key term is boldfaced in the chapter and appears in the
glossary included at the end of the textbook.
Real Life Case Studies: In almost every chapter a case study is
presented that reflects different scenarios that mutual fund
representatives may face during their career.
Chapter Summaries: Each chapter closes with a concise summary
of the material organized by learning objective. The summaries will
help to reinforce the relationship between the material and the
chapter learning objectives and may suggest areas of weakness
that require further study.
Online Exercises: Online Exercises are provided in each module
of your online course. These exercises allow you to practice
calculations or test your comprehension of the key concepts
presented in the textbook. Every time there is an activity that is
relevant to a section, there is an invitation in the textbook to
complete the online activity. Also, at the end of each chapter you
will be invited online to complete the end of Chapter Exercise and
read the Chapter FAQs.
HOW TO USE THIS TEXT

This course package is designed on a self-study basis. The
textbook includes examples, review questions and case studies
that help you to practice key areas of the material. In terms of
studying for the course, we suggest the following:
• Review the learning objectives prior to reading the chapter; the
final exam will cover the information required in meeting these
objectives.
M ake notes by summarizing the key points under each major
•
heading and learning objective.
• Review the definitions of key terms found in the Glossary.
• After reading the chapter, complete all online exercises, and
read the online FAQs to find answers to your questions. They
are intended to reinforce your learning and develop your ability
to explain and discuss the required knowledge and desired
skills.
The course material is intentionally presented in a learning
sequence to help you build on the knowledge from one chapter
before moving onto the next. A clear understanding of each chapter
is a required foundation for the next one. By completing the text
reading, the review questions and case studies, it will prepare you
to write the IFC exam.
The term “mutual fund sales representative” has been used mostly
through this text to represent the broad base of individuals that sell
mutual funds. Depending on the firm or institution you work for, your
job title might be different from that of “mutual funds sales
representative.”
THE CANADIAN SECURITIES INSTITUTE

CSI has been setting the standard for world-class, life-long
education for financial professionals for more than 45 years. Having
trained over 700,000 global professionals, makes us the preferred
partner for individual and corporate financial services education
internationally. Our expertise extends from securities to mutual
funds, from banking and trust to insurance, from portfolio
management to financial planning and wealth management.
CSI is a thought leader whose real world training sets
professionals apart in their field, by developing them into leaders
who are able to excel in their chosen careers. Our focus on leading
educational and ethical standards means that our graduates have
met the highest level of proficiency and certification. We develop
course content based on industry trends and continuous
involvement from our worldwide partners to ensure our graduates
are the most current in every financial sector.
CSI is a partner – Working collaboratively with practitioners and
industry regulators leads to a higher educational standard in an
evolving financial services marketplace. Anticipating industry
requirements allows us to develop relevant curriculum and testing
for real world application.
CSI grants designations that have become a true measure of
expertise. We focus on state of the art industry knowledge that is
the recognized standard for regulatory authorities, financial
organizations and associations in Canada and around the globe.
Our graduates come with highly endorsed credentials respected
throughout the financial services industry.
CSI is valued for its expertise in both course content and
program delivery. CSI has established professional designations in
growing specialties like financial derivatives and wealth
management, adding to our respected and established courses and
seminars. We’ve also pioneered the use of the Internet as a
powerful tool for teaching and professional development, launching
online courses and study aids.
CSI – leaders in innovative, lifelong education for career-minded
financial professionals. CSI courses are available on demand in a
variety of formats anywhere and anytime to suit the needs of
learners and their organizations.
INVESTMENT FUNDS IN CANADA
Content Overview
1 The Role of the Mutual Fund Sales Representative
2 Overview of the Canadian Financial Marketplace
3 Overview of Economics
4 Getting to Know the Client
5 Behavioural Finance
6 Tax and Retirement Planning
7 Types of Investment Products and How They Are Traded
8 Constructing Investment Portfolios
9 Understanding Financial Statements
10 The Modern Mutual Fund
11 Conservative Mutual Fund Products
12 Riskier Mutual Fund Products
13 Alternative Managed Products
14 Understanding Mutual Fund Performance

15 Selecting a Mutual Fund
16 Mutual Fund Fees and Services
17 Mutual Fund Dealer Regulation
18 Applying Ethical Standards to What You Have Learned

Table of Contents
SECTION 1 | INTRODUCTION TO THE MUTUAL FUND

MARKETPLACE
1 The Role of the Mutual Fund Sales

Representative
INTRODUCTION
HOW HAS THE MUTUAL FUND INDUSTRY

EVOLVED?
A Brief History of Mutual Funds
History of the Canadian Mutual Fund Industry
WHAT IS THE VALUE IN LICENSING?
How this Course Prepares You
WHY PROVIDE EXCELLENT CLIENT SERVICE?
Rewards for Prov iding Excellent Client Serv ice
Why Client Serv ice is so Critical
WHY IS UNDERSTANDING YOUR CLIENTS AND
PRODUCTS IMPORTANT?
Ty pes of Responsibility
Personal Trust, Ethics and Compliance
KNOW YOUR CLIENT, KNOW YOUR PRODUCT
AND SUITABILITY
WHAT IS THE ROLE OF A MUTUAL FUND SALES

REPRESENTATIVE?
MUTUAL FUND SALES IN PRACTICE
SUMMARY
2 Overview of the Canadian Financial

Marketplace
INTRODUCTION
WHAT IS INVESTMENT CAPITAL?

Characteristics of Capital
Sources and Users of Capital
WHAT ARE THE FINANCIAL INSTRUMENTS?
Financial instruments
WHAT ARE THE FINANCIAL MARKETS?
Auction Markets in Canada
Dealer Markets
WHO ARE THE DIFFERENT FINANCIAL
INTERMEDIARIES?
The Role of Inv estment Dealers
Other Intermediaries
WHAT IS THE CANADIAN SECURITIES
REGULATORY FRAMEWORK?
Self-Regulatory Organizations (SROs)
SUMMARY
INTRODUCTION
WHAT IS ECONOMICS?
Microeconomics and Macroeconomics
The Decision Makers
Demand and Supply
HOW IS ECONOMIC GROWTH MEASURED?
Measuring Gross Domestic Product
Productiv ity and Determinants of Economic Growth
WHAT ARE THE PHASES OF THE BUSINESS
CYCLE?
Phases of the Business Cy cle
Using Economic Indicators
Identify ing Recessions
WHAT ARE THE KEY LABOUR MARKET
INDICATORS?
Labour Market Indicators
Ty pes of Unemploy ment
WHAT ROLE DO INTEREST RATES PLAY?
Determinants of Interest Rates
How Interest Rates Affect the Economy
Expectations and Interest Rates
Negativ e Interest Rates
WHAT IS THE NATURE OF MONEY AND
INFLATION?
The Nature of Money
Inflation
Disinflation
Deflation
HOW DO FISCAL AND MONETARY POLICIES AND
INTERNATIONAL ECONOMICS IMPACT
THE ECONOMY?
Monetary Policy
Fiscal Policy
How Fiscal Policy Affects the Economy
International Economics
SUMMARY
SECTION 2 | THE KNOW YOUR CLIENT


INTRODUCTION
WHY ARE CLIENT COMMUNICATION AND

PLANNING IMPORTANT?
WHAT IS THE FINANCIAL PLANNING

APPROACH?
WHAT ARE THE STEPS IN THE FINANCIAL

PLANNING PROCESS?
Establishing the Client-Adv isor Relationship
Collecting Data and Information
Analy zing Data and Information
Recommending Strategies to Meet Goals
Implementing Recommendations
Conducting a Periodic Rev iew or Follow-Up
WHAT IS THE LIFE-CYCLE HYPOTHESIS?
The Stages in the Life-Cy cle
Summarizing the Life Cy cle
The Planning Py ramid
SUMMARY
INTRODUCTION
INVESTOR BEHAVIOUR
Behav ioural Finance
Behav ioural Biases
HOW DO REPRESENTATIVES APPLY BIAS
DIAGNOSES WHEN STRUCTURING ASSET
ALLOCATIONS?
SUMMARY

INTRODUCTION
HOW DOES THE CANADIAN TAXATION SYSTEM

WORK?
The Income Tax Sy stem in Canada
Ty pes of Income
Calculating Income Tax Pay able
Taxation of Inv estment Income
Tax-Deductible Items Related to Inv estment Income
WHAT ARE THE MAIN PENSION PLANS IN
CANADA?
Gov ernment Pension Plans
Employ er-Sponsored Plans
WHAT ARE TAX DEFERRAL PLANS?
Registered Retirement Sav ings Plans (RRSPs)
Registered Retirement Income Funds (RRIFs)
Locked-In Retirement Accounts
Tax-Free Sav ings Accounts (TFSA)
Registered Education Sav ings Plans (RESPs)
Pooled Registered Pension Plans (PRPPs)
SUMMARY
SECTION 3 | UNDERSTANDING INVESTMENT

7 Types of Investment Products and

How They Are Traded
INTRODUCTION
WHAT ARE FIXED-INCOME SECURITIES?
Gov ernment Bonds
Treasury Bills
Prov incial and Municipal Gov ernment Securities
Corporate Bonds
Guaranteed Inv estment Certificates (GICs)
Bankers’ Acceptances and Commercial Paper
WHAT ARE THE FUNDAMENTALS OF BOND
PRICING AND PROPERTIES?
The Inv erse Relationship between Bond Prices and
Interest Rates
The Impact of Maturity and Coupon on Price Volatility
Bond Yield Calculations
The Yield Curv e
WHAT ARE EQUITY SECURITIES?
Common Shares
Preferred Shares
Preferred Share Features
Risks of Inv esting in Preferred Shares
HOW ARE NEW SECURITIES BROUGHT TO
MARKET?
Trading Securities
Ty pes of Market Transactions
WHAT ARE DERIVATIVE SECURITIES?
Use of Deriv ativ es by Mutual Funds
SUMMARY

INTRODUCTION
WHAT IS RISK AND RETURN?

Putting Risk and Return into Practice
WHAT ARE THE IMPACTS OF ECONOMIC
CONDITIONS IN COMPARING RETURNS?
Inflation
Purchasing Power
Taxation
HOW TO CALCULATE A RETURN
Rate of Return on a Single Security
Rate of Return on a Portfolio
HOW TO MEASURE RISK
Measures of Price Volatility of Equities
Measures of Price Volatility of Bonds
WHAT IS PORTFOLIO ANALYSIS?
Div ersification and Risk
Combining Securities in a Portfolio
HOW ARE PORTFOLIOS MANAGED?
Inv estment Objectiv es
Strategic Asset Allocation
WHAT ARE THE METHODS OF ANALYSIS?
Fundamental Analy sis
Technical Analy sis
SUMMARY

INTRODUCTION
WHAT ARE THE FINANCIAL STATEMENTS?
WHAT IS THE STATEMENT OF FINANCIAL

POSITION?
Assets
Liabilities
Shareholders’ Equity
WHAT IS THE STATEMENT OF COMPREHENSIVE
INCOME?
WHAT IS THE STATEMENT OF CHANGES IN
EQUITY?
The Auditor’s Report
WHAT IS FINANCIAL STATEMENT ANALYSIS?
Ratio Analy sis
Liquidity Ratios
Financial Lev erage (Risk Analy sis Ratios)
Operating Performance Ratios
Value Ratios
Trend Analy sis
External Comparisons
SUMMARY
APPENDIX A: XYZ INC. FINANCIAL STATEMENTS
SECTION 4 | UNDERSTANDING MUTUAL FUNDS AND

MANAGED PRODUCTS

INTRODUCTION
WHAT IS A MUTUAL FUND?

Adv antages of Mutual Funds
Disadv antages of Mutual Funds
The Structure of Mutual Funds
HOW ARE MUTUAL FUNDS ORGANIZED?
Directors and Trustees
The Fund Manager
Independent Rev iew Committee
Mutual Fund Distribution
The Custodian
HOW ARE MUTUAL FUNDS REGULATED?
National Instruments 81-101 and 81-102
General Mutual Fund Disclosure Requirements
The Fund Facts Document
The Simplified Prospectus
SUMMARY

INTRODUCTION
WHAT ARE MONEY MARKET MUTUAL FUNDS?

Money Market Funds: Inv estment Objectiv es
The Returns on Money Market Funds
Reading Performance Tables: Money Market Funds
Sample Money Market Fund
WHAT ARE MORTGAGE MUTUAL FUNDS?
Introduction to Mortgages
Mortgage Funds: Inv estment Objectiv es
The Returns on Mortgage Mutual Funds
A Ty pical Mortgage Mutual Fund
WHAT ARE BOND AND OTHER FIXED-INCOME
FUNDS?
Interest Rate Risk and the Concept of Duration
Bond Mutual Funds: Inv estment Objectiv es
The Returns on Bond Funds
A Ty pical Canadian Bond Fund
Short-Term Bond Funds: Inv estment Objectiv es
Preferred Div idend Funds: Inv estment Objectiv es
SUMMARY

INTRODUCTION
WHAT ARE EQUITY MUTUAL FUNDS?

Standard Equity Funds
Equity Growth Funds
Equity Index Funds
Responsible Inv estment
Returns on Equity Mutual Funds
Hy pothetical Examples of Equity Funds
WHAT ARE BALANCED MUTUAL FUNDS?
Inv estment Objectiv es of Balanced Mutual Funds
Returns on Balanced Mutual Funds
Hy pothetical Examples of Balanced Funds
Target-Date Funds
WHAT ARE GLOBAL MUTUAL FUNDS?
Inv estment Objectiv es of Global Mutual Funds
Returns on Global Equity Funds
Hy pothetical Examples of Global Funds
WHAT ARE SPECIALTY MUTUAL FUNDS?
Risk Factors of Specialty Mutual Funds
Hy pothetical Examples of Specialty Funds
Fund Wraps
SUMMARY

INTRODUCTION
WHAT ARE PRINCIPAL-PROTECTED NOTES?

Costs of Principal-Protected Notes
Adv antages and Risks of Principal-Protected Notes
Before Inv esting in Principal-Protected Notes
WHAT ARE HEDGE FUNDS?
Inv esting in Hedge Funds
Hedge Fund Strategies
Costs of Hedge Funds
Adv antages and Risks of Hedge Funds
Before inv esting in Hedge Funds
WHAT ARE CLOSED-END FUNDS?
Adv antages and Risks of Closed-End Funds
Before Inv esting in Closed-End Funds
WHAT ARE EXCHANGE-TRADED FUNDS?
Adv antages and Risks of Exchange-Traded Funds
Costs of Exchange-Traded Funds
Before Inv esting in Exchange-Traded Funds
WHAT ARE SEGREGATED FUNDS?
Adv antages and Risks of Segregated Funds
Costs of Segregated Funds
Before Inv esting in Segregated Funds
SUMMARY
SECTION 5 | EVALUATING MUTUAL FUNDS

INTRODUCTION
HOW IS PORTFOLIO PERFORMANCE

EVALUATED?
Measuring Mutual Fund Performance
Calculating the Risk-Adjusted Rate of Return
Other Factors in Performance Measurement
HOW IS PERFORMANCE ASSESSMENT
CONDUCTED?
Benchmark Indexes
HOW IS A COMPARISON UNIVERSE USED?
Issues that Complicate Mutual Fund Performance
HOW IS QUARTILE RANKING USED?
SUMMARY

INTRODUCTION
HOW DOES VOLATILITY IMPACT MUTUAL FUND

RETURNS?
WHAT ARE THE STEPS IN SELECTING A MUTUAL

FUND?
Research the Performance Data
Focus on Appropriate Inv estment Objectiv es
Focus on Best Long-Term Performance
Focus on Best Year-to-Year Performance
Focus on Good Performers with Lower Volatility
Focus on Funds with Successful Inv estment
Managers
Compare Fund Facts Documents and Compare
Prospectuses
Examine Fees and Charges
Analy ze the Size of the Fund
Make the Decision
WHAT OTHER ELEMENTS SHOULD BE
CONSIDERED WHEN ANALYZING AND
SELECTING MUTUAL FUNDS?
People
Philosophy
Process
Performance
SUMMARY

INTRODUCTION
WHAT ARE THE FEES AND CHARGES OF

MUTUAL FUNDS?
Fees Paid by Indiv idual Mutual Fund Inv estors
Fees and Expenses Paid by Mutual Funds
Fees and Expenses Paid by Fund Managers
Mutual Fund Costs: Analy sis and Implications
WHAT ARE ACCUMULATION PLANS?
Dollar Cost Av eraging
WHAT ARE SYSTEMATIC WITHDRAWAL PLANS?
Fixed-Dollar (or Constant) Withdrawal Plan
Ratio Withdrawal Plan
Fixed-Period Withdrawal Plan
Life Withdrawal Plan
Annuities
HOW ARE MUTUAL FUNDS TAXED?
Tax Consequences
Reinv esting Distributions
SUMMARY
SECTION 6 | ETHICS, COMPLIANCE AND MUTUAL

FUND REGULATIONS

INTRODUCTION
WHAT ARE THE MANDATE AND SCOPE OF

SECURITIES ADMINISTRATORS?
Regulatory Change You Should Know
WHAT ARE SELF-REGULATORY
ORGANIZATIONS?
Objectiv es of the MFDA
Autorité Des Marchés Financiers
Compliance Superv ision
WHAT ARE THE REGISTRATION
REQUIREMENTS?
Educational Qualifications
The Registration Process
The National Registration Database
Dual Employ ment
Transfer and Termination of Registration
Client Focused Reforms
Conflicts of Interest
Know Your Client
Suitability
Know Your Product Rule
Vulnerable Clients
The Role of KYC Information in Opening an Account
WHAT ARE THE STEPS IN OPENING A MUTUAL
FUND ACCOUNT?
Relationship Disclosure
New Accounts
The New Account Application Form (NAAF)
Ty pes of Accounts
Intermediaries, Transfers, and Referrals
WHAT ARE THE PROHIBITED SELLING
PRACTICES?
WHAT ARE THE RULES FOR COMMUNICATIONS

WITH CLIENTS?
Sales Communications
Handling Complaints
WHAT ARE YOUR OTHER LEGAL
RESPONSIBILITIES?
Priv acy Law
Anti-Money Laundering and Terrorist Financing
SUMMARY
18 Applying Ethical Standards to What You

Have Learned
INTRODUCTION
WHAT ARE ETHICS AND THE STANDARD OF

CONDUCT?
Ethical Decision-Making
The Standard of Conduct and Ethical Guidelines
Duty of Care
Integrity
Professionalism
Compliance
Confidentiality
HOW TO APPLY WHAT YOU’VE LEARNED TO
CASE STUDIES
Case 1: Roger Black
Analy sis — Case 1: Roger Black
Case 2: Janet Chen
Analy sis — Case 2: Janet Chen
SUMMARY
G Glossary
SECTION 1
INTRODUCTION TO THE
MUTUAL FUND MARKETPLACE
1 The Role of the Mutual Fund Sales Representative
2 Overview of the Canadian Financial Marketplace
SECTION 1 | INTRODUCTION TO THE
MUTUAL FUND
MARKETPLACE
Section 1 introduces the role of the mutual fund sales
representative and the products that make up the financial
marketplace. This first section consists of three chapters.
Chapter 1 covers the role of the mutual fund sales representative.
We define this role, explain why it exists and give an example of
what the job involves. The chapter also provides you with an
overview of the mutual funds industry from a historical perspective.
Chapter 2 covers an overview of the Canadian financial
marketplace. We include an introduction to financial markets and
review the market participants that make up those markets. The
current regulatory framework is also introduced in this chapter.
Chapter 3 introduces the concepts of economics. We provide an
overview of the laws that govern microeconomics and discuss the
elements of macroeconomics, including national income, gross
domestic product, interest rates and inflation, among others.
These three chapters provide you with the foundation to work from
as you study the material presented in this course.
The Role of the Mutual Fund
1
Sales Representative
CONTENT AREAS
How has the Mutual Fund Industry Evolved?
What is the Value in Licensing?
Why Provide Excellent Client Service?
Why is Understanding your Clients and Products Important?
Know Your Client, Know Your Product and Suitability
What is the Role of a Mutual Fund Sales Representative?
Mutual Fund Sales in Practice
LEARNING OBJECTIVES
1 | Describe the evolution of the mutual fund industry and

the impact mutual funds have had on the financial
services marketplace.
2 | Explain the value of becoming a licensed mutual fund

sales representative and how it prepares you to deal
more confidently with clients to protect their interests
and provide quality advice.
3 | Discuss the importance of providing excellent client

service.
4 | Identify the legal, ethical and professional responsibilities

of a mutual fund sales representative.
5 | List and describe the five components of knowing your

client.
6 | Describe the important role a mutual fund sales

representative plays in the client relationship and how
this role differs from that of a financial planner.
KEY TERMS
Key terms are defined in the Glossary and appear in bold

text in the chapter.
client service
compliance
disclosure
ethical conduct
ethical responsibility
ethics
financial planner
fund facts
investment fund
Know Your Client
Know Your Product
legal responsibility
mutual fund
mutual fund sales representative
net worth
professional responsibility
prospectus
suitability
volatility
INTRODUCTION
A mutual fund is an investment vehicle that pools contributions
from investors and invests these proceeds into a variety of
securities, including stocks, bonds and money market instruments.
Individuals who contribute money become share or unit holders 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. Professional money managers manage the fund’s assets by
investing the proceeds according to the fund’s policies and
objectives and based on a particular investing style.
The mutual fund industry in Canada has experienced tremendous
growth over the past several decades, both in choice of products
available to investors and in the dollar value of assets under
management. Accordingly, the industry offers mutual fund sales
representatives and investors many opportunities and challenges.
Are mutual funds ideal for all investors? As we will learn in this
chapter and throughout the course, there is no one perfect
investment that suits all investors; however, it is worthwhile to
point out that mutual funds have become important investment
products for many investors.
Although they may seem simple and nearly universally available,
mutual funds are in fact a complex investment vehicle. Available in
a variety of different forms and through a variety of different
distribution channels, they may be one of the most visible vehicles
for many investors. The funds themselves are subject to a range of
unique provisions and regulations; thus, it is important to ensure a
full understanding of this particular investment vehicle.
This first chapter provides you with a brief history of mutual funds
and explores the role of the mutual fund sales representative.
HOW HAS THE MUTUAL FUND INDUSTRY

EVOLVED?
Investment products vary over time with changing economic and
social conditions. Among the investment products known as
investment funds that offer investors access to a portfolio of
securities, mutual funds represent a fairly recent development.
They have evolved from earlier types of investment funds with
which they still compete for investment dollars. Overall, the
evolution of the mutual fund industry has been characterized by
significant growth in the number of funds available, the popularity of
those funds with small investors, and the dollar value of fund
assets under management.
A BRIEF HISTORY OF MUTUAL FUNDS

Financial historians generally agree that mutual funds are more than
two centuries old. Some believe they had their start in the
Netherlands in 1774, while others point to the modern mutual fund
having its start in England in the mid-1800s. Regardless of where
mutual funds started out, their popularity grew steadily, primarily
because of their design.
For many investors, building a portfolio of individual stocks can be a
costly venture. There are the fees associated with buying stocks,
not to mention the time involved in researching individual
companies. M utual funds solved this problem by giving investors
who have minimal funds to invest access to a product that offered
a professionally managed and diversified portfolio of securities at a
relatively low cost.
HISTORY OF THE CANADIAN MUTUAL FUND

INDUSTRY
The number of mutual funds in Canada grew slowly until after the
Second World War. During the 1950s and 1960s, the number of
mutual funds grew dramatically. The 1970s, however, was a difficult
period for stock market investors, and the mutual fund industry did
not experience the same level of rapid growth. A better market
climate in the 1980s and 1990s, in combination with other factors,
resulted once again in a period of strong growth in mutual funds.
Canada’s financial services landscape also played an important
role in contributing to this strong growth. The chartered banks
aggressively entered the mutual fund market in the early 1980s and
this helped to lay the ground work and distribution channels for the
strong growth that was to follow.
The following timeline gives you an idea of the evolution of the
mutual fund industry in Canada.
1930s Three mutual funds open for business in Canada.
1960s 30 mutual funds and total assets under management of

about $560 million. Total assets double to almost $1 billion
by the middle of the decade.
1980s Chartered banks enter the industry. Number of funds

grows from about 80 to 400 by the end of the decade.
2000s Assets under management reached about $400 billion.
2021 M ore than $1.98 trillion in assets under management.
Source: IFIC Industry Ov erv iew, July 2021 – https://www.ific.ca
WHAT IS THE VALUE IN LICENSING?

In Canada, individuals who sell financial products, such as mutual
funds, insurance, stocks, or who have specific duties within a
financial services company, such as portfolio management or
supervisory responsibilities, are required to meet educational,
employment and work experience criteria in order to be licensed.
Once the licensing requirements have been met, the application for
registration is handled either by your employer or, if you are
working independently, by a sponsoring financial services firm. After
you are licensed you may also be required to take further
educational courses to maintain your license. Your license has
clear value to you and your clients in establishing investor
relationships and participating in the mutual fund industry.
Acquiring your license to deal with clients as a mutual fund sales
representative has value because it demonstrates:
• You are committed to your professional development, which
shows your clients that you understand the features,
characteristics, and types of mutual funds in the market.
• You have achieved a level of competence in understanding the
importance of making recommendations that are suitable based
on knowing your client.
• You understand the importance of dealing with clients in an
ethical manner.
• You understand the responsibility regulators play in protecting
the integrity of the industry.
HOW THIS COURSE PREPARES YOU

This course covers a wide range of topics related to understanding
mutual funds from a product, client, and regulatory perspective.
M eeting client needs is the focal point of any relationship and the
better informed you are, the greater the likelihood of successful
client relationships. These relationships are built on trust—the trust
clients put in you to help them fulfill their financial needs and the
confidence you show by knowing your client and the products you
are recommending.
Keep in mind however, that this course is just the beginning. As
you progress and begin to deal with more sophisticated clients,
your education and training will also need to change, becoming
more specialized to meet the changing needs of your clients.
Additionally, you may need to satisfy continuing education
requirements throughout your career, depending on the industry
licenses you acquire. This can only be viewed positively from a
client’s perspective, because it shows your commitment to staying
current and keeping your skills sharp.
WHY PROVIDE EXCELLENT CLIENT
SERVICE?
In virtually every type of business, providing excellent client
service has become the business differentiator. But what does
client service mean? Generally, it means:
• Fully understanding client needs, and then
• Identifying the “right” solutions to satisfy those needs.
The mutual funds business is no exception; every client is unique.
Providing excellent client service has important rewards and is
perhaps the most critical aspect of your job.
REWARDS FOR PROVIDING EXCELLENT

CLIENT SERVICE
The rewards for providing excellent client service are substantial.
Happy clients:
• Come back for repeat business.
• They bring more business to your institution because they tell
their friends and families about you.
• They buy other related products and services because they
are satisfied when they deal with you.
WHY CLIENT SERVICE IS SO CRITICAL

This book is about mutual funds and goes into mutual funds in
great detail later in the text. On another level, however, the book is
really about providing first-rate client service as an employee or
independent representative of a mutual fund dealer. It might seem
strange to begin with client service, especially when you might
already be providing excellent client service for your organization.
There are, however, two important reasons why client service is a
central issue here:
• M utual funds are subject to sales regulations and disclosure
requirements, and this demands a specialized client service
approach.
• The rapidly changing financial services environment requires
you to understand the characteristics and purpose of many
products.
We deal with client service early in the text so you will think of
client service first and then mutual funds second.
WHY IS UNDERSTANDING YOUR CLIENTS

AND PRODUCTS IMPORTANT?
For many clients, the purchase of mutual funds can be a new
experience. Some clients wanting to buy mutual funds know little
about the nature of the funds offered. Often, they are not sure
which fund they should buy. Not all clients have the skill or
knowledge to judge whether a particular mutual fund investment is
suitable. M any of them will look to you for guidance. This means
that you have special responsibilities for understanding your
industry, its products, and the clients who come to you for help.
TYPES OF RESPONSIBILITY
When dealing with clients, you have legal, ethical and professional
responsibilities:
Legal Responsibility
You must ensure any investment you recommend or client order
that you accept is suitable for the client. An investment is suitable if
it fits the client’s investment needs and objectives, personal and
financial circumstances, investment knowledge, risk profile, and
investment time horizon. All provincial securities acts make this
legal responsibility clear.
Ethical Responsibility
You must place your client’s needs before your own needs (such
as reaching a sales target) or those of your dealer.
Professional Responsibility
You must provide the best client service possible.
You can meet all these responsibilities if you know your client,
know your products, and know that you have the obligation to
refuse to sell an unsuitable product to the client.
To develop successful client relationships, you must earn a client’s
respect. You can accomplish this through good business practices
as well as through ethical behaviour that reflects well on the
profession and its practitioners.
PERSONAL TRUST, ETHICS AND

COMPLIANCE
The mutual fund industry is based on trust and confidence. As a
consequence, even though the industry already has many rules
and regulations, mutual fund professionals must conduct
themselves in an ethical manner. Every year, your organization
likely requires that you sign a “code of conduct” outlining the
important aspects of protecting client information, maintaining client
confidentiality and following best practices.
In addition to expectations of ethical conduct, the mutual fund
industry also sets out rules and regulations that cover the
compliance aspects of the sale of mutual funds.
• Compliance means following the rules, whether those rules
are legal requirements or dealer policies. If you are not in
compliance you may be liable or subject to dismissal.
• Ethical conduct involves complying not only with the letter of
the law but also with the spirit of the law. Ethics are moral
principles that go beyond prescribed behaviour and addresses
situations where rules are unclear or contradictory. It is
possible to behave unethically even when complying with the
rules.
As a mutual funds sales representative, you may have a fiduciary
responsibility to your clients (i.e., a responsibility to always put the
client’s interests first). Criteria that may be used to determine
whether a fiduciary duty is present in a mutual fund sales
representative-client relationship include a high degree of reliance
by the client on the representative’s advice and the vulnerability of
the client. To ensure that the client’s needs are met, you must
gather specific information from the client. The “Know your Client”
(KYC) rule imposes a higher standard of care on you than if you
were merely executing the client’s orders. The mutual fund sales
representative-client relationship requires that you act carefully,
honestly, and in good faith when dealing with the client, and do not
take advantage of the trust the client has placed in you.
EXAMPLE
A retired couple with little investment experience told an advisor

that they required a secure monthly income from their
investments to maintain their current standard of living. Following
the advisor’s advice, the couple invested the bulk of their money
in equity mutual funds on the assurance that such investments
were safe. The couple eventually suffered large losses on their
investments after a sudden and severe market downturn. The
court found liability on several grounds, including negligence for
the firm’s failure to follow the KYC rule and choose suitable
investments for the couple.
When disputes between mutual fund sales representatives and

clients are resolved through civil litigation, the courts generally hold
that the mutual fund sales representative owes a fiduciary duty to
the client. The existence of such a duty imposes a high standard of
care upon the representative.
An example of an area for compliance is the disclosure rule. Full,
true, and plain disclosure of facts is necessary to make
reasonable investment decisions. The fund facts document issued
by mutual funds must disclose enough detail for the client to make
an informed investment decision. The fund facts document is
designed to be no more than four pages in length and gives
investors key information that is relevant to their investment
decisions, including facts about the fund itself, performance history,
investments and the costs of investing in the fund. The client can
also request the mutual fund’s prospectus, which provides greater
detail than the fund facts document and is much greater in length.
The subject of fund facts documents and mutual fund prospectuses
are covered in more detail later in the text.
KNOW YOUR CLIENT, KNOW YOUR

PRODUCT AND SUITABILITY
On October 3, 2019, the Canadian Securities Administrators (CSA)
released its final amendments to National Instrument 31-103
Registration Requirements, Exemptions and Ongoing Registrant
Obligations. This initiative, known as the Client Focused Reforms
(the CFRs), made changes to the representative conduct
requirements with the following intent:
• To better align the interests of securities advisers, dealers, and
representatives (registrants) with the interests of their clients
• To improve outcomes for clients
• To clarify for clients the nature and terms of their relationship
with registrants
The CFR initiative is based on the concept that client’s best
interests must come first in the client-registrant relationship. The
M utual Fund Dealers Association (M FDA), the national self-
regulatory organization for the distribution side of the mutual fund
industry in Canada, is aligning its rules with the CSA CFR
amendments.
ABOUT THE CFRS
Over the past few decades, the securities industry has changed
from a transactional, trading focused environment to one where
advice and guidance exemplify the role and expectations of
mutual fund sales representatives.
Ensuring that each investment recommendation is suitable has
become a fundamental obligation of all representatives. You
must appreciate, apply, and document the components of
suitability, a requirement at the intersection of the Know Your
Product (KYP) and Know Your Client (KYC) rules (which we
discuss later in the course).
The CFRs cover the enhanced expectations regarding KYC and
KYP, along with rules on conflicts of interest. The CFRs are
aimed at enhancing the standards of conduct in the securities
industry and better aligning the expectations of customers with
their firms. These new regulations will be fully effective by
December 31, 2021 and M FDA regulated firms have been
mandated to comply with them. These regulatory reforms will
translate to stronger processes to further support a winning team
approach and demonstrate an ongoing commitment to putting
customers first.
The three pillars of registrant expectations are suitability, know your

client and know your product. While these pillars, along with other
rules and regulations, are affected by the CFRs, what follows is a
brief introduction to these important cornerstones of the industry. A
more detailed discussion of these concepts and the CFRs can be
found in Chapter 17.
One way of integrating ethics into rules compliance is through
ensuring the suitability of investment recommendations for a
particular client. Suitability means ensuring that all
recommendations:
• take into account the client’s unique situation and investment
objectives;
• are based on the sales representative’s understanding of the
client’s personal and financial situation; and
• are based on the sales representative’s understanding of the
investment products being recommended.
The Know Your Client (KYC) rule states that you must take
reasonable steps to learn the essential facts relevant to every
client and every order. Information concerning the client’s financial
status (both income and net worth), family and other commitments,
as well as financial goals, is required to make an appropriate
investment recommendation.
What if the client refuses to provide the information that you need
to make a decision? The client may say, “Take my order or I’m
leaving!” If you cannot determine investment suitability but go
ahead and accept the client’s order, then you will have violated
securities law. You will have exposed your dealer and yourself to
legal action should the client sue. You will have done a disservice
to yourself, your employer and the client. No one likes to turn away
a client, but your legal, ethical and professional responsibilities
might require you to do so in some cases.
Clients who do not believe they will benefit from providing you with
detailed information may be right. In some cases, clients may have
more investment knowledge than you. There may be little you can
do to improve on their decisions. In other cases, clients may think
they know more than they actually do. In any case, you must rely
on the legal requirement of judging suitability. If you cannot
determine investment suitability, then you should not accept the
order.
Knowing your clients means knowing their:
1. personal circumstances
2. financial circumstances
3. investment needs and objectives
4. investment knowledge
5. risk profile
6. investment time horizon
We cover these six interrelated components more fully in Chapter
4 in the discussion on analyzing client data and information.
Related to knowing your client is the notion of knowing your
product. In the case of mutual funds, Knowing your Product
(KYP) is a question of understanding all the characteristics of the
funds you are recommending to clients. You must understand the
investment’s structure, features, risks, initial and ongoing costs and
the impact of those costs. In addition, the representative must only
consider those investments that have been approved by the
M ember. If the representative’s M ember firm has not approved an
investment, the representative cannot make the investment
available to the client.
Once you know your client and your product, you can judge if an
investment product is right or wrong for that client. Thus product
knowledge is a key element in determining suitability. The question
of suitability ultimately comes down to whether the investment’s
risk and return characteristics fit the client’s characteristics. If you
know your clients and your products, then you can help clients
avoid bad investments. That is what it takes to fulfill your legal,
ethical and professional responsibilities.
WHAT IS THE ROLE OF A MUTUAL FUND

SALES REPRESENTATIVE?
As a mutual fund sales representative, you play the important
role of ensuring that clients’ purchases are suitable given their
predetermined financial goals, financial circumstances, personal
circumstances, investment knowledge, risk profile, and investment
time horizon. You and your client will work together to obtain the
necessary information and then judge whether the client’s
characteristics fit the characteristics of any investment products the
client might have in mind. When the fit is poor, you must explain to
your client why the product is unsuitable and, where feasible,
suggest suitable alternatives.
In some cases, the role of the mutual fund sales representative is
very simple. For example, many clients will quickly be able to
provide reasons for their purchase (their goals) and will indicate
that they have considered their financial condition and are aware of
the investment risks that a mutual fund might present. Some clients
are highly sophisticated investors. In these cases, it is easy to
ensure suitability. In other cases, with less sophisticated clients,
you must carefully document the client’s goals and circumstances
and carefully explain the nature of the products the client has in
mind. In many cases, you will play the role of an educator – and
that just makes good business sense.
At the same time, there are limits to your role. Clients generally are
looking for solutions to attain financial goals through mutual fund
offerings. However, your role does not extend to helping clients
with developing a financial plan through establishing household
budgets, for example. This would be the role of a financial planner.
In situations where clients require planning to attain their goals,
your role is to refer the client to persons qualified to give advice in
the appropriate specialist area. A mutual fund sales representative
may only provide guidance on mutual funds and only after obtaining
a mutual funds license. If you think that a particular client would be
interested in individual stocks, then he or she must be directed to a
salesperson who is registered to sell those securities. Your mutual
fund registration restricts you to speak only about mutual fund
products.
MUTUAL FUND SALES IN PRACTICE

You will examine all the elements of providing guidance in detail as
you move through the text. At this point, however, you might be
curious about the actual job of a mutual fund sales representative.
Following is an example of investment guidance in action. In the
example, some basic knowledge of mutual funds is assumed, so
don’t worry if some aspects are unclear. The case is meant only to
provide you with a sense of the mutual fund professional’s role.
Exhibit 1.1 | Investment Guidance in Action (for information

purposes only)
Background
You are a registered mutual fund sales representative meeting with
a new client for the first time.
In situations like this, you begin by filling out your dealer’s mutual
fund application form. These forms typically have sections for:
• The applicant’s name, address and birth date.
• The amount of money the client wishes to invest.
• Investment needs and objectives, investment knowledge,
annual income, and net worth. Net worth is the value of all of
the client’s assets after subtracting outstanding loan and
mortgage balances.
• An evaluation of the client’s risk profile.
There are other areas to be filled out on the form as well.
The section for client information is there to help you ensure that
you “know your client”, just as the law requires. If a client refuses
to provide this information, then you cannot legally sell him or her a
mutual fund investment.
In our example, assume that you have obtained the client’s name,
address and birth date. His name is Dave Wills, he is single, lives
in London, Ontario, and is 29 years old.
The Interview
You start off with a few client-related questions you are legally
obligated to ask to ensure that M r. Wills invests only in suitable
funds. You work toward understanding his personal and financial
circumstances.
Your questions also deal with his investment needs and
objectives. M r. Wills is starting to save for a down payment on a
house and needs to have that money in about two or three years.
This information is important because the short length of M r. Wills’
investment horizon makes some mutual funds unsuitable. In your
own mind, you have already limited him to a money market fund, or
perhaps a bond fund. Equity funds would not work with a short
investment horizon.
Your have M r. Wills fill out a questionnaire that helps you to
determine his risk profile. M r. Wills has a moderate willingness to
accept risk and a moderate ability to endure a financial loss. This is
critical information since mutual funds are not suitable for highly risk
averse investors. The only exception to this rule might be money
market funds, but even that is questionable. Highly risk tolerant
investors are suitable mutual fund clients, but you would tend to
see few of them, because this type of investment does not usually
interest them. Given M r. Wills’ risk profile, he continues to be a
candidate for mutual funds.
M r. Wills has a net worth of about $40,000, made up of the
balances of two savings accounts, and an annual income of
$42,000. Based on the information you have so far, you would be
surprised if M r. Wills said that he had excellent or even moderate
investment knowledge, because a moderately knowledgeable,
moderately risk tolerant client with a net worth of $40,000 would
probably already have some type of mutual fund or other
investment besides savings accounts. In response to your
question, M r. Wills describes his investment knowledge as poor.
Investment Guidance
By this point, you know enough about M r. Wills to provide some
guidance. You have ruled out equity mutual funds. You believe that
he could probably tolerate some investment risk. You also know
that he is not a knowledgeable investor. With this information in
mind, you ask M r. Wills if he has selected a type of mutual fund of
the three that you offer. He answers that he would like to invest
$10,000 in the equity fund. A relative told him that he could get the
best returns with equity funds.
You must now clearly explain that, while it is true that equity funds
should provide a better return than either bond or money market
funds over the longer term, they are among the most risky of all
mutual funds. That means that over shorter periods, equity funds
might fall and then not rise again until well after the investor needs
the money. In M r. Wills’ case, in the first year, the equity fund might
do very well, but in the second year, it might do very poorly. If M r.
Wills needs the money at the end of the second year, he might
find that his capital has declined. For this reason, given M r. Wills’
short investment time horizon, equity funds are not suitable.
You next explain that this problem of fluctuating value (known as
volatility) is not as pronounced with most bond funds and hardly
exists at all with money market funds.
In cases like this, when the client does not have much investment
knowledge, it is particularly important to explain as much as you
can about the risk characteristics of suitable and unsuitable funds.
Documents, known as the fund facts and the prospectus, describe
these characteristics for each fund. You will give a copy of the fund
facts document (and prospectus upon request) to the client, but it
would be helpful to point out, and even read through, key areas of
concern, such as the fund’s investment objectives. In M r. Wills’
case, you could read the warning about equity fund volatility
contained in the fund facts or prospectus and contrast this with the
objectives of the money market and bond funds.
The Decision
M r. Wills asks whether you think the bond fund is the more suitable
choice of the remaining two funds. In response, you ask M r. Wills
to fill out a special questionnaire designed by your firm that will
lead to a recommended mutual fund portfolio made up of some of
the funds offered. M r. Wills fills out the questionnaire and the
resulting suggested portfolio is 5% equity mutual fund, 10% bond
fund and 85% money market fund.
M r. Wills decides to invest the $10,000 in the suggested mutual
fund portfolio.
Legal, ethical and professional responsibilities — notice how you
have successfully taken them in charge.
• First, you respected legal requirements by the care you took in
making sure that the investments made by the client were
suitable given his objectives, financial and personal
circumstances, investment knowledge, risk profile, and
investment time horizon.
• Second, you fulfilled your ethical responsibility by looking after
the client’s needs rather than your own or your dealer’s needs.
In this case, you have recommended that most of the client’s
capital be invested in a money market mutual fund. M oney
market mutual funds generate lower fees for the financial
institution’s mutual fund dealer-subsidiary than other types of
mutual funds.
• Finally, by carefully obtaining critical client information and using
it to guide and inform, you have acted professionally. Because
you have provided excellent client service, you have increased
the likelihood that M r. Wills will continue to invest with your
institution.
Case Study | A Day in the Life of a Mutual Fund
Representative: Mary Gets Set for Success (for
information purposes only)
M ary, a mutual fund sales representative at a major Canadian

financial institution, begins her working day watching business
channels to get up-to-date on the previous day’s news and any
overnight developments, setting her up to be well-prepared to
address questions from clients and colleagues. Upon her arrival at
the office, M ary reviews her schedule for that day’s meetings. She
notices that she has two meetings booked, one with a brand-new
client to investing and one where she will be reviewing a client’s
existing portfolio.
For the first meeting, M ary prepares the necessary documents to
set up a new account. She reviews to ensure that she is well
prepared to discuss the fundamental principles of investing to help
her new-to-investing client establish a solid foundation of
investment knowledge. Her primary goal will be to help her client
articulate their investment goals. Also, she wants to establish a
clear understanding of the client’s risk tolerance and their time
horizon. All of this information will help ensure that M ary provides
the right investment solutions to set the client on the right path for
their investment journey.
For her second meeting, M ary reviews her client’s investment
profile and existing mutual fund holdings, checking that the client’s
portfolio is properly aligned to their profile and reflecting their stated
goals. M ary notices that the client’s portfolio has drifted from the
strategic asset allocation since their last review six-months ago, so
she prepares appropriate recommendations to re-align the client’s
portfolio. She also prepares some recommendations for the client
to consider replacing existing mutual funds with funds that are
providing similar gross returns but with lower fees – thereby
enhancing the client’s potential returns.
Now, M ary is set-up for success and ready to provide excellent
client service to her clients.
TERMINOLOGY REVIEW
How familiar are you with the terminology you have been
introduced to in this chapter? Complete the online learning
activity to assess your knowledge.
Note: To access the online components of your course,
login to your Student Profile at www.csi.ca and, once
logged in, click on the ‘Access Online Courses’ button.
YOUR RESPONSIBILITIES AND YOUR CLIENT
How well do you know the different responsibilities of a

mutual fund representative, and how well do you know your
client? Complete the online learning activity to assess your
knowledge.
SUMMARY
After reading this chapter, you should be able to:
1. Describe the evolution of the mutual fund industry and the
impact mutual funds have had on the financial services
marketplace.
◦ The growth in the demand for mutual funds can be tied to
their design: investors who have minimal funds to invest
have access to a product that offers a professionally
managed and diversified portfolio of securities at a relatively
low cost.
The mutual fund industry in Canada grew dramatically in the
◦ 1980s and 1990s, spurred by a declining interest rate market,
the chartered banks entering the fund industry, and a
proliferation of choice in the number of funds available.
◦ Assets under management in Canada was more than $1.45
trillion by the end M arch 2020.
2. Explain the value of becoming a licensed mutual fund sales
representative and how it prepares you to deal more
confidently with clients to protect their interests and provide
quality advice.
◦ Individuals who sell financial products such as mutual funds
are required to meet educational, employment and work
experience criteria in order to be licensed.
◦ M eeting client needs is the focal point of any relationship
and the better informed you are the greater the likelihood of
successful client relationships.
3. Discuss the importance of providing excellent client service.
◦ Client service means fully understanding client needs and
identifying the right solutions to satisfy those needs.
◦ The rewards for providing excellent client service include
repeat business and the potential for expanding your client
base.
4. Identify the legal, ethical and professional responsibilities of a
mutual fund sales representative.
◦ Your legal responsibility ensures that any investment you
recommend is suitable for the client.
◦ Your ethical responsibility ensures that client interests are
placed ahead of your own needs and those of your dealer.
◦ Your professional responsibility is to provide the best client
service possible.
5. List and describe the five components of knowing your client.
◦ Knowing clients means knowing their personal and financial
circumstances, investment needs and objectives,
investment knowledge, risk profile, and time horizon.
◦ Knowing your product is a question of understanding all the
characteristics of the funds you are recommending to
clients.6. Describe the important role a mutual fund sales
representative plays in the client relationship and how this
role differs from that of a financial planner.
◦ The mutual fund sales representative plays the important
role of ensuring that client mutual fund purchases are
suitable.
◦ Depending on the investing experience of clients, you will
also play the role of educator.
◦ It is also important to recognize what services you cannot
provide, for example financial planning.
◦ In situations where clients require planning to attain those
goals, your role is to refer the client to persons qualified to
give advice in the appropriate specialist area.
REVIEW QUESTIONS
Now that you have completed this chapter, you should be

ready to answer the Chapter 1 Review Questions.
FREQUENTLY ASKED QUESTIONS
If you have any questions about this chapter, you may find
answers in the online Chapter 1 FAQs.
Overview of the Canadian
2
Financial Marketplace
CONTENT AREAS
What is Investment Capital?
What are the Financial Instruments?
What are the Financial Markets?
Who are the Different Financial Intermediaries?
What is the Canadian Securities Regulatory Framework?
LEARNING OBJECTIVES
1 | Define investment capital and describe the role played

by suppliers and users of capital in the economy.
2 | Describe and differentiate among the types of financial

instruments used in financial market transactions.
3 | Describe the roles and distinguish among the different

types of financial markets and define primary and
secondary markets.
4 | Describe the roles of the financial intermediaries in the
Canadian financial services industry.
5 | List the industry regulators and their main functions and

requirements affecting mutual fund
sales representatives.
KEY TERMS

ask price
auction market
Autorité des Marchés Financiers (AMF)
bid price
capital
Chambre de la sécurité financière
dealer market
derivatives
equities
financial intermediaries
financial market
fixed-income securities
foreign investors
initial public offering
institutional investors
investment fund
Investment Industry Regulatory Organization of Canada

(IIROC)
liquidity
mutual fund
Mutual Fund Dealers Association (MFDA)
open-end fund
over-the-counter (OTC)
primary market
retail investors
secondary market
securities
self-regulatory organizations
source of capital
stock exchange
underwriting
users of capital
INTRODUCTION
The Canadian financial services industry plays a significant role in
sustaining and expanding the Canadian economy. The industry
grows and evolves to meet the ever-changing needs of Canadian
investors, both from domestic and international perspectives.
In some way, we are all affected by the financial services industry.
The vital economic function the industry plays is based on a simple
process: the transfer of money from those who have it (savers) to
those who need it (users). This capital transfer process is made
possible through the use of a variety of financial instruments:
stocks, bonds, mutual funds and derivatives. Financial
intermediaries, such as banks, trust companies, and investment
and mutual fund dealers, have evolved to make the transfer
process efficient.
This chapter introduces the Canadian financial system and its
participants: investment markets, products, intermediaries, and the
regulatory environment.
For those new to this material, we offer a suggestion: stay
informed about the markets and the industry because it will help
you better understand the material presented in this textbook.
There are countless sources of financial market information,
including newspapers, the Internet, books and magazines. The
course material will be easier to grasp if you can relate it to the
activity that unfolds each day in the financial markets. Ultimately,
this will help you achieve your goal of becoming an informed and
effective participant in the mutual fund industry.
WHAT IS INVESTMENT CAPITAL?

In general terms, capital is wealth – both real, material things such
as land and buildings, and representational items such as money,
stocks and bonds. All of these items have economic value. Capital
represents the invested savings of individuals, corporations,
governments and many other organizations and associations. It is
in short supply and is arguably the world’s most important
commodity.
Capital savings are useless by themselves. Only when they are
harnessed productively do they gain economic significance. Such
utilization may take the form of either direct or indirect investment.
• Capital savings can be used directly by, for example, a couple
investing their savings in a home; a government investing in a
new highway or hospital; or a domestic or foreign company
paying start-up costs for a plant to produce a new product.
• Capital savings can also be harnessed indirectly through the
purchase of such representational items as stocks, bonds or
mutual funds or through the deposit of savings in a financial
institution.
Indirect investment occurs when the saver buys the securities
issued by governments and corporations, who in turn use the funds
for direct productive investment – equipment, supplies, etc. Such
investment is normally made with the assistance of the retail or
institutional sales department of investment firms.
CHARACTERISTICS OF CAPITAL
Capital has three important characteristics. It is mobile, sensitive to
its environment and scarce. Therefore capital is extremely
selective. It attempts to settle in countries or locations where
government is stable, economic activity is not over-regulated, the
investment climate is hospitable and profitable investment
opportunities exist.
The decision as to where capital will flow is guided by country risk
evaluation, which analyzes such things as:
The political whether the country is involved or likely to be

environment: involved in internal or external conflict.
Economic growth in gross domestic product, inflation rate,

trends: levels of economic activity, etc.
Fiscal policy: levels of taxes and government spending and

the degree to which it encourages savings and
investment.
Monetary the sound management of the growth of the

policy: nation’s money supply and the extent to which
it promotes price and foreign exchange stability.
Investment opportunities for investment and satisfactory

opportunities: returns on investment when considering
the risks.
Characteristics whether it is skilled and productive.

of the labour
force:
Because of its mobility and sensitivity, capital moves in or out of

countries or localities in anticipation of changes in taxation,
exchange policy, trade barriers, regulations, government attitudes,
etc. It moves to where the best use can be made of it and
attempts to avoid areas where the above factors are not positive.
Thus, capital moves to uses and users that reliably offer the
highest returns. Capital is scarce worldwide and is in great demand
everywhere.
SOURCES AND USERS OF CAPITAL

The only source of capital is savings. When revenues of non-
financial corporations, individuals, governments and non-residents
exceed their expenditures, they have savings to invest.
Non-financial corporations, such as steel makers, food distributors
and machinery manufacturers, have historically generated the
largest part of total savings mainly in the form of earnings, which
they retain in their businesses. These internally generated funds
are usually available only for internal use by the corporation and
are not normally invested in other companies’ stocks and bonds.
Thus, corporations are not important providers of permanent funds
to others in the capital market.
Individuals may decide, especially if given incentives to do so, to
postpone consumption now in order to save so that they can
consume in the future. Governments that are able to operate at a
surplus are “savers” and able to invest their surpluses. Other
governments are “dis-savers” and must borrow in capital markets to
fund their deficits.
Non-residents, both corporations and private investors, have long
regarded Canada as a good place to invest. Canada has
traditionally relied on savings for both direct plant and equipment
investment in Canada and portfolio investment in Canadian
securities.
SOURCES OF CAPITAL
Retail, institutional, and foreign investors are a significant source of
investment capital.
Retail Retail investors are individual investors who buy

investors and sell securities for their own personal accounts,
and not for another company or organization.
Institutional Institutional investors are organizations, such as

investors a pension fund or mutual fund company, that trade
large volumes of securities and typically have a
steady flow of money to invest. Retail investors
generally buy in smaller quantities than larger,
institutional investors.
Foreign Foreign investors also are a significant source of

investors investment capital. Historically, Canada has
depended upon large inflows of foreign investment
for continued growth. Foreign direct investment in
Canada has tended to concentrate in particular
industries: manufacturing, petroleum and natural
gas, and mining and smelting. Some industries also
have restrictions with respect to foreign
investment.
USERS OF CAPITAL
Based on the simplest categorization, the users of capital are
individuals, businesses and governments. These can be both
Canadian and foreign users. The ways in which these groups use
capital are described below.
INDIVIDUALS
Individuals may require capital to finance housing, consumer
durables (e.g., automobiles, appliances) or other types of
consumption. They usually obtain it through incurring indebtedness
in the form of personal loans, mortgage loans or charge accounts.
Since individuals do not issue securities to the public and the focus
of this text is on securities, individual capital users are not
discussed further.
Just as foreign individuals, businesses or governments can supply
capital to Canada, capital can flow in the other direction. Foreign
users (mainly businesses and governments) may access Canadian
capital by borrowing from Canadian banks or by making their
securities available to the Canadian market. Foreign users will want
Canadian capital if they feel that they can access this capital at a
less expensive rate than their own currency. Access to foreign
securities benefits Canadian investors, who are thus provided with
more choice and an opportunity to further diversify their
investments.
BUSINESSES
Canadian businesses require massive sums of capital to finance
day-to-day operations, to renew and maintain plant and equipment
as well as to expand and diversify activities. A substantial part of
these requirements is generated internally (e.g., profits retained in
the business), while some is borrowed from financial intermediaries
(principally the chartered banks). The remainder is raised in
securities markets through the issuance of short-term money
market paper, medium- and long-term debt, and preferred and
common shares.
GOVERNMENTS
Governments in Canada are major issuers of securities in public
markets, either directly or through guaranteeing the debt of their
Crown corporations.
Federal When revenues fail to meet expenditures and/or

Government when large capital projects are planned, the
federal government must borrow. The
government makes use of two main instruments:
treasury bills (T-bills) and marketable bonds.
Provincial Like the federal government, the provinces issue

Governments debt directly themselves.
When revenues fail to meet expenditures and/or
when large capital projects are planned,
provinces must borrow. They may issue bonds to
the federal government or borrow funds from
Canada Pension Plan (CPP) assets (or the
Québec Pension Plan in the case of Québec).
Alternatively, a province may issue debt
domestically through a syndicate of investment
dealers who sell the issue to financial institutions
or to retail investors. In addition to conventional
debt issues, some provinces issue their own
short-term treasury bills and, in some cases, their
own savings bonds.
Municipal M unicipalities are responsible for the provision of

Governments streets, sewers, waterworks, police and fire
protection, welfare, transportation, distribution of
electricity and other services for individual
communities. Since many of the assets used to
provide these services are expected to last for
twenty or more years, municipalities attempt to
spread their cost over a period of years through
the issuance of instalment debentures (or serial
debentures).
SOURCES AND USERS OF CAPITAL
Who are the typical sources of capital and users of capital?

Complete the online learning activity to assess your
knowledge.
WHAT ARE THE FINANCIAL INSTRUMENTS?

Transferring money from one person to another may seem
relatively straightforward. Why, then, do we need formal financial
instruments called securities?
As a way of distributing capital in a large, sophisticated economy,
securities have many advantages. Securities are formal, legal
documents that set out the rights and obligations of the buyers and
sellers. Securities tend to have standard features, which facilitates
their trading. Furthermore, there are many types of securities,
enabling both investors (buyers) and users (sellers) of capital to
meet their particular needs.
FINANCIAL INSTRUMENTS
M uch of this text deals with the characteristics of different financial
instruments – primarily stocks, bonds, and mutual funds. The brief
discussion included here introduces you to the different types of
financial instruments discussed throughout this text.
Financial instruments are divided into broad classes: debt
instruments, equity instruments, investment funds, derivatives and
other financial instruments.
Debt Debt instruments formalize a relationship in which

Instruments the issuer promises to repay the loan at maturity
and in the interim makes interest payments to the
investor. The term of the loan ranges from very
short to very long, depending on the type of
instrument. Bonds, debentures, mortgages,
treasury bills and commercial paper are all
examples of debt instruments (also referred to as
fixed-income securities).
Equity Equities are usually referred to as stocks or

Instruments shares because the investor actually buys a
“share” of the company, thus gaining an ownership
stake in the company. As an owner, the investor
participates in the corporation’s fortunes. If the
company does well, the value of the company may
increase, giving the investor a capital gain when
the shares are sold. In addition, the company may
distribute part of its profit to shareowners in the
form of dividends. Unlike interest on a debt
instrument, however, dividends are not obligatory.
Different types of shares have different
characteristics and confer different rights on the
owners. In general, there are two main types of
stock: common and preferred.
Investment An investment fund is a company or trust that

Funds manages investments for its clients. The most
common form is the open-end fund, also known
as a mutual fund. The fund raises capital by
selling shares or units to investors, and then
invests that capital. As unitholders, the investors
receive part of the money made from the fund’s
investments.
Derivatives Unlike stocks and bonds, derivatives are suited

mainly for more sophisticated investors.
Derivatives are products based on or derived from
an underlying instrument, such as a stock or an
index. The most common derivatives are options
and forwards.
Other In the past few years, investment dealers have

Financial used the concept of financial engineering to create
Instruments structured products that have various combinations
of characteristics of debt, equity and investment
funds. Two of the most popular are linked notes
and exchange-traded funds (ETFs).
WHAT ARE THE FINANCIAL MARKETS?

Securities are a key element in the efficient transfer of capital from
savers to users, benefiting both. M any of the benefits of
investment products, however, depend on the existence of efficient
markets in which these securities can be bought and sold. A well-
organized market provides speedy transactions and low
transaction costs, along with a high degree of liquidity and effective
regulation.
Like a farmers’ market, a financial market (or securities market)
provides a forum in which buyers and sellers meet. But there are
important differences. In the securities markets, buyers and sellers
do not meet face to face. Instead, intermediaries, such as
investment advisors (IAs) or bond dealers, act on their clients’
behalf.
Unlike most markets, a securities market may not manifest itself in
a physical location. This is possible because securities are
intangible – at best, pieces of paper, and often not even that. Of
course, some securities markets do have a physical component.
Other securities markets, such as the bond market, exist in
“cyberspace” as a computer- and telephone-based network of
dealers who may never see their counterparts’ faces. In Canada,
all exchanges are electronic.
The capital market or securities market is made up of many
individual markets. For example, there are stock markets, bond
markets and money markets. In addition, securities are sold on
primary and secondary markets.
• In the primary market new securities are sold by companies
and governments to investors for the first time. Companies can
raise capital by selling stocks or bonds to investors while
governments raise capital by selling bonds. In this market,
investors purchase securities directly from the issuing company
or government. When a company issues stocks for the very
first time in the primary market, the sale is known as an initial
public offering (IPO). M utual funds are also sold in the primary
market. Investors buy and sell M utual fund units directly from
and to the fund itself.
• In the secondary market investors trade securities that have
already been issued by companies and governments. In this
market, buyers and sellers trade among each other at a price
that is mutually beneficial to both parties. The security is then
transferred from the seller to the buyer. The issuing company
does not receive any of the proceeds from transactions in the
secondary market - the issuer received payment when the
securities were first issued in the primary market.
AUCTION MARKETS IN CANADA

M arkets can also be divided into auction and dealer markets. In an
auction market, buyers enter bids and sellers enter offers for a
stock. The price at which a stock is traded represents the highest
price the buyer is willing to pay (the bid price) and the lowest price
the seller is willing to accept (the ask price). These orders are
then channelled to a single central market and compete against
each other.
CANADIAN EXCHANGES
A stock exchange is a marketplace where buyers and sellers of
securities meet to trade with each other and where prices are
established according to the laws of supply and demand. On
Canadian exchanges, trading is carried on in common and preferred
shares, rights and warrants, listed options and futures contracts,
instalment receipts, exchange-traded funds (ETFs), income trusts,
and a few convertible debentures.
Liquidity is fundamental to the operation of an exchange. A liquid
market is characterized by:
• Frequent sales
• Narrow price spread between bid and ask prices
• Small price fluctuations from sale to sale
Canada’s stock exchanges are auction markets. During trading
hours, Canada’s exchanges receive thousands of buy and sell
orders from all parts of the country and abroad.
Exchanges in Canada include: the Toronto Stock Exchange (TSX)
and the TSX Venture Exchange, the TSX Alpha Exchange, and the
M ontreal Exchange (M X, also known as the Bourse de M ontréal)
owned by the TM X Group Inc. Other exchanges in Canada include
ICE NGX Canada, the Canadian Securities Exchange (CSE) and
the NEO Exchange. Each exchange is responsible for the trading
of certain products.
• The TSX lists senior equities, some debt instruments that are
convertible into a listed equity, income trusts and Exchange-
Traded Funds (ETFs).
• The TSX Venture Exchange trades junior securities and a few
debenture issues.
• The TSX Alpha Exchange lists equities, debentures, exchange-
traded funds and structured products. Alpha Exchange offers
trading in securities listed on the Toronto Stock Exchange and
the TSX Venture Exchange.
• The M ontreal Exchange trades all financial and equity futures
and options.
• ICE NGX provides electronic trading, central counterparty
clearing and data services to the North American natural gas
and electricity markets.
• CSE trades securities of emerging companies.
• The NEO exchange is an exchange that provides listing
services and facilitates trading in securities listed on the NEO
Exchange, TSX, and the TSX Venture Exchange.
M ore information about global stock exchanges can be found on
the World Federation of Exchanges website.
DEALER MARKETS
Dealer markets are the second major type of market on which
securities trade. They consist of a network of dealers who trade
with each other, usually over the telephone or over a computer
network. Unlike auction markets, where the individual buyer’s and
seller’s orders are entered, a dealer market is a negotiated market
where only the dealers’ bid and ask quotations are entered by
those dealers.
Almost all bonds and debentures are sold through dealer markets.
These dealer markets are less visible than the auction markets for
equities, so many people are surprised to learn that the volume of
trading (in dollars) on the dealer market for debt securities is
significantly larger than the equity market.
Dealer markets are also referred to as over-the-counter (OTC) or
as unlisted markets – securities on these markets are not listed on
an organized exchange as they are on auction markets.
AUCTION AND DEALER MARKETS
What is the difference between an auction market and a

dealer market? Complete the online learning activity to
assess your knowledge.
WHO ARE THE DIFFERENT FINANCIAL

INTERMEDIARIES?
The term “financial intermediary” is used to describe any
organization that facilitates the trading or movement of the financial
instruments that transfer capital between suppliers and users.
Intermediaries include banks and trust companies, which
concentrate on gathering funds from suppliers in the form of saving
deposits and transferring them to users in the form of mortgages,
car loans and other lending instruments. Other intermediaries, such
as insurance companies and pension funds, collect funds and
invest them in bonds, equities, real estate, etc., to meet their
customers’ needs for financial security.
In an efficient and well-ordered economy, suppliers and users of
capital must be able to meet. It does little good to have surplus
funds to invest if there is no mechanism for finding someone who
needs those funds. In other words, you must have access to a
market. Whether an individual, a company, or government is a
supplier or user of capital, market access is organized through
other companies known as financial intermediaries.
Intermediaries can be divided into two broad categories: the
deposit-taking and non-deposit-taking institutions.
• The deposit-taking institutions are the banks and trust
companies. They pool the deposits of thousands of savers and
then invest those funds in different types of investments.
Banks, for example, will lend money to users of funds, such as
individuals, companies, and governments. They will also invest
some funds in money market securities.
• A life insurance company is an example of a non-deposit-taking
institution. It acquires capital by pooling the premiums from
policies it issues to individuals and then investing those
premiums in capital market securities. In this way, it provides
sufficient funds to satisfy the claims of policy holders.
THE ROLE OF INVESTMENT DEALERS

Another example of a non-deposit-taking institution is an
investment dealer. Investment dealers serve a number of functions,
sometimes acting on their clients’ behalf as agents in the transfer of
instruments between different investors, at other times acting as
principal. Investment dealers sometimes are known by other
names, such as brokerage firms or securities houses. Investment
dealers play a significant role in the securities industry’s two main
functions.
• First, investment dealers help to transfer capital from savers to
users through the underwriting and distribution of new
securities. This takes place in the primary market.
• Second, investment dealers maintain secondary markets in
which previously issued or outstanding securities can be traded
among investors. The secondary market enables investors
who originally bought the investment products to sell them and
obtain cash. As noted previously, without secondary market
liquidity – the ability to sell the securities with ease at a
reasonable price – investors would not buy securities in the
primary market.
OTHER INTERMEDIARIES
Investors’ confidence in Canada’s financial systems is high. It is
based upon a long record of integrity and financial soundness
reinforced by a legislative framework that provides close
supervision of their basic activities.
CHARTERED BANKS
Chartered banks operate under the Bank Act, which has been
regularly updated, usually through revisions every five years. The
Act sets out specifically what a bank may do and provides
operating rules enabling it to function within the regulatory
framework.
According to the Office of the Superintendent of Financial
Institutions, at the end of July 2021, Canada had 83 banks, made
up of 35 domestic banks, 17 foreign bank subsidiaries and 31
foreign bank branches. The largest six domestic banks control
more than 90% of banking industry assets. The Canadian banking
industry is one of Canada’s largest industries in terms of
employment. As a result of international consolidation, the largest
Canadian banks are becoming relatively smaller when judged
against their international competitors. However, in April 2020, the
Royal Bank of Canada, the Toronto-Dominion Bank, the Bank of
Nova Scotia and the Bank of M ontreal are in the list of top 50
banks worldwide, when ranked by assets.
LIFE INSURANCE COMPANIES

The insurance industry has two main businesses: life insurance
and property and casualty insurance. Life insurance and related
products include insurance against loss of life, livelihood or health,
such as health and disability insurance, term and whole life
insurance, pension plans, registered retirement savings plans and
annuities.
The Canadian insurance industry, including agents, appraisers and
adjusters, employs more than 150,000 people, divided more or less
evenly between the life insurance industry and the property and
casualty insurance industry. Between the two industries, more than
$800 billion in assets is managed either directly or indirectly on
behalf of policyholders.
CREDIT UNIONS AND CAISSES POPULAIRES

Early in the 1900s, many individual savers and borrowers felt that
chartered banks were too profit oriented. This led to the
establishment of many co-operative, member-owned credit unions
in English-speaking communities in Canada (predominantly in
Ontario, Saskatchewan and British Columbia), and the parallel
caisses populaires in Quebec. Frequently, credit unions seek
member-savers from common interest groups such as those in the
same neighbourhood, those with similar ethnic backgrounds and
those from the same business or social group.
Credit unions and caisses populaires offer diverse services such
as business and consumer deposit taking and lending, mortgages,
mutual funds, insurance, trust services, investment dealer services,
and debit and credit cards. Local credit unions and caisses
populaires belong to central provincial societies to further common
interests. These societies provide broader services such as
investing surplus funds from member locals, lending them funds
when required, and cheque clearing. M any are as small as one
branch.
INVESTMENT FUNDS
An investment fund (or mutual fund) is a 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.
Individuals who contribute money become share or unitholders in
own. Professional money managers manage the assets of the fund
by investing the proceeds according to the fund’s policies and
M utual fund shares/units are redeemable on demand at the fund’s
current price, which depends on the market value of the fund’s
portfolio of securities at that time.
Case Study | Helping Clients Understand Mutual Funds (for

M ary is meeting with a young client to set up their first investment

account. The client’s goal is to save for retirement. M ary
recommends using a Registered Retirement Savings Plan or
RRSP (covered in more detail in Chapter 6 of the textbook). M ary
explains to her client that an RRSP is a savings plan registered
with the Canada Revenue agency, contributions to the plan are tax
deductible, and tax on any income or gains within the plan are
deferred until money is withdrawn from the plan. Investing in
RRSPs will help to maximize the client’s long-term investment
growth potential through tax-deferred compounding.
After establishing the client’s “know your client” (KYC) information,
M ary suggests using mutual funds within an RRSP to help the
client save and grow their investments. The client has no idea
what a mutual fund is. M ary explains that:
• It is an investment pool into which investors combine their
contributions.
• With those contributions, investors purchase units of the pool –
once they do, they become unit holders in the pool or fund.
• The mutual fund’s investment manager then takes those
investor contributions and purchases assets, such as equities
or bonds.
• The fund’s investment manager does this based on the fund’s
mandate. This mandate guides and directs the investment
manager as to how to invest the pool of investors’
contributions – for example, a fund with a mandate to invest in
Canadian government short-term bonds will use unit holders’
contributions to purchase federal and provincial government
bonds with maturities between one and three years.
• If the value of the assets in the pool rises beyond the costs
associated with running the fund and any fees the fund charges
unit holders, investor’s units rise in value; if the assets held by
the fund fall in value, then the unit holder’s units decline in
value.
• Investors can buy more or sell some or all of their units at any
time.
• M utual funds can be purchased and sold within an RRSP.
WHAT IS THE CANADIAN SECURITIES
REGULATORY FRAMEWORK?
Regulation of the financial system and financial transactions is a
complex matter in Canada, involving both federal and provincial
regulators, as well as a number of self-regulatory organizations
(SROs). At the federal level, there are several pieces of
legislation — such as the Consumer Protection Act, the Criminal
Code, the Bank Act, and the Canada Business Corporations Act —
that define the limits of activity for participants in the financial
system. In general, however, most legislation regarding the trading
and distribution of securities is a provincial matter, dealt with in each
province’s securities act and is the responsibility of each province’s
securities administrator. Collectively, the provincial regulators work
together to harmonize and coordinate the regulation of the
Canadian capital markets through the Canadian Securities
Administrators (CSA).
SELF-REGULATORY ORGANIZATIONS
(SROS)
Self-regulatory organizations (SROs) are private industry
organizations that have been granted the privilege of regulating
their own members by the provincial regulatory bodies. SROs are
responsible for enforcement of their members’ conformity with
securities legislation and have the power to prescribe their own
rules of conduct and financial requirements for their members.
SROs are delegated regulatory functions by the provincial
regulatory bodies, and SRO by-laws and rules are designed to
uphold the principles of securities legislation. The provincial
securities commissions monitor the conduct of the SROs. They
also review the rules of the SROs in the province to ensure that
the SRO rules do not conflict with securities legislation and are in
the public’s interest. SRO regulations apply in addition to provincial
regulations. If an SRO rule differs from a provincial rule, the more
stringent rule of the two applies.
Canadian SROs include the M utual Fund Dealers Association
(M FDA) and the Investment Industry Regulatory Organization of
Canada (IIROC).
MUTUAL FUND DEALERS ASSOCIATION (MFDA)

The Mutual Fund Dealers Association (M FDA) is the mutual
fund industry’s SRO for the distribution side of the mutual fund
industry. It does not regulate the funds themselves. That
responsibility remains with the securities commissions.
M FDA members are mutual fund dealers licensed with provincial
securities commissions. The M FDA is not responsible for
regulating the activities of mutual fund dealers who are already
members of another SRO, however. For example, The Investment
Industry Regulatory Organization of Canada (IIROC) members
selling mutual fund products continue to be regulated by the IIROC.
In Quebec, the mutual fund industry is under the responsibility of
the Autorité des marches financiers (AM F) and the Chambre de
la sécurité financière. The AM F is responsible for overseeing the
operation of fund companies within the province, while the
Chambre is responsible for setting and monitoring continuing
education requirements and for enforcing a code of ethics. A
cooperative agreement currently in place between the M FDA and
the AM F will help to avoid regulatory duplication and to ensure that
investor protection is maintained.
INVESTMENT INDUSTRY REGULATORY

ORGANIZATION OF CANADA
The Investment Industry Regulatory Organization of Canada
(IIROC) is the SRO which oversees all investment dealers and
trading activity in Canada.
IIROC carries out its regulatory responsibilities through setting and
enforcing rules regarding the proficiency, business and financial
conduct of investment dealers and their registered employees and
through setting and enforcing market integrity rules regarding
trading activity on Canadian marketplaces.
All Canadian investment dealers must be members of IIROC.
SUMMARY
1. Define investment capital and describe the role played by
suppliers and users of capital in the economy.
◦ Investment capital is available and investable wealth (e.g.,
real estate, stocks, bonds, and money) that is used to
enhance the economic growth prospects of an economy.
◦ In direct investment, an individual or company invests
directly in an item (e.g., house, new plant, or new road);
indirect investment occurs when an individual buys a
security and the issuer invests the proceeds.
◦ Capital has three characteristics: it is mobile, it is sensitive,
and it is scarce.
◦ The only source of capital is savings. Capital comes from
retail, institutional, and foreign investors. Users of capital are
individuals, businesses and governments. These can be
both Canadian and foreign users.
2. Describe and differentiate among the types of financial
instruments used in financial market transactions.
◦ Debt (bonds or debentures): the issuer promises to repay a
loan at maturity, and in the interim makes payments of
interest or interest and principal at predetermined times.
◦ Equity (stocks): the investor buys a share that represents a
stake in the company.
◦ Investment funds (mutual funds): a company or trust that
manages investments for its clients.
◦ Derivatives (options, futures, rights): products derived from
an underlying instrument such as a stock, other financial
instrument, commodity, or index.
◦ Other financial instruments (linked-notes, ETFs): these
relatively new products have been financially engineered
and have various combinations of characteristics of debt,
equity and investment funds.
3. Describe the roles and distinguish among the different types of
financial markets and define primary and secondary markets.
◦ The financial markets facilitate the transfer of capital
between investors and users through the exchange of
securities.
◦ The exchanges do not deal in physical movement of
securities; they are simply the venue for agreeing to transfer
ownership.
◦ The primary market is the initial sale of securities to an
investor. M utual funds are bought and sold in the primary
market.
◦ The secondary market is the transfer of already issued
securities among investors.
◦ In an auction market, clients’ bid and ask quotations for a
stock are channelled to a single central market (stock
exchange) and compete against each other.
◦ Dealer markets are a network of dealers that trade directly
between each other. M ost bonds and debentures trade on
these markets.
4. Describe the roles of the financial intermediaries in the
Canadian financial services industry.
◦ A financial intermediary is an organization that facilitates the
movement of capital between suppliers and users.
◦ Financial intermediaries can be divided into two broad
categories: the deposit-taking and non-deposit-taking
institutions.
◦ The deposit-taking institutions are the banks and trust
companies.
◦ The non-deposit-taking institutions can be life insurance
companies and investment dealers, among others.
5. List the industry regulators and their main functions and
requirements affecting mutual fund sales representatives.
◦ M ost of the legislation regarding the trading and distribution
of securities is a provincial matter, dealt with in each
province’s securities act and is the responsibility of each
province’s securities administrator.
◦ Regulation of the financial system and financial transactions
in Canada involves both federal and provincial regulators.
Collectively, the provincial regulators work together to
harmonize and coordinate the regulation of the Canadian
capital markets through the Canadian Securities
Administrators (CSA).
◦ Self-Regulatory Organizations (SROs) are private industry
organizations that have been granted the privilege of
regulating their own members by the provincial
regulatory bodies.
◦ The M utual Fund Dealers Association (M FDA) is the mutual
fund industry’s SRO for the distribution side of the mutual
fund industry. It does not regulate the funds themselves.
That responsibility remains with the securities commissions.
◦ The Investment Industry Regulatory Organization of Canada
(IIROC) is the self-regulatory organization that oversees
investment dealers and trading activity in Canada.
REVIEW QUESTIONS

Overview of Economics 3
CONTENT AREAS
What is Economics?
How is Economic Growth Measured?
What are the Phases of the Business Cycle?
What are the Key Labour Market Indicators?
What Role do Interest Rates Play?
What is the Nature of Money and Inflation?
How do Fiscal and Monetary Policies and International

Economics Impact the Economy?
LEARNING OBJECTIVES
1 | Define microeconomics and the tools used to

understand how prices are determined, and describe the
process for achieving market equilibrium.
2 | Define gross domestic product and explain how it is

calculated.
3 | Describe the phases of the business cycle, and
distinguish among the economic indicators used to
analyze business conditions.
4 | Define unemployment and the various categories of

unemployment.
5 | Describe the determinants of interest rates, define

inflation and discuss the costs of inflation.
6 | Discuss monetary policy and fiscal policy, including the

balance of payment accounts, and list the tools used by
governments to implement these policies.
KEY TERMS

balance of payments
Bank Rate
basis point
business cycle
capital and financial account
cash management
coincident indicators
Consumer Price Index
contractionary
cost-push inflation
current account
cyclical unemployment
deflation
demand
demand-pull inflation
discouraged workers
disinflation
economic indicators
equilibrium price
expansionary
final good
fiscal policy
frictional unemployment
gross domestic product
inflation rate
interest rates
labour force
lagging indicators
leading indicators
macroeconomics
market
microeconomics
monetary aggregates
monetary policy
natural unemployment rate
nominal GDP
nominal interest rate
open-market operations
output gap
overnight rate
participation rate
Payments Canada
Phillips curve
potential GDP
real GDP
real interest rate

sacrifice ratio
seasonal unemployment
soft landing
structural unemployment
supply
unemployment rate
INTRODUCTION
Economic news and events are announced daily. There are
monetary policy reports from the Bank of Canada, quarterly gross
domestic product estimates, regular changes in the Canadian
exchange rate relative to the U.S. dollar, and data on monthly
unemployment and housing starts to consider. For an investor or
advisor, being able to recognize the impact these events could
have on markets and individual investments helps make wise
investment decisions.
Economics is fundamentally about understanding the choices
individuals make and how the sum of those choices affects our
market economy. Whether it is the purchase of groceries, a home,
or stocks and bonds, the interaction between consumer choices
and the economy takes place in an organized market and at a price
determined by demand and supply for goods and services by
consumers, investors and governments.
An example of an organized market is the Toronto Stock Exchange.
Investors come together to buy and sell securities anonymously.
M illions of transactions are carried out each day, and this
anonymous interaction creates a market and an equilibrium price for
a variety of securities. The buyer and seller of a security clearly
have different views about the security (generally, the buyer
believes it will go up in value and the seller believes it will go
down), and it is likely that some type of economic analysis went
into the decision to buy or sell.
In this chapter on economics, we start with some of the building
blocks, such as economic growth, interest rates, the labour
markets, the causes of inflation and the fiscal and monetary
policies. These principles are important because they are the basis
of your understanding of how economics and the economy tie into
the process of making an investment decision.
WHAT IS ECONOMICS?
Economics is a social science concerned with an understanding of
production, distribution, and consumption of goods and services.
M ore specifically, the focus of economics is on how consumers,
businesses, and governments make choices when allocating
resources to satisfy their needs. The sum of those choices
determines what happens in the economy.
M ost of us would like to have more of what we have, or at least be
able to buy or consume as much as we can. In reality, this is not
possible because our spending habits are constrained by the
amount of income we earn and by the fact that there is a limit to
what an economy can produce during a given period. Because
scarcity prevents us from having as much as we would like of
certain goods, the performance of the economy hinges on the
collective decisions made by millions of individuals. Ultimately, the
interaction between these market participants determines what we
pay for a good or service, or a stock or mutual fund, for example.
MICROECONOMICS AND
MACROECONOMICS
Economics is divided into two main topic areas: microeconomics
and macroeconomics.
Microeconomics analyzes the market behaviour of individual
consumers and firms, how prices are determined, and how prices
determine the production, distribution, and use of goods and
services. For example, consumers decide how much of various
goods to purchase, workers decide what jobs to take, and firms
decide how many workers to hire and how much output to produce.
M icroeconomics looks to answer such questions as:
• How do minimum wage laws affect the supply of labour and
company profit margins?
• How would a tax on softwood lumber imports affect the growth
prospects in the forestry industry?
• If a government placed a tax on the purchase of mutual funds,
will consumers stop buying them?
Macroeconomics focuses on the performance of the economy as
a whole. It looks at the broader picture and to the challenges facing
society as a result of the limited amounts of natural resources,
human effort and skills, and technology. Whereas microeconomics
looks at how the individual is impacted by changes in prices or
income levels, macroeconomics focuses on such important issues
as unemployment, inflation, recessions, government spending and
taxation, poverty and inequality, budget deficits and national debts.
M acroeconomics looks to answer such questions as:
• Why did total output shrink last quarter?
• Why have the number of jobs fallen in the last year?
• Will a decrease in interest rates stimulate economic growth?
• How can a nation improve its standard of living?
THE DECISION MAKERS
There are three main groups that interact in the economy:
consumers, firms and governments.
Consumers Consumers set out to maximize their satisfaction

or well-being within the limitations of their
available resources – income from employment,
investments or other sources.
Firms Firms set out to maximize profits by selling their

goods or services to consumers, governments or
other firms.
Governments Governments spend money on education, health

care, employment training and the military. They
oversee regulatory agencies, and they take part
in public works projects, including highways,
hydro-electric plants and airports.
THE MARKET
The activity between consumers, firms and governments takes
place in the various markets that have developed to make trade
possible. A market is any arrangement that allows buyers and
sellers to conduct business with one another. For example, the
fixed income market is a network of investment professionals,
distribution channels, suppliers and wholesalers who develop and
trade products to meet various investor needs. These decision
makers do not meet physically, but they are connected and make
their deals by a variety of electronic means. Ultimately, this
organized marketplace allows participants access to a product that
investors want to buy or sell.
DEMAND AND SUPPLY

The price of a product is probably one of the most important factors
that determines how much of that product individuals will buy or sell
in the marketplace. Everything has a price, and financial products
and services are not exempt; stocks, bonds, commodities,
currency all have visible prices that allow individuals to make
investment decisions. The price paid for any product is largely
determined by the demand for and supply of that product in the
marketplace.
Two general economic principles help to explain the interaction
between demand and supply:
• The quantity demanded of a good or service is the total
amount consumers are willing to buy at a particular price during
a given time period. According to the Law of Demand, the
higher the price the lower the quantity demanded, while the
lower the price the higher the quantity demanded, other factors
held constant.
• The quantity supplied of a good or service is the total amount
that producers are willing to supply at a particular price during a
given time period. According to the Law of Supply, the higher
the price of a good, the greater the quantity supplied.
MARKET EQUILIBRIUM
The interaction that takes place between buyers and sellers in the
market ultimately determines an equilibrium price for that product –
basically, this is the price that matches what someone is willing to
pay for the product with the price at which someone is willing to
supply it.
For example, we can find the market equilibrium of a fictitious laptop
market using the information from Table 3.1.
Table 3.1 | Market for Laptops
Price Quantity Demanded Quantity Supplied

(units) (units)
$1,000 500 0
$1,500 350 100
$2,000 200 200
$2,500 150 300
$3,000 10 450
Figure 3.1 shows the market for laptops.
Figure 3.1 | Shows the Market for Laptops
Table 3.1 lists the quantities demanded and the quantities supplied
at each price level. The one price that ensures a balance between
the quantity demanded and the quantity supplied is $2,000. This
intersection yields an equilibrium price of $2,000 and an
equilibrium supply of 200 units.
Demand and supply forces are instrumental in regulating the price

of financial instruments. Consider these scenarios:
The housing market in Asia is growing rapidly resulting in an
increased demand for Canadian forestry products. The demand
for Canadian dollars will rise because manufacturers in Asia will
need to purchase products from Canada with Canadian dollars.
The increased demand would result in an increase in the price of
the Canadian dollar—this assumes the supply of money does not
change.
In another example, if a corporation reports poor financial
performance, investors who own stock in the company may
decide to sell their common shares. The increased supply of the
company’s common shares in the marketplace would result in a
decrease in the price of the shares.
HOW IS ECONOMIC GROWTH MEASURED?

There are different ways of valuing a nation’s total production of
goods and services – i.e., its output. Economic growth is an
economy’s ability to produce greater levels of output over time and
is expressed as the percentage change in a nation’s gross
domestic product (GDP) over a given period. By measuring
growth, we can better gauge the performance and overall health of
the entire economy.
MEASURING GROSS DOMESTIC PRODUCT

Gross domestic product is the market value of all final goods and
services produced within a country in a given time period, usually a
year or a quarter. The quarterly reports are used to keep track of
the short-term activity within the market, while the annual reports
are used to examine trends and changes in production and the
standard of living.
Goods and services go through many stages of production before
they end up in the hands of their final users. The calculation of
GDP looks at the total amount of final goods produced over the
period. A final good is a finished product, one that is purchased by
the ultimate end user.
EXAMPLE
A computer is a final good, but the chip inside it is not since the
chip was used to manufacture the computer. If the market value
of all the chips were added together with the market value of all
the computers, GDP would be overstated. Only the market
value of the computer, a final good, is included in GDP.
THE EXPENDITURE APPROACH, INCOME APPROACH,

AND PRODUCTION APPROACH
There are three ways of measuring GDP: the expenditure
approach, the income approach, and the production approach.
Table 3.2 | Expenditure Approach, Income Approach, and

Production Approach Versus Income Approach
Expenditure The expenditure approach to calculating GDP adds

approach up everything that consumers, businesses, and
governments spend money on during a certain
period.
This approach measures GDP as the sum of four
components:
1. Personal consumption (C)
2. Investment (I)
3. Government spending on goods and services
(G)
4. Net exports (exports less imports) of goods and
services (X – M )
The GDP using this approach is measured as
follows:
GDP = C + I + G + (X – M )
Income The income approach starts from the idea that total
approach spending on goods and services should equal the
total income generated by producing all of those
goods and services. The GDP using the income
approach is the sum of all income generated by this
economic activity.
Production The production approach, also known as the value-

approach added approach, calculates an industry or sector’s
output and subtracts the value of all goods and
services used to produce the outputs. For example,
if the computer industry produced a total of $5 billion
in computers and spent $2 billion on goods and
services to produce the computers, the value added
to GDP by the computer industry would be $3 billion.
Adding up the value-added contributions of the
various economic sectors produces a country’s total
GDP for the measurement period.
These three measures of GDP show that all production results in

income earned by workers, firms or investors, and all production is
eventually consumed (or stored as inventory). Thus, GDP is
obtained by adding up either all income earned in the economy, all
spending in the economy, or all value-added production.
In theory, GDP measured by the three different approaches should
be the same.
REAL AND NOMINAL GDP

Producing more goods and services represents an improvement in
a nation’s standard of living. However, if the increase in GDP was
simply the result of higher prices, then the cost of buying those
goods and services has increased, which reflects an increase in
our cost of living but not an improvement in living standards.
Nominal GDP is the dollar value of all goods and services
produced in a given year at prices that prevailed in that same year
and is typically the amount reported in the financial press. Changes
in nominal GDP from year to year reflect both changes in the prices
of goods and services and changes in the amount of output
produced in a year.
Real GDP, or constant dollar GDP, is the dollar value of all goods
and services produced in a given year valued at prices that
prevailed in some base year. Holding prices constant to this base
year establishes a better measure of the change in GDP that is the
result of changes in the amount of output produced during the year.
A doubling of GDP during the year tells us nothing about what is
happening to the rate of real production unless we also know how
prices or inflation also changed over the year. Therefore,
differences between real and nominal GDP are entirely the result of
changes in prices. Real GDP tells us what would have happened
to spending on goods and services if quantities had changed but
prices had not changed.
EXAMPLE
Assume the financial press reports that nominal GDP grew by

4.4% last year and prices rose by 1.1%. Is this a good outcome
for the economy?
In nominal terms, the economy grew by 4.4%, which is a good
amount of economic growth. However, when we adjust by 1.1%
for the effect of rising prices, real economic growth was actually
3.3% (4.4% – 1.1%). The nation was more productive this year
than last, but not as much as the nominal GDP might lead you to
believe.
However, what if the financial press reported that nominal GDP
grew by 2.4% last year, whereas prices rose by 3.1%? Is this
bad news for the economy?
In nominal terms, the economy grew by 2.4%, but if we adjust by
3.1% for inflation, we see that the economy actually shrank by
approximately 0.7% (2.4% – 3.1%). Real GDP growth therefore
was negative, which means that the nation was less productive
last year than the year before.
PRODUCTIVITY AND DETERMINANTS OF

ECONOMIC GROWTH
Since the industrial revolution, the GDP of industrialized economies
has tended to grow over time.
Growth in GDP results from a variety of factors; among the more
important are:
• Increases in population over time. Even if the output of every
worker remained constant, GDP would rise due to the growing
work force.
• Increases in the capital stock. As more workers are provided
with additional equipment and as their skills have been
improved with better training and education, individual
productivity rises.
• Improvements in technology. Technological innovation helps
firms and workers to recombine existing resources of land,
capital and labour in new and increasingly productive ways.
Generally, this has involved the substitution of capital (i.e.,
improved machinery) for labour in the production of goods and
services. A recent example is the continuing replacement of
bank tellers by ATM machines.
Gains in individual prosperity are ultimately related to increases in
productivity. If productivity growth exceeds increases in the unit
costs of production, firms are able to lower the prices of the goods
and services they sell.
Sustained growth compounds remarkably over time. A policy
measure that increases annual growth from 2% to 3% doubles a
nation’s standard of living over a 30- to 40-year period.
The analysis of long-term trends in GDP growth rates is important,
as it allows for the identification of countries with higher expected
growth rates. If the analysis is correct, investment in these
countries can lead to superior investment returns.
THE DETERMINANTS OF ECONOMIC GROWTH

Increases in output per worker, or productivity, must originate from
either an increase in capital per worker or improvements in the
technology that combine labour and capital to produce output. The
liquidity to support investment – i.e., additions to the capital stock –
is generated from savings.
Current research on the determinants of economic growth (which
are reflected in higher investment values) suggests the following
conclusions:
• Capital accumulation alone cannot sustain growth. Eventually,
increased capital leads to smaller and smaller gains in output.
So, a higher savings rate is not responsible for a sustained
higher growth rate over long periods of time. Nonetheless, a
higher savings rate can ultimately support a higher level of
output per individual.
• Sustained growth requires technological progress which is
associated with a complex pattern of basic research, applied
research and product development situated in a supportive
entrepreneurial context.
ECONOMICS OVERVIEW
How well do you understand GDP, measuring growth,
phases of the business cycle, and labour market factors?
knowledge.
WHAT ARE THE PHASES OF THE BUSINESS

CYCLE?
Economic fluctuations present a recurring problem for policy makers
as downturns in economic growth are directly related to rising
unemployment. Such fluctuations in output and employment are
called the business cycle, and directly affect the value of
investments over time.
PHASES OF THE BUSINESS CYCLE

Growth in the economy is measured by the increase in real GDP.
Even though the term cycle suggests that the business cycle is
regular and predictable, this is not really the case. In reality,
fluctuations in real output are both irregular and unpredictable, and
this makes each business cycle unique. Nonetheless, the following
sequence of events is relatively typical over the course of a
business cycle.
EXPANSION
In times of normal growth, the economy is steadily expanding. An
expansion is characterized by the following activities:
• Inflation is stable.
• Businesses have adjusted inventories to meet higher demand
and are investing in new capacity to meet increased demand
and to avoid shortages.
• Corporate profits are rising.
• New business start-ups outnumber bankruptcies, and stock
market activity is strong.
• Job creation is steady, and the unemployment rate is steady or
falling.
Overall, real GDP is rising during an expansion.
PEAK
The top of the cycle is called a peak. A peak is characterized by
the following activities:
• Demand begins to outstrip the capacity of the economy to
supply it.
• Labour and product shortages cause wage increases and
inflation to rise.
• Interest rates rise, and bond prices fall. This begins to dampen
business investment and reduce sales of houses and big-ticket
consumer goods.
• Business sales decline, resulting in accumulation of unwanted
inventory and reduced profits.
• Stock prices fall and stock market activity declines.
CONTRACTION
When an economy passes its peak, it enters a downturn, or
contraction. If the contraction lasts at least two consecutive
quarters, then the economy is considered to be in recession. A
contraction is characterized by the following activities:
• The level of economic activity begins to decline, meaning that
real GDP decreases.
• Businesses faced with unwanted inventories and declining
profits reduce production, postpone investment, curtail hiring
and may lay off employees.
• Business failures outnumber start-ups.
• Falling employment erodes household income and confidence.
• Consumers react by spending less and saving more, which
further cuts into sales, fuelling the contraction.
If other countries are also experiencing a contraction – especially
the United States – the magnitude and duration of the contraction
in Canada is significantly increased by the reduction in the sale of
goods to those outside Canada; in short, by the reduction in our
exports. In turn, the rate of default and the probability of default by
corporate borrowers increase, which is reflected in a higher default
premium on corporate borrowings.
TROUGH
As the contraction continues, falling demand and excess capacity
curtail the ability of businesses to raise prices and of workers to
demand higher salaries. The growth cycle reaches its lowest point
and is characterized by the following activities:
• Interest rates fall, triggering a bond rally.
• Inflation falls.
• Consumers who postponed purchases during the contraction
are spurred by lower interest rates and begin to spend.
• Stock prices rally.
RECOVERY
During the recovery, GDP returns to its previous peak. The
recovery typically begins with renewed buying of interest rate–
sensitive items like houses and cars.
A recovery is characterized by the following activities:
• Businesses that reduced inventories during the contraction
must increase production to meet the new demand.
• They are typically still too cautious to hire back significant
numbers of workers, but the period of widespread layoffs is
over.
• Businesses are not yet ready to make significant new
investment.
• Unemployment remains high; wage pressures are restrained,
and inflation may decline further.
When the economy rises above its previous peak, at point A in
Figure 3.2, another expansion has begun.
Figure 3.2 | The Business Cycle
Case Study | Seeing the Business Cycle at a Micro Level:

Joe’s Hardware Store (for information purposes
only)
Financial advisor Paul is meeting with his client, Joe, a local
hardware store owner who wants to adjust his non-registered
investment portfolio from income-focused to growth-focused.
Joe has been in the hardware business for over 20 years,
managing to grow his small business into a success. Joe’s
business was very profitable through most of the 2000’s. The
economy was strong, and his customers were spending on fixing
up their existing homes to sell or just to better enjoy them. New
customers were coming in to buy products to customize and
improve their newly purchased homes.
However, in 2008, as the financial crisis hit and recession set in,
Joe noticed a substantial downturn in his customer traffic and
revenue. Joe began to cut his prices to attract business, hurting his
profitability in the process. As job losses mounted and the local
real estate market declined, people began to cut back on their
spending, deferring home improvements and purchases until they
felt more financially secure. This forced Joe to cut back on his
inventory purchases; eventually, he was forced to lay off two of his
five staff. Needing more income, he asked Paul to adjust his non-
registered portfolio of mutual funds to income-producing from
balanced growth.
In 2010, Joe noticed that sales were rising again, as more people
were finding work and real estate prices began to rise. With
interest rates low to spur economic growth, Joe eventually felt
confident enough to borrow to increase his inventory. After a year,
with his revenue rising, he felt confident enough to raise his prices
back to pre-recession levels. With his profit margins restored, Joe
was able to hire back his two former employees.
With his business income back to a satisfactory level, Joe no
longer needs to draw income from his investment portfolio. After a
full investment review, Paul adjusts Joe’s mutual fund holdings
back to balanced growth. Joe adds additional savings to his
portfolio, anticipating that as the economy strengthens, so will
corporate profits and stock prices.
USING ECONOMIC INDICATORS

Economic indicators are statistics or data series that are used to
analyze business conditions and current economic activity. They
can help to show whether the economy is expanding or
contracting. For example, if certain key indicators suggest that the
economy is going to do better in the future than had previously
been expected, investors may decide to change their
investment strategy.
Economic indicators are classified as leading, coincident or lagging.
LEADING INDICATORS
Leading indicators tend to peak and trough before the overall
economy in anticipation of emerging trends in economic activity.
They are the most useful and widely used of the economic
indicators because they anticipate change by indicating what
businesses and consumers have begun to produce and spend.
Leading indicators include the following:
• Housing starts.
• M anufacturers’ new orders, which indicate expectations of
higher levels of consumer purchases of such items as
automobiles and appliances.
• Commodity prices, which reflect rising or falling demand for raw
materials.
• Average hours worked per week, which rise or fall depending
on the level of output and therefore anticipate changes in
employment.
• Stock prices, which suggest changing levels of profits.
The money supply, which indicates available liquidity and thus
• has an impact on interest rates.
COINCIDENT INDICATORS
Coincident indicators are those which change at approximately
the same time and in the same direction as the whole economy,
thereby providing information about the current state of
the economy.
Coincident indicators include the following:
• Personal income
• GDP
• Industrial production
• Retail sales
EXAMPLE
Personal income is a good example because if it is rising,

economic growth will typically follow.
LAGGING INDICATORS
Lagging indicators are those that change after the economy as a
whole changes. These indicators are important because they can
confirm that a business cycle pattern is occurring.
Lagging indicators include the following:
• Unemployment
• Private sector plant and equipment spending
• Business loans and interest on such borrowing
• Labour costs
• The inflation rate
EXAMPLE
Unemployment is one of the more popular lagging indicators
because a rising unemployment rate is an indication that the
economy is doing poorly or that companies are anticipating a
downturn in the economy.
IDENTIFYING RECESSIONS
A popular definition of a recession is at least two consecutive
quarters of declining real GDP. However, Statistics Canada and the
U.S. National Bureau of Economic Research describe a recession
differently.
Statistics Canada judges a recession by the depth, duration and
diffusion of the decline in business activity. Here is some of the
criteria they look at:
• The decline must be of substantial depth, since marginal
declines in output may be merely statistical error.
• The duration must be more than a couple of months, since bad
weather alone can cause a temporary decline in output.
• The decline must be a feature of the whole economy. While a
strike in a major industry can cause GDP to decline, that does
not constitute a recession.
• The behaviour of employment and per capita income may also
be taken into account.
In recent years, the term soft landing has been used to describe a
business cycle phase when economic growth slows sharply but
does not turn negative, while inflation falls or remains low. Soft
landings are considered the “Holy Grail” of policy makers, who want
sustained growth without the cost of recurring recessions.
Exhibit 3.1 | Recent Periods of Economic Slowdown and

Recession in Canada
DATES DURATION
* April 2001 to September 2001 5 months
July 2008 to July 2009 12 months
January 2015 to June 2015 6 months
In M arch 2020, Canada’s real GDP fell by more than 7% as a
result of the worldwide pandemic. Canada’s GDP finished 2020
5.4% lower than the previous year. In the first quarter of 2021,
Canada’s real GDP growth rate was 1.38%. Canadian GDP has
grown significantly since the second quarter of 2020, but at the
time of writing, it has yet to surpass the previous real GDP high of
$2.11 trillion set in the last quarter of 2019.
* Technically, this was a growth slowdown or downturn, not a recession.
Source: Adapted from Statistics Canada, www.statcan.gc.ca.
WHAT ARE THE KEY LABOUR MARKET

INDICATORS?
For most Canadians, the performance of the economy affects them
most personally in the labour market. When the economy is strong,
so is the demand for labour. Employment rises, the unemployment
rate falls, and workers win bigger wage raises and/or non-wage
benefits. Conversely, when the economy weakens, so does the
demand for labour, and wage demands are restrained.
Statistics Canada divides the population into two groups: the
working-age population (those individuals aged 15 years and older)
and those too young to work. Statistics Canada also defines the
labour force as the sum of the working-age population who are
either employed or unemployed.
LABOUR MARKET INDICATORS
There are two key indicators that describe the labour market: the
participation rate and the unemployment rate.
• The participation rate represents the share of the working-
age population that is in the labour force. For Canada, the
current participation rate is approximately 66% (Source:
Statistics Canada Labour Force Survey). The participation rate
is an important indicator because it shows the willingness of
people to enter the work force and take jobs.
• The unemployment rate represents the share of the labour
force that is unemployed and actively looking for work. The
unemployment rate may rise either because the number of
employed fell or the number of people entering the work force
looking for work rose, or both. The unemployment rate in
Canada was 5.6% in late 2018.
The participation rate in Canada has followed a mostly upward
trend over the last 50 years, rising from 54% in the early 1960s to
its current level of 66%.
CANADIAN UNEMPLOYMENT RATE
Figure 3.3 shows the patterns in the Canadian unemployment

rate since the 1960s. In general, the upward trend with large
fluctuations corresponds to the trend and stages of the business
cycle.
• Significant post-war peaks in unemployment were recorded
during the last two major recessions in Canada.
• The peak at 11.9% corresponds to the recession of 1980–
1983, while the peak of 11.4% corresponds to the recession
of 1991.
• Typically, the impact of economic downturns varies across
workers, with young and unskilled workers the most
vulnerable.
• The recession of 1990–91 was somewhat different as the
unemployment rate among prime-age workers jumped higher
than usual.
• The sudden unemployment rate increase to 13.7% in early
2020 was a result of the worldwide pandemic.
Unemployment finished the year at 8.8%. In the first half of
2021, the unemployment rate has fallen to 7.8%.
Figure 3.3 | Unemployment Rate in Canada (%) 1976 – May

2020
Source: Bloomberg
Some people are unemployed for a short time, while others are
unemployed for longer periods. The average duration of
unemployment varies over the business cycle and is typically
shorter during an expansion and longer during a recession. At
times, job prospects are so poor that some of the unemployed
simply drop out of the labour force and become discouraged
workers. Discouraged workers are those individuals who are
available and willing to work but cannot find jobs and have not
made efforts to find a job within the previous month. They are
therefore not included as part of the labour force. The
disappearance of discouraged workers from the labour force can
produce an artificially low unemployment rate.
TYPES OF UNEMPLOYMENT
There are four general types of unemployment: cyclical, seasonal,
frictional and structural.
Type Description
Cyclical Cyclical unemployment is tied directly to

unemployment fluctuations in the business cycle. It rises when
the economy weakens and firms lay off workers
in response to lower sales. It drops when the
economy strengthens again.
Seasonal Seasonal unemployment occurs in industries

unemployment that operate only during part of the year. For
example, farmhands are hired to pick fruits and
vegetables only during the months of June to
October. In the winter months, seasonal
unemployment is a regular occurrence in such
industries.
Frictional Frictional unemployment is the result of

unemployment normal labour turnover resulting from people
entering and leaving the work force and from the
ongoing creation and destruction of jobs. Even
in the best of economic times, people are
looking for work because they have finished
school, quit, been laid off, or been fired from
their most recent job. This is a normal part of a
healthy economy.
Structural Structural unemployment occurs when
unemployment workers are unable to find work or fill available
jobs because they lack the necessary skills, do
not live where jobs are available, or decide not
to work at the wage rate offered by the market.
This type of unemployment is closely tied to
changes in technology, international competition
and government policy. Structural unemployment
typically lasts longer than frictional
unemployment because workers must retrain or
possibly relocate to find a job.
The distinction between frictional and structural unemployment is

sometimes difficult to determine. There are always job openings
and potential workers to fill those jobs. With frictional
unemployment, unemployed workers have the required skill levels
to fill a job vacancy. With structural unemployment, however,
unemployed workers looking for work do not possess the needed
skills to find a job.
The existence of frictional and structural factors in the economy
prevents unemployment from falling to zero. This means that even
in times of healthy economic growth, there is a level below which
unemployment will not drop without causing other negative
economic effects.
This minimal level of unemployment is called the natural
unemployment rate. At this level of unemployment, the economy
is thought to be operating at close to its full potential or capacity
such that all resources, including labour, are fully employed. Further
employment growth is achieved either through increased wages to
attract people into the labour force which fuels inflation, or by more
fundamental changes to the labour market that removes
impediments to job creation.
The Bank of Canada pays close attention to the actual
unemployment rate and the natural unemployment rate as the gap
between the two has an important influence on wage inflation.
• When the actual unemployment rate is above the natural rate,
an excess supply of workers in the market weakens labour
bargaining power, which discourages wage gains and helps to
keep inflation in check.
• When the actual unemployment rate is below the natural rate, a
shortage of workers contributes to an increase in wage gains
and higher inflation.
Thus, the natural unemployment rate is often viewed as the level
of unemployment that is consistent with stable inflation, which is
why it is an important number with respect to monetary and fiscal
policy decisions.
WHAT ROLE DO INTEREST RATES PLAY?

Interest rates are an important link between current and future
economic activity. For consumers, interest rates represent the gain
from deferring consumption from today to tomorrow via saving. For
businesses, interest rates represent one component of the cost of
capital – i.e., the cost of borrowing money. Thus, the rate of growth
of the capital stock, which determines future output, is related to
the current level of interest rates.
Interest rates are one of the most important financial variables
affecting securities markets. Since they are essentially the price of
credit, changes in interest rates reflect, and affect, the demand and
supply for credit and debt, and this has direct implications for the
bond and money markets. Changes in interest rates made by the
Bank of Canada also signal changes in the direction of monetary
policy, and this has broader implications for the entire economy.
DETERMINANTS OF INTEREST RATES

A broad range of factors influences interest rates:
Demand A large government deficit or a boom in business

and investment raises the demand for capital and forces
supply up the price of credit (interest rates), unless there is
of capital an equivalent increase in the supply of capital. In turn,
the higher interest rate may encourage people to
save more. An increase in the savings of
government, businesses or consumers may reduce
their demand for borrowing. This, in turn, may reduce
interest rates.
Default The greater the risk that borrowers may default on

risk money they have borrowed, the higher the interest
rate demanded by lenders. If the central government
is at risk of defaulting on its debt, interest rates rise
for everybody. This additional interest rate is referred
to as a default premium.
Foreign Since Canada has an open economy and investors

interest are free to move their money between Canada and
rates and other countries, foreign interest rates and financial
the conditions influence Canadian interest rates.
exchange Example: A rise in interest rates in the U.S.
rate increases investors’ returns on money invested
there. Investors holding Canadian dollars and who
would like to invest in the U.S. will need to sell their
Canadian dollars to purchase U.S. dollar-denominated
securities. This increases the supply of Canadian
dollars on the foreign exchange market and places
downward pressure on the value of the Canadian
dollar. If the Bank of Canada would like to slow or
reduce the fall in the value of the Canadian dollar,
they can intervene and raise short-term interest
rates, even if underlying conditions in Canada are
unchanged. This will encourage investors to continue
holding Canadian investments rather than switch
to U.S. dollar-denominated securities.
Central The central bank exercises its influence on the

bank economy by raising and lowering short-term interest
credibility rates. One of its main responsibilities is to keep
inflation low and stable. The more credible and long-
established a commitment to low inflation has been,
the lower interest rates will be to compensate for the
risk of rising inflation.
Inflation The higher the expected inflation rate, the higher the
interest rate that must be charged by lenders to
compensate for the erosion of the purchasing power
of money over the duration of the loan.
HOW INTEREST RATES AFFECT THE

ECONOMY
Higher interest rates affect the economy in the following ways:
• They may raise the cost of capital for business investments.
An investment should earn a greater return than the cost of the
funds used to make the investment. Higher interest rates
reduce the possibility of profitable investments. In turn, this
reduces business investment.
• By increasing the cost of borrowing, higher interest rates
discourage consumers from spending, especially to buy
houses and major durable goods like cars and furniture on
credit. This encourages consumers to save more.
• By increasing the portion of household income needed to
service debt, such as mortgage payments, they reduce the
income available to be spent on other items. This effect may
be offset somewhat by the higher interest income earned by
savers.
Thus, higher interest rates have a negative effect on growth
prospects. The effect of lower interest rates is the opposite in each
case and can provide a positive environment for economic growth.
EXPECTATIONS AND INTEREST RATES

Investment decisions are forward-looking. Any decision to
purchase a security is based on an expectation about the future
return from the security. Increased optimism in the market can
generate a rise in stock prices. Consumer pessimism can stall
economic growth and decrease share prices. M oreover,
government economic policies may work only through their impact
on people’s expectations. For example, the Bank of Canada makes
considerable effort to maintain the credibility of its commitment to
low inflation.
The role of inflation expectations is particularly important in
determining the level of nominal interest rates. The nominal
interest rate is one where the effects of inflation have not been
removed – for example, the rate charged by a bank on a loan, or
the quoted rate on an investment such as a Guaranteed
Investment Certificate or Treasury bill. Other things equal, the
higher the rate of inflation, the higher nominal interest rates will be.
In contrast, the real interest rate is the nominal interest rate minus
the expected inflation rate.
EXAMPLE
Nominal and historical real rates in Canada have slowly trended

downwards over the last 30 years. Nominal interest rates are
considerably lower than they were in the early 1980s. Real rates
have fluctuated between 5% and 7% until recently when they
dropped below 1%.
NEGATIVE INTEREST RATES
A negative interest rate occurs when the interest rate charged on
borrowed funds is less than zero. In a negative interest rate
environment, banks may charge their customers for keeping
deposits in their account, or they may pay a customer to take a
loan. The latter seems almost too good to be true, given that,
under negative interest rates, the borrower does not have to make
any interim interest payments over the term of the loan. They make
periodic payments related to principal amortization only and are
required to repay only a discounted amount of the total original loan
at maturity.
A negative interest rate is an unusual scenario, most likely to occur
when monetary policy has already moved interest rates to zero or
near zero, but further economic stimulus is required. When a central
bank pushes interest rates into negative territory, thereby charging
commercial banks to store their deposits with the central bank, the
commercial banks have an incentive to lend more money, which, in
turn, may stimulate economic growth.
NEGATIVE INTEREST RATES IN THE U.S. AND

CANADA
Prior to 2020, negative interest rates prevailed mostly in some EU
countries and in Japan. The U.S. appeared immune to negative
interest rates up until aggressive monetary and fiscal policy
programs were launched in response to the potential debilitating
effects of the COVID-19 pandemic on the U.S. economy in general
and on U.S. unemployment levels in particular.
However, on M arch 25, 2020, history was made in the U.S. when
both the one- and three-month U.S. Treasury bills traded at
negative yields for the first time.
As of M ay 2020, negative interest rates in the U.S. had not
appeared again. In Canada, none of the Bank of Canada’s
administered rates had reached negative territory. Due to various
fundamental factors, Canadian interest rates are normally higher
than their U.S. equivalents. This difference provides a buffer if (or
when) negative interest rates appear in Canada. Of course, there is
always the risk that U.S. government bond market yields could
move into negative territory again. Depending on the size and
extent of this move, Canada could also end up with negative
interest rates, which would start with Treasury bills and possibly
extend to short- and mid-term government bonds.
WHAT IS THE NATURE OF MONEY AND

INFLATION?
M oney is the essential ingredient that makes the economy
function.
Inflation occurs when prices are rising. This is problematic because
as prices rise money begins to lose its value—that is, more and
more money is needed to buy the same amount of goods and
services, and this has a negative effect on living standards.
Inflation is an important economic indicator for securities markets
because it is the rate at which the real value of an investment
is eroded.
THE NATURE OF MONEY

M oney can be any object that is accepted as payment for goods
and services, and that can be used to settle debts.
• Its function as a medium of exchange is essential. Without
money, goods and services would need to be exchanged with
other goods and services in some form of barter system.
• M oney also acts as a unit of account so that we know exactly
the price of a good or service.
• Finally, money represents a store of value since it does not
have an expiration date if a consumer decides to save it for a
later use. The more stable the value of money, the better it can
act as a store of value.
The amount of money in circulation can be measured in a variety of
ways. Some of these different measures, known as monetary
aggregates, are one way of monitoring economic activity. The
Bank of Canada looks primarily at changes in the growth rate of the
various monetary aggregates it tracks when conducting monetary
policy because these aggregates provide information about
changes that are occurring in the economy. By monitoring these
aggregates, the Bank strives to keep the rate of money growth
consistent with low inflation and long-term growth.
INFLATION
Inflation in an economy-wide sense is a generalized, sustained
trend of rising prices:
• A one-time jump in prices caused by an increase in the price of
oil or the introduction of a new sales tax is not true inflation,
unless it feeds into wages and other costs and initiates a
wage-price spiral.
• Likewise, a rise in the price of one product is not, in itself, a
result of inflation; it may just be a relative price change
reflecting the increased scarcity of that product.
Inflation is ultimately about money growth. It is a reflection of “too
much money chasing too few products.”
MEASURING INFLATION
The Consumer Price Index (CPI) is one of the most widely used
indicators of inflation and is considered a measure of the cost of
living in Canada. Statistics Canada tracks the retail price of a
shopping basket comprised of 600 different goods and services,
each weighted to reflect typical consumer spending. In this way,
the CPI represents a measure of the average of the prices paid for
this basket of goods and services.
Statistics Canada has a difficult task creating a basket of goods

and services that is representative of the typical Canadian
household. They try to make the relative importance of the items
included in the CPI basket the same as that of an average
Canadian household. However, it is almost impossible to
construct a “basket of goods” that would be representative of all
consumers. For example, the spending patterns of a family with
young children would not be the same as the spending patterns
of a retired couple.
When calculating CPI, prices are measured against a base year,

which at the moment is 2002 in Canada, and this base year is
given a value of 100. The total CPI was 136.4 at the end of
December 2019, which indicates that the basket of goods costs
36.4% more than it did in 2002.
The inflation rate is calculated by comparing the current period CPI
with a previous period:
The CPI was 136.6 in M arch 2020 and 135.4 in M arch 2019. The
inflation rate over the 12-month period was 2.03%:
The Inflation Rate in Canada
Inflation has not been much of a problem over the last decade. In
recent history, Canada’s inflation rate reached a high of 12.2% in
1981 and fell as low as –0.9% in July 2009. The inflation rate
declined dramatically in both the early 1980s and 1990s based on
monetary policy actions taken by the Bank of Canada.
Figure 3.4 shows the inflation rate in Canada since 1965.
Figure 3.4 | The Inflation Rate in Canada 1965 – 2021
Source: Bloomberg
THE COSTS OF INFLATION

Inflation imposes many costs on the economy:
• It erodes the standard of living of those on a fixed income and
those who lack wage bargaining power. It rewards those able
to increase their income either through increased wages or
changes to their investment strategy, in response to inflation.
• Inflation reduces the real value of investments such as fixed-
rate loans, since the loans are paid back in dollars that buy
less. This can be good for the borrower if his or her income
rises with inflation. But, more likely, inflation results in lenders
demanding a higher interest rate on the money they lend.
• Inflation distorts the signals prices send to participants in
market economies, where prices are critical for balancing supply
with demand. Rising prices draw resources into areas of
scarcity, and falling prices move funds away from glutted areas.
When inflation is high, it is difficult to determine if a price
increase is simply inflationary, or a genuine relative
price change.
• Accelerating inflation usually brings about rising interest rates
and a recession. Thus, high-inflation economies usually
experience more severe booms and busts than low-inflation
economies.
THE CAUSES OF INFLATION

The relationships among the growth rate of money, inflation and the
rate of unemployment are a subject of considerable controversy.
An important determinant of inflation is the balance between supply
and demand conditions in the economy. Economists use an
indicator called the output gap to measure inflation pressures in
the economy by looking at the difference between real GDP (what
the economy actually produces) and potential GDP (what the
economy is capable of producing when its existing inputs of labour,
capital, and technology are fully employed at their normal levels of
use).
Think of potential output as the maximum level of real GDP that the
economy can maintain without inflation increasing.
• A negative output gap occurs when actual output is below
potential output. In this case, economists would say there is
spare capacity in the economy – the economy can produce
more output because its resources are not being used to their
full capacity. Unemployed workers and unused plant and
equipment resources can be called into service without
impacting wages or prices. Thus, inflation will fall or remain
steady.
• A positive output gap occurs when actual output is above
potential output. In this case, economists would say the
economy is operating above capacity – the economy is trying
to produce more than it can with existing resources. Scarce
labour fuels wage increases, and other strains on productive
resources place upward pressure on inflation.
In general, a positive output gap occurs as the economy
moves through an expansion toward the peak. Output
continues to expand, consumer income is rising, and this leads
to strong consumer demand for goods and services. However,
this creates a situation whereby if companies can continue to
operate well above normal capacity, they can raise prices in
response to this strong demand. In this way, higher and
continued consumer demand pushes inflation higher. This state
of affairs is called demand-pull inflation.
• Inflation can also rise or fall due to shocks from the supply side
of the economy – when the cost of producing output changes.
At a given price level, when faced with higher costs of
production from higher wages or increases in the price of raw
materials, firms respond by raising prices and producing a
smaller amount of their product. In this way, the higher costs
push inflation higher. This is an example of cost-push
inflation.
DISINFLATION
Just as there are costs associated with rising inflation, a falling rate
of inflation can also have a negative impact on the economy.
Disinflation is a decline in the rate at which prices rise – i.e.,
a decrease in the rate of inflation. Prices are still rising, but at a
slower rate.
The potential cost of disinflation is captured by the Phillips curve,
which says that when unemployment is low, inflation tends to be
high, and when unemployment is high, inflation tends to be low.
According to this theory:
• Lower unemployment is achieved in the short run by increasing
inflation at a faster rate.
• Lower inflation is achieved at the cost of possibly increased
unemployment and slower economic growth.
To gauge the cost of disinflation, the sacrifice ratio is used to
describe the extent to which GDP must be reduced with increased
unemployment to achieve a 1% decrease in the inflation rate.
Disinflation in Canada
Experts suggest that the sacrifice ratio is as high as 4; that is, 4%

of output must be sacrificed to bring down inflation 1%. So, there
may be a considerable cost in lost output in pursuing the goal of
lower inflation. This cost could involve a significant period of
relatively high unemployment.
DEFLATION
Deflation is a sustained fall in prices where the annual change in
the CPI is negative year after year. In fact, deflation is just the
opposite of inflation. Falling prices are generally preferred over
rising prices. Goods and services become cheaper, and our income
seems to go a little farther than it used to. Although true in the
short term, there are negative consequences of deflation.
One view holds that the impact of sustained falling prices
eventually leads to a decline in corporate profits. As prices
continue to fall, businesses must sell their products at lower and
lower prices. Businesses cut back on productions costs and wage
rates, and if conditions worsen, lay off workers. For the economy
as a whole, unemployment rises, economic growth slows, and
consumers shift their focus from spending to saving. Ultimately,
declining company profits will negatively impact stock prices.
As the economy slows and enters a recession, the central bank
can use lower short-term interest rates to stimulate consumer and
business spending.
EXAMPLE
In 2007, the Bank Rate in Canada was as high as 4.75% (the

Bank Rate is the rate of interest that the Bank of Canada
charges on very short-term loans to financial institutions and is
used as a signal of monetary policy actions). During the 2008-
2009 recession the Bank Rate fell to as low as 0.50% and
remained there for more than a year to help stabilize the
economy. For Canada, the recession was not as deep as
expected and low interest rates played a key role in stimulating
the Canadian economy.
The Bank of Canada, in response to the worldwide pandemic,
once again dropped the Bank Rate to 0.50% in M arch 2020. The
Bank Rate remained at 0.50% for more than a year.
INTEREST RATES AND INFLATION
How do interest rates and inflation affect the economy?

knowledge.
HOW DO FISCAL AND MONETARY POLICIES

AND INTERNATIONAL ECONOMICS IMPACT
THE ECONOMY?
MONETARY POLICY
Monetary policy refers to regulation of the money supply and
available credit for the purpose of promoting sustained economic
growth and price stability.
The goal of monetary policy is to maintain the value of our currency
and our economic health.
Canada’s central bank, the Bank of Canada, uses its influence over
short-term interest rates to control changes in the money supply
and available credit. (External economic developments also have
an impact on monetary policy objectives.)
The duties and role of the Bank are stated in a general way in the
preamble of the Bank of Canada Act:
• “To regulate credit and currency in the best interests of the
economic life of the nation...
• To control and protect the external value of the national
monetary unit...
• To mitigate by its influence fluctuations in the general level of
production, trade, prices and employment, as far as may be
possible within the scope of monetary action and generally...
• To promote the economic and financial welfare of the
Dominion.”
The Act does not specify the manner in which the Bank should
pursue these objectives but it (and other legislation) grants powers
to the Bank which are designed to enable it to fulfill its role.
While the Bank administers policy independently without day-to-
day government intervention, the thrust of policy is the ultimate
responsibility of the elected government.
M onetary policy can be either expansionary or contractionary,
as defined below.
An expansionary monetary policy increases the amount of money
and credit available in the economy.
EXAMPLE
If the Bank of Canada lowers the Bank Rate or buys bonds in
the market, borrowing will become cheaper, and spending will be
more attractive to consumers. As a result, more loans will be
made, and less money will be tied up in investments. These
activities will increase the money supply.
A contractionary monetary policy decreases the amount of money

and credit available in the economy.
EXAMPLE
If the Bank of Canada increases the Bank Rate or sells bonds in
the market, borrowing will become more expensive, and saving
will be more attractive to consumers. As a result, fewer loans will
be made, and more money will be tied up in investments. These
activities will decrease the money supply.
Both expansionary and contractionary policies are implemented

with the help of the Bank Rate and cash management
techniques, as defined below.
BANK RATE
The Bank of Canada carries out monetary policy primarily through
changes to what it calls the target for the overnight rate. The
overnight rate is the interest rate set in the overnight market – a
marketplace where major Canadian financial institutions lend each
other money on an overnight basis. When the Bank changes the
target for the overnight rate, other short-term interest rates also
usually change.
Currently, this band is 50 basis points (or one-half of a percentage
point) wide. Each day, the Bank targets the mid-point of the
operating band as its key monetary policy objective. For example, if
the operating band is 1% to 1.5%, then the target for the overnight
rate is 1.25%.
The target is an important policy tool as it tells financial institutions
the average interest rate that the Bank wants to see in the
overnight market. Changes in the operating band for overnight
rates are very important events. They may signal a policy shift
toward an easing or tightening of monetary conditions in order to
meet the Bank’s inflation-control targets.
The Bank Rate is the minimum rate at which the Bank of Canada
will lend money on a short-term basis to the chartered banks and
other members of Payments Canada in its role as lender of last
resort. It is closely related to the target for the overnight because
the Bank Rate is the upper limit of the operating band. Continuing
with our example from above, with an operating target range of
between 1% and 1.5%, the Bank Rate is 1.5%.
EXAMPLE
If the Bank of Canada decreases the Bank Rate, nominal

interest rates will also fall. As a result, the money supply will
increase (expansionary policy).
If the Bank of Canada increases the Bank Rate, nominal interest
rates will also rise. As a result, the money supply will decrease
(contractionary policy).
CASH MANAGEMENT
In cash management, or open-market operations, a central bank
controls its national money supply through the buying or selling of
bonds in the market.
EXAMPLE
If the Bank of Canada buys bonds in the market, the price of the
bonds will rise, causing interest rates to fall. As a result, the
money supply will increase (expansionary policy).
If the Bank of Canada sells bonds in the market, the price of
bonds will fall, causing interest rates to increase. As a result, the
money supply will decrease (contractionary policy).
The trend of the Bank Rate affects both users and suppliers of
credit. For example, a rising trend signals a desire on the part of the
Bank of Canada to reduce the demand for credit by raising the cost
of credit. Administered rates (those rates determined by each
financial institution), such as prime rates, usually follow the trend of
the Bank Rate.
DRAWDOWNS AND REDEPOSITS

Drawdowns and redeposits represent a third strategy in defining
monetary policy. The federal government maintains accounts with
the Bank of Canada and the chartered banks. By transferring funds
to or from the Bank of Canada and to or from its accounts at the
chartered banks, the federal government can influence short-term
interest rates.
A drawdown refers to a transfer of deposits to the Bank of Canada
from the chartered banks.
EXAMPLE
A drawdown drains the supply of available cash balances from

the banking system. This transfer of funds decreases deposits
and reserves available to the banks. The result is a contraction
in loans to consumers and businesses and an upward pressure
on interest rates.
A redeposit refers to a transfer of funds from the Bank of Canada

to the chartered banks.
EXAMPLE
A redeposit increases deposits and reserves and the availability
of funds in the banking system. This transfer of funds places
downward pressure on interest rates and gives banks an
incentive to increase loans to consumers and businesses.
FISCAL POLICY
Fiscal policy is a deliberate action by the government (federal,
provincial or territorial) to influence the economy through changes
either in spending or in taxation initiatives.
Similar to monetary policy, fiscal policy can be either expansionary
or contractionary. These categories of fiscal policy are described
below.
EXPANSIONARY POLICY
If the government believes that current economic growth is lower
than a specific target level, it may attempt to stimulate the
economy. The government may implement an expansionary fiscal
policy, which will either increase spending or decrease taxes.
EXAMPLE
If the government believes the unemployment rate is too high, it

might cut business taxes to encourage businesses to hire more
workers.
CONTRACTIONARY POLICY
If the government believes that current economic growth is rising
too quickly, it may attempt to cool off the economy. The
government may implement a contractionary fiscal policy, which will
either decrease spending or increase taxes.
EXAMPLE
If the government believes that public spending is too high, it
might cut public programs, such as health care spending, even
though such cuts may increase unemployment.
HOW FISCAL POLICY AFFECTS THE

ECONOMY
Fiscal policy affects the economy in several ways:
• Spending: Governments can purchase goods or services
themselves, such as a new highway, thereby boosting
economic activity. Or they can simply transfer money to
citizens to spend or save themselves, such as with social
security cheques. Only the first type is recorded as
government spending in GDP.
• Taxes: The amount of tax collected may vary because the size
of the tax base changed, i.e., the number of people or
companies paying the tax expanded or contracted. Also, it can
vary because the tax rate changed, so that each dollar of
economic activity yields more or less tax. Raising tax rates
reduces the disposable income of consumers, thereby
dampening their spending. The main types of taxes are as
follows:
◦ Direct taxes levied on the income of individuals and
companies
◦ Sales taxes, including value-added taxes, such as the goods
and services tax, and excise taxes, such as on liquor
◦ Payroll taxes levied as a share of wages
◦ Capital taxes levied on the size of a company’s assets or
capital
◦ Property taxes levied on residential and commercial property
By using a mixture of monetary policies and fiscal policies,
governments are better able to control economic phenomena.
INTERNATIONAL ECONOMICS
International economics deals with the interactions Canada has
with the rest of the world – trade, investments and capital flows,
and the exchange rate. Since the end of the Second World War,
the dependence of industrial economies on trade has risen
significantly. This is especially so for Canada – exports of goods
and services are approximately 30% of GDP, compared to 20% in
the 1960s. As a result, the economic performance of our trading
partners is an important determinant of Canadian economic growth.
THE BALANCE OF PAYMENTS

The balance of payments is a detailed statement of a country’s
economic transactions with the rest of the world for a given period,
typically over a quarter or a year. The two components of the
balance of payments are the current account and the capital and
financial account.
• The current account records the exchanges of goods and
services between Canadians and foreigners, the earnings from
investment income, and net transfers such as for foreign aid.
• The capital and financial account records financial flows
between Canadians and foreigners related to investments by
foreigners in Canada and investments by Canadians abroad.
Balance of payments transactions can be thought of as incurring
either a demand or supply of foreign currency and a corresponding
supply or demand of Canadian currency. Current account outflows,
such as to buy foreign goods or pay interest on debt held by
foreigners, create a demand for foreign currency to make those
payments. Canadian dollars are offered in exchange for this foreign
currency unless there is a corresponding demand for Canadian
dollars.
Think of the current account as what we spend on things and the
capital and financial account as what we use to finance this
spending.
• During a given year, if Canada buys more goods and services
from abroad than it sells, it will run a current account deficit for
the year. It will need to sell more assets to finance the
spending, which means running a capital and financial account
surplus, or go into debt.
• As an analogy, when an individual spends more than he/she
earns, the difference is made up by either borrowing money or
selling something of value and using the proceeds to pay off
the debt. In this way, a country experiencing a current account
surplus is saving more than it is spending and can lend out this
surplus amount to foreigners.
THE CURRENT ACCOUNT

The most important component of the current account is
merchandise trade – the goods and services we produce and sell
abroad and those we import from other countries.
A number of factors influence the performance of Canada’s trade.
The most important is the relative pace of demand in foreign and
Canadian economies. Strong growth in U.S. demand for
automobiles, raw materials and other products made in Canada
boosts exports. Likewise, strong demand in Canada for foreign
products boosts imports.
The competitive position of Canadian firms in foreign markets and
foreign firms in Canada also influences trade. A falling Canadian
dollar, for example, lowers the price of Canadian exports in foreign
markets and raises the price of imports in Canada. This boosts
exports and depresses imports. Those benefits are lost, however,
if the price of Canada’s goods rises in response to the lower dollar.
A rising Canadian dollar has the opposite effect.
THE CAPITAL AND FINANCIAL ACCOUNT
The key difference between current and capital and financial
account transactions is that the latter result in an acquisition of an
asset and the right to any income it earns. Thus, the purchase of a
computer made in Canada is a current account transaction,
whereas the purchase of the company that made the computer is a
capital and financial account transaction.
SUMMARY
1. Define microeconomics and the tools used to understand how
prices are determined, and describe the process for achieving
market equilibrium.
◦ Economics is fundamentally about understanding the
choices individuals make and how the sum of those choices
affects our economy. Whether it is the purchase of
groceries, a home or stocks and bonds, this interaction
ultimately takes place within organized markets.
◦ The three main decision makers in the economy are
consumers, companies and governments. While consumers
set out to maximize their well-being and firms aim to
maximize profits, governments set out to maximize the
public good.
◦ The forces of demand and supply and the interaction
between buying and selling decisions by consumers
ultimately leads to market equilibrium, and this is the price at
which we buy and sell goods and services.
2. Define gross domestic product and explain how it is calculated.
◦ Economic growth is an economy’s ability to produce greater
levels of output over time and is expressed as the
percentage change in a nation’s GDP. GDP is the market
value of all finished goods and services produced within a
country in a given time period, usually a year or a quarter.
◦ There are three ways to measure GDP. The expenditure
approach measures GDP as the sum of personal
consumption, investment, government spending, and net
exports of goods and services. The income approach
measures GDP as the total income earned producing those
goods and services. The production approach calculates
output and subtracts the value of all goods and services
used to produce the output.
3. Growth in GDP is tied to increases in population over time,
increases in the capital stock, and improvements in
technology. Describe the phases of the business cycle, and
distinguish among the economic indicators used to analyze
business conditions.
◦ There are five phases to a typical business cycle: recovery,
expansion, peak, contraction and trough.
◦ Various leading, lagging and coincident economic indicators
are used to analyze business conditions and current
economic activity. They are useful to show whether the
economy is expanding or contracting. For example, the
combination of higher new housing starts, new orders for
durable goods, and an increase in furniture and appliance
sales suggests an economy that is moving from recovery to
expansion.
◦ Improvements in long-term economic growth are attributed
to improvements in productivity. Productivity growth has
major implications for the overall wealth of an economy, as
there is a direct relationship between the amount of output
generated per worker and the standard of living of a typical
family.
4. Define unemployment and the various categories of
unemployment.
◦ The participation rate represents the share of the working-
age population that is in the labour force. The unemployment
rate represents the share of the labour force that is
unemployed and actively looking for work.
◦ Cyclical unemployment is the result of fluctuations in the
business cycle. Frictional unemployment is the result of
normal labour turnover, for example, from people entering
and leaving the work force and from the ongoing creation
and destruction of jobs. Structural unemployment occurs
when workers are unable to find work or fill available jobs
because they lack the necessary skills, do not live where
jobs are available, or decide not to work at the wage rate
offered by the market. Seasonal unemployment results from
industries that only operate during part of the year.
5. Describe the determinants of interest rates, define inflation and
discuss the cost of inflation.
◦ A broad range of factors influences interest rates: demand
for and supply of capital, default risk, central bank operations,
foreign interest rates and inflation.
◦ Higher interest rates raise the cost of capital for consumers
and businesses. This discourages consumers from spending
and borrowing money to purchase, for example, homes,
cars, and other big-ticket items. Businesses forgo taking part
in expansion projects or other forms of investment. Thus,
higher rates lead to slower economic growth.
◦ In contrast, lower interest rates have an expansionary effect
on the economy.
◦ Negative interest rates occur when the interest rate charged
on borrowed funds is less than zero.
◦ Inflation is a generalized, sustained trend of rising prices
measured on an economy-wide basis. A one-time jump in
prices caused by an increase in the price of a good or
service is not inflation unless it ultimately leads to higher
wages and other costs felt throughout the economy.
◦ The CPI is considered a measure of the cost of living in
Canada. The CPI can be used to measure the inflation rate:
◦ Inflation erodes the standard of living for those on a fixed
income, it reduces the real value of investments because
the loans are paid back in dollars that buy less, and it
distorts the signal that prices send to participants in the
market. Rising inflation typically brings about rising interest
rates and slower economic growth.
◦ Disinflation is a decline in the rate at which prices rise,
meaning a decrease in the rate of inflation. The Phillips
curve can be used to gauge the potential costs of
disinflation.
◦ Deflation is a sustained fall in prices where the annual
change in the CPI is negative year after year. Although
falling prices are generally good for the economy, a
sustained fall in prices can have negative implications for
corporate profits and the economy.
6. Discuss monetary policy and fiscal policy, including the balance
of payment accounts, and list the tools used by governments
to implement these policies.
◦ M onetary policy refers to regulation of the money supply
and available credit for the purpose of promoting sustained
economic growth and price stability.
◦ Fiscal policy is a deliberate action by the government
(federal, provincial or territorial) to influence the economy
through changes either in spending or in taxation initiatives.
◦ The balance of payments is a detailed statement of a
country’s economic transaction with the rest of the world.
◦ The current account records the exchange of goods and
services between Canadians and foreigners, the earnings
from investment income, and net transfers.
◦ The capital and financial account records financial flows
between Canadians and foreigners, related investments by
foreigners in Canada, and investments by Canadians
abroad.
REVIEW QUESTIONS

SECTION 2
THE KNOW YOUR CLIENT


SECTION 2 | THE KNOW YOUR CLIENT
In Section 1, we introduced you to the role of the mutual fund sales
representative. This role requires that representatives know their
clients and products well enough so that recommendations can be
made based on client preferences, wants, and needs.
In Section 2, our job is to help you understand how to “know your
client.” This part of the client service equation is as important as
understanding the mutual funds the client may wish to buy.
In Chapter 4, we explain what specific information must be obtained
from each client before you are in a position to make investment
recommendations based on suitability. Suitability means making
recommendations once all information about a client and a security
is analyzed to determine if an investment is suitable for the client’s
account. The chapter ends with a classification of clients based on
the Life-Cycle Hypothesis.
In Chapter 5, we introduce behavioural finance, which is the use of
psychology to understand human behavior in finance or investing.
As a mutual fund sales representative, you must be aware that
clients may be making decisions based on irrational or emotional
biases and how this may affect your relationship with your clients.
In Chapter 6, we provide an overview of the tax and retirement
planning options that clients have available to them. Since
accumulating wealth for retirement is a primary goal for most clients,
it is important for the mutual fund sales representative to acquire
knowledge about the various programs and vehicles available to
save for retirement.
Getting to Know the Client 4
CONTENT AREAS
Why are Client Communication and Planning Important?
What is the Financial Planning Approach?
What are the Steps in the Financial Planning Process?
What is the Life-Cycle Hypothesis?
LEARNING OBJECTIVES
1 | Describe the client communication and planning process.
2 | Summarize the six steps of the planning process and

describe how to apply them to client scenarios.
3 | Describe and differentiate between the five stages of

the life-cycle hypothesis.
KEY TERMS

asset allocation
capital gains
capital growth
cash flow
current income
discretionary funds
discretionary income
financial circumstances
financial goals and objectives
financial planning pyramid
household budget
investment horizon
investment knowledge
life insurance
life-cycle hypothesis
net worth
personal data
record keeping
safety of capital
savings
suitability
total assets
total liabilities
INTRODUCTION
One of your obligations as a mutual fund sales representative is to
recommend only suitable investment products, ensuring that any
solicited or unsolicited purchases are reasonable. To do this, you
need complete knowledge of the products you offer and you must
have a complete understanding of your client’s goals and
investment constraints. Without these two elements, the guidance
you provide will be incomplete and may result in a dissatisfied
client.
This chapter is devoted to knowing the client: learning what
information to obtain and how to go about getting that information.
To start, the chapter provides an overview of your responsibilities
as a mutual fund sales representative presented within a financial
planning framework. This framework gives you a structure and
process for understanding your clients well enough to formulate
suitable investment recommendations.
WHY ARE CLIENT COMMUNICATION AND

PLANNING IMPORTANT?
A mutual fund sales representative evaluates investment suitability
usually on the basis of a client’s predetermined financial goals and
objectives. Your job is to determine which mutual funds provide an
acceptable fit. For this you need excellent communication and
planning skills. You undertake financial planning as a process to
better understand how clients can attain their financial objectives.
This planning is a continuous process because plans must be
revised to reflect changes in the financial and personal
circumstances of the client and in the economy.
Judging whether a client’s financial goals are reasonable requires
that you understand how they are set. Thus, you must look at the
client from a financial planner’s perspective even though you will
not be helping the client to set goals. You must know whether the
goals are consistent with the client information you obtain. The
goals also must be consistent with what you know about the long-
and short-term performance of mutual funds and other securities.
EXAMPLE
A client who requires earnings of 30% a year on a mutual fund

investment in order to achieve a retirement goal will likely find
that goal is unattainable. A 30% return is unrealistic, especially
with the volatility markets have experienced over the last
ten years.
WHAT IS THE FINANCIAL PLANNING

APPROACH?
The financial planning approach means assessing clients’ current
financial and personal situation, constraints, goals and objectives
and making recommendations through a financial plan to achieve
these goals and objectives. The advisor may call on specialists in
investment management, taxes, estate and financial planning and
integrate the expert analysis, findings, and recommendations into a
coherent plan to meet the client’s needs. In fact, many large
financial institutions have created internal teams of these
specialists to support their advisors.
Financial planning involves analysis of clients’ age, wealth, career,
marital status, taxation status, estate considerations, risk profile,
investment objectives, legal concerns and other matters.
Accordingly, a very comprehensive view of present circumstances
can be formed and future goals better defined. In addition, the very
discipline and self-analysis required to flesh out a plan causes
clients to have a clearer understanding of themselves and their
goals, making success in achieving those objectives far more
realistic and likely.
Before that plan is prepared, there are four objectives that must be
considered. The plan to be created:
• M ust be achievable
• M ust accommodate changes in lifestyle and income level
• Should not be intimidating
• Should provide for not only the necessities but also some
luxuries or rewards
Each person or family will have a unique financial plan with which to
reach goals. However, there are some basic procedures that can
be followed to begin a simple financial plan. These steps are
common to all.
WHAT ARE THE STEPS IN THE FINANCIAL

PLANNING PROCESS?
Typically, the financial planning process can be divided into the
following steps:
1. Establishing the Client-Advisor relationship
2. Collecting data and information
3. Analyzing data and information
4. Recommending strategies to meet goals
5. Implementing recommendations
6. Conducting a periodic review or follow-up
Although financial planning involves the same set of steps for each
client, an effective plan is a unique and specific plan that addresses
the distinct needs of each client.
ESTABLISHING THE CLIENT-ADVISOR

RELATIONSHIP
Interviewing the client provides an opportunity to determine what
issues and problems the client has identified and whether
development of a financial plan will deal with them. It also helps
both the advisor and the client to determine whether they feel that
a long-term relationship can exist. During the interview, the advisor
should discuss the financial planning approach and how it will help
the client meet his or her objectives. The advisor should
communicate to the client that there will be choices and decisions
to be made regarding alternative strategies for dealing with planning
issues. Likewise, there will be alternatives in choice of product
which should be dealt with by specialists in each area. The advisor
should also disclose any areas where a conflict of interest may
arise.
If the initial interview is successful from both the advisor’s and the
client’s viewpoint, the advisor should formalize the relationship with
either a letter of engagement or a formal contract. This is to ensure
that the client is fully aware of exactly what services the advisor will
provide and what information the advisor will require in order to
prepare a plan. The letter should also outline matters such as the
method of compensation and the client’s responsibility for the
compensation of other professionals, such as lawyers and
accountants.
COLLECTING DATA AND INFORMATION
An advisor contributes to a client’s well-being by understanding the
difference between the client’s current status and future
requirements and goals, and by helping to resolve these
differences. To do this effectively, information must be gathered
about the client. To acquire this information, an advisor has to
follow intuition and instinct while applying some sound techniques
for gathering data and assessing the client’s requirements.
Advisors are required to know the essential details about each of
their clients including:
• The client’s current financial and personal status
• The client’s investment goals and preferences
• The client’s risk profile
Successful advisors go beyond just knowing the essential details
of a client’s situation. They understand the client’s unique personal
needs and goals including:
• The process the client uses to make important decisions
• The way in which the client prefers to communicate with the
advisor
• The psychological profile of the client
• The needs, goals, and aspirations of the client’s family, if
applicable
An advisor does far more than just manage the financial lives of
clients and provide advice to help them achieve their financial
goals. Clients must also be encouraged to assess and re-examine
their goals in the context of their evolving business and personal
lives. Clients’ motivations must be understood. Sometimes the
advisor has to dig deep to find them, because clients’ motivations
are not always readily apparent. The advisor must work with the
clients to understand what makes them tick and how they can best
build a financial strategy.
There are a number of methods to identify and define clients’
motivations for pursuing a particular financial objective. M ost of
them involve actively listening to clients and interpreting their
statements in the context of their unique personality, background,
character and context.
It is the advisor’s job to help the client articulate those emotions
and build a financial strategy to keep them under control.
COMMUNICATING WITH AND EDUCATING THE CLIENT

The job of gathering information about the client is really just the
start of the client communication process. This process also
includes regular contact and education. Clients rely on an advisor
for a number of reasons, but almost all of them share one
characteristic. They all want someone to understand and attend to
the details of their financial lives.
Clients want to know they have an advisor who is watching out for
their interests, one who is thinking about them and is prepared to
take the time and effort to call them, even when the news is not
favourable.
The advisor’s job will be easier if clients understand why specific
decisions about the plan have been made. The advisor can explain
in simple terms the technical nature of the plan’s individual
elements – “A global equity fund invests in stocks on markets
around the world”.
The greater challenge is to earn clients’ full co-operation and trust
in making these decisions. In fact, without a client’s co-operation,
advisors cannot do their job. To gain this trust, advisors have to
explain how specific investments will help clients achieve their
goals and what type of risks these investments carry.
OTHER INFORMATION REQUIRED

A great deal of information is necessary to prepare a plan,
including:
Personal data: These include age, marital status, number of
dependants, risk profile and health and employment status. An
analysis of these factors may reveal special portfolio restrictions or
investment objectives and thus help define an acceptable level of
risk and appropriate investment goals.
Net worth and family budget: The advisor can obtain a precise
financial profile by showing the client how to prepare a Statement
of Net Worth and a Family Budget if the client does not already
have these documents available. It is important to determine the
exact composition of the client’s assets and liabilities, the amount
and nature of current income and the potential for future investable
capital or savings. This information will be invaluable in determining
the amount of income a portfolio will have to generate and the level
of risk that may be assumed to achieve the client’s financial goals.
Record keeping: Part of any financial plan includes advice or
perhaps instructions for the client on keeping and maintaining
adequate and complete records. It is important for family members
to be aware of where records are kept so that they can access this
information in an emergency. A document should be prepared
which gives the location and details of wills, insurance policies,
bank accounts, investment accounts as well as any other financial
information. There should also be a list of the professional advisors
used by the client, such as the name and contact information of
any lawyers, accountants, financial planners, IAs or doctors
consulted by the client.
ANALYZING DATA AND INFORMATION

Your goal must be to obtain all the information needed to determine
the type of mutual funds that would be suitable in view of the
client’s objectives and constraints. In some cases, the information
obtained will lead you to suggest a revision of the client’s
objectives. For example, if a client has three dependants and no
cash reserve, then it is premature to focus on long-term goals.
The KYC rule requires that the mutual fund sales representative
gather the following information, at a minimum when opening an
account for a new client:
• The client’s investment needs and objectives.
• The client’s personal circumstances.
• The client’s financial circumstances, including annual income
and net worth.
• The client’s investment knowledge.
• The client’s risk profile.
• The client’s investment time horizon.
Based upon the above and other information you gather, you can
diligently decide on suitable mutual fund investments. Client
account documentation should reflect all material information about
a client’s current status. It should be updated regularly to reflect all
material changes to the client’s status to ensure the continuing
suitability of investment recommendations.
M ost mutual fund sales representatives have a standard
application form their firms use to gather this information. M ost
firms require the following information:
• For all clients: name, type of account, residential address and
contact information, date of birth, employment information,
number of dependants, other persons with trading authorization
on the account, other persons with a financial interest in the
account, investment knowledge, risk profile, investment needs
and objectives, investment time horizon, financial
circumstances including income and net worth, and any other
information required by law.
• Waiver of information: If a client refuses to provide any part of
the minimum information required on the application, a waiver
should be obtained from the client in written form acceptable to
your dealer. Refer the client to your dealer’s branch compliance
officer or manager for assistance in these situations.
You must have a special authorization agreement signed by the
client if the client intends to place orders by fax or phone.
Otherwise, orders taken over the phone may expose you to risk if
a loss occurs. Today, calls from clients are recorded to ensure that
there is a verifiable record of the order and what was said between
the sales representative and the client. Dealers also record calls
for quality control purposes.
Your recommendations must all be based on careful analysis of
information about both the client and the particular transaction. This
duty is independent of whether a mutual fund order is solicited or
unsolicited. Your recommendations will flow directly from the client’s
goals and objectives.
INVESTMENT NEEDS AND OBJECTIVES

Clients often state their financial goals and objectives with a
particular set of targets in mind. For example:
• “I’d like to retire at 55.”
• “When I retire in 20 years, I’ll need $60,000 in annual income.”
Financial objectives are personal and depend to a large extent on
the client’s tastes and preferences. For example, some clients
prefer to enjoy a more expensive current lifestyle even if that might
mean a more meagre retirement. Others prefer to save toward a
comfortable retirement and are willing to accept a more frugal
current lifestyle. Clients’ individual lifestyle choices usually are not
subject to debate.
Properly set objectives should be stated in clear financial terms;
that is, a monetary value for a financial target should be established
for whatever goal the client has in mind. A typical target for a
retirement goal states how much pre-tax income should be
available for a given number of years following retirement.
EXAMPLE
A 30-year-old client wants $40,000 per year in retirement

income, before taxes, with the purchasing power in today’s
dollars, for 25 years after retiring at age 65.
Precise goals—those stated with numbers—make the whole

planning process more orderly and controllable. If goals are vague,
then the actions needed to attain those goals are likely to be
vague as well.
Not all goals are long-term like that of a 30-year-old saving for
retirement in 35 years. Some goals are short-term, such as saving
for a down payment on a house (3-5 years). Others are medium
term, such as saving for a child’s university education (10-
15 years). However, all goals should be stated as precisely as
possible.
Case Study | New Parents Teresa and Patrick: Turning Dreams

into Goals (for information purposes only)
Teresa and Patrick are meeting with Yvonne, a financial advisor at

their bank. M arried for two years and with a newborn child, they are
hoping to begin their investment journey and turn their financial
dreams into achievable goals.
Yvonne begins by discussing the couple’s dreams: first, they want
to buy a house as soon as possible; second, they want to start
saving for their child’s education; and third, they want to begin
saving for retirement as early as possible. Yvonne helps Teresa
and Patrick establish their budget and cash flow, determining that
the couple has limited resources after day-to-day expenses to
save. Fortunately, a wedding present from Teresa’s parents have
given them enough for a substantial down payment towards the
purchase of their first home.
Yvonne helps the couple to establish their short- (i.e. house
purchase), medium- (i.e. child’s education) and long-term (i.e.
retirement) goals. She also advises them to have a “rainy day” fund
for emergencies and unforeseen expenses. Yvonne explains the
benefits of opening a Registered Retirement Savings Plan (RRSP)
to take advantage of the immediate tax savings and the long-term
benefit of tax-deferred compounding, while also educating them
about the Home Buyer’s Plan (a plan that allows qualified home
buyers to use RRSP money to finance the down payment on a
home).
The couple agree that their first priority is to save for their home
purchase, ideally within one to three years. With Yvonne’s
guidance, they decide to each establish an RRSP, depositing most
of the funds from Teresa’s parents. The remainder will be used to
open a Registered Education Savings Plan (RESP) for their
daughter. The couple are excited to learn that an RESP will allow
them to build tax-deferred income on contributions made to the
plan for a child’s post-secondary education. The tax refunds from
the large RRSP deposit will be used to fund a Tax-Free Savings
Account (TFSA) as an emergency fund. Their excess cash flow will
be split between further contributions to their respective RRSPs
and the remainder will go into the RESP (RESPs and TFSAs are
covered in more detail in Chapter 6).
Given the short timeframe and uncertain timing for purchasing their
new home, Yvonne recommends cashable GICs to ensure that
their funds are available when they need them and so that their
principle is not at risk. She recommends money market funds for
their TFSA, again to ensure that the funds are available whenever
they may require them. She recommends a target-dated education
fund for their child’s RESP, which will manage the risk of the
portfolio overtime, reducing the growth component as the child’s
targeted post-secondary education start date nears.
With their short- and mid-term dreams now achievable goals,
Teresa and Patrick agree to revisit their long-term retirement
savings goal. They will review their savings plans and portfolios
every six months to ensure that they stay on track to realizing their
dreams that have now become real goals.
M utual fund order forms typically offer a limited number of general
objectives, such as safety of capital, maintenance of current
income, capital growth (or capital gains) and tax minimization. While
these are called objectives, they really represent the types of
returns the client hopes to generate from the investment:
• Safety of capital is the return generated on investments that
are least likely to erode the client’s capital even in the short-
term. The only type of mutual fund with this characteristic is a
money market fund. All other funds contain some risk so that, in
the short-term, capital may decline. This type of return is
expected to just maintain the client’s purchasing power. It is not
expected to increase wealth. Safety of capital returns, since
they come from investments such as term deposits and money
market funds, are in the form of interest income.
• Current income is earned from mortgage funds, bond funds,
preferred dividend funds, and, to a certain extent, equity funds
that seek out dividend paying companies to hold in their
portfolios. These fixed-income funds are riskier than money
market funds, whose goal is to preserve capital and provide
modest interest income. Because these funds are generally
more volatile than money market funds, the client’s investment
horizon (the length of time the money is expected to remain
invested) must be longer. Earning current income means not
only preserving purchasing power but also generating enough
income so that the client can live off the proceeds of the
investment and still preserve the capital base.
• Investors seeking capital growth or capital gains must be
willing to invest in the riskier types of mutual funds that offer the
possibility of capital gains. Although fixed-income funds offer
some capital gains potential, most capital gains are offered by
equity growth funds. Portfolios consist of companies that tend
not to pay current dividends but whose shares may increase in
value over time. Equity growth funds can be highly volatile, so
they are suitable mainly for clients with long-term investment
horizons. Over the long-term, growth funds should increase the
client’s wealth.
• When assessing the return from any investment, you must
consider the effect of taxation. The tax treatment of any
investment varies depending on whether the returns are
categorized as interest, dividends or capital gains. Thus, tax
treatment of the returns influences the choice among
investments.
PERSONAL CIRCUMSTANCES
Personal circumstances may represent challenges or constraints to
the client’s choices, including factors such as marital status, number
of dependents and age. These factors have a major impact on the
client’s ability to bear risk and the financial goals selected.
EXAMPLE
A client who is 25 years old, single and without dependents is

likely to have different short- and medium-term goals than a
married, 40-year-old with two high school aged children.
Changing personal circumstances might result in the need to
make adjustments to objectives. Some objectives attainable for
a dual-income couple with no children can suddenly become
unattainable with the arrival of a child or the breakup of a
marriage. Changing personal circumstances make personal
financial planning a dynamic process requiring the regular
monitoring and readjusting of goals.
Other problems or constraints may arise from the client’s

investment knowledge, or lack of it, and the client’s risk profile.
FINANCIAL CIRCUMSTANCES
A client’s financial circumstances are important when assessing
investment suitability because it helps to determine the amount of
savings a client can commit to the purchase of mutual funds and
the level of risk they can afford. The better a client’s financial
circumstances, the more risk he or she can assume and the better
the returns will be in the long run.
Financial circumstances generally improve with the size of the
investment portfolio, the excess income from employment and
investment over living expenses (savings), and the stability of the
clients’ employment situation.
An individual’s ability to save depends on cash flow, which is the
amount of money coming in from employment and other sources
and the amount of money going out to pay bills. The difference
between these two amounts is the discretionary income
available for savings. Savings is the amount of money not needed
for current expenditures.
The best way for clients to determine how much discretionary
income for savings they will have is to prepare a household
budget on a monthly or yearly basis. The format of a typical budget
is shown in Figure 4.1. You may want to adopt this format when
discussing budget matters with clients or in assessing your own
financial situation.
Note that it has a place to enter both inflows and outflows. Key
outflows include mortgage payments or rent, loan interest and
repayments, and life insurance. Life insurance is important in that
it replaces lost earnings with a lump-sum payment should the
investor die. While the need for life insurance is debatable for a
young, single client, it is practically a requirement for families with
children.
Figure 4.1 | A Typical Household Budget
Monthly Total Total Annual

Monthly
NET EARNINGS
Self $
____________
Spouse ____________
Net Investment ____________ $ $

Income ____________ ____________
EXPENSES &
SAVINGS
Maintaining
Your Home
Rent or $
M ortgage ____________
Payments
Property Taxes ____________

Insurance ____________
Light, Water & ____________
Heat
Telephone, ____________
Cable
M aintenance & ____________

Repairs
Other ____________
TOTAL $
M ONTHLY ____________
TOTAL ANNUAL $
____________
Maintaining
Your Family
Food $
____________
Clothing ____________
Laundry ____________
Auto Expenses ____________
Education ____________
Child Care ____________

M edical, Dental, ____________
Drugs
Accident & ____________
Sickness
Insurance
Other ____________
TOTAL $
M ONTHLY ____________
TOTAL ANNUAL $
____________
Maintaining
Your Lifestyle
Religious, $
Charitable ____________
Donations
M embership ____________
Fees
Sports & ____________

Entertainment
Gifts and ____________

Contributions
Vacations ____________
Personal ____________
Expenses
TOTAL $
M ONTHLY ____________
TOTAL ANNUAL $
____________
Maintaining
Your Future
Life Insurance $
Premiums ____________
RRSP & Pension ____________ $ $
Plan ____________ ____________
Contributions
TOTAL M ONTHLY EXPENSES $
AND SAVINGS ____________
TOTAL ANNUAL EXPENSES $
AND SAVINGS ____________
AVAILABLE $ $
FOR ____________ ____________
INVESTM ENT
Whatever savings the client has accumulated to date is considered
part of the client’s overall net worth. Net worth is the difference
between the client’s total assets and total liabilities, or more simply
put, net worth is the amount owned less the amount owed. Total
assets include the estimated market value of real estate, plus the
value of all investments, and the value of all other assets held by
the client. Total liabilities are calculated by adding up the
outstanding amount on mortgages and loans (e.g., car loan). Any
unpaid bills are counted as liabilities as well (e.g., income taxes
payable).
The net worth number alone does not provide a complete
indication of how much the client has accumulated toward his or her
goals. For example, fluctuating real estate values can have a
dramatic effect on a client’s net worth but little significance in terms
of accumulated savings. Real estate is an illiquid asset, not readily
convertible to cash, and is subject to market fluctuations.
EXAMPLE
If a client owns a house worth $400,000 that she paid $50,000

for several years ago, then her net worth has increased
significantly. Conversely, if a client paid $400,000 for a home that
is now worth $350,000 in today’s market, then there would be a
reduction in net worth.
Figure 4.2 shows a typical layout of a net worth statement.
Figure 4.2 | Statement of Net Worth
ASSETS
Readily Marketable Assets
Cash (savings accounts, chequing accounts, etc.) $

__________
__
Guaranteed investment certificates and term __________
deposits __
Bonds – at market value __________

__
Stocks – at market value __________
__
M utual funds – at redemption value __________
__
Cash surrender value of life insurance __________
__
M ortgages at principal value __________
__
Other __________
__
Non-liquid Financial Assets
Pensions – at vested value $

__________
__
RRSPs __________
__
Tax shelters – at cost or estimated value __________

__
Annuities __________
__
Other __________
__
Other Assets
Home – at market value $
__________
__
Recreational properties – at market value __________
__
Business interests – at market value __________
__
Antiques, art, jewellery, collectibles, gold and __________
silver __
Cars, boats, etc. __________
__
Other real estate interests __________

__
Other __________
__
TOTAL ASSETS $
__________
__
LIABILITIES
Personal Debt
M ortgage on home $ ____________
M ortgage on recreational ____________

property
Credit card balances ____________

Investment loans ____________
Consumer loans ____________
Other loans ____________
Other ____________
Business Debt
Investment loans $ ____________
Loans for other business-related ____________

debt
Contingent Liabilities
Loan guarantees for others $ ____________

TOTAL LIABILITIES $ ____________
ASSETS $ ____________
NET WORTH M inus LIABILITIES $

____________
NET WORTH $ ____________
Both net worth and annual income are categories usually covered
in a mutual fund account application form. The form has a number of
check-box choices that vary from institution to institution. The net
worth box provides an indication of the current status of the client’s
wealth, and how far the client has come toward the ultimate wealth
accumulation goals. The annual income box indicates how
attainable the goals are likely to be.
Savings represent surplus or discretionary funds (i.e., funds that
are not needed for day-to-day living). All clients should build up an
emergency cash reserve. How much should be held will depend
upon personal circumstances, but should be in the range of three
to six months of net income.
How should a mutual funds sales representative deal with clients
who have little or no liquid (cash) reserve as part of their net
worth? These clients tend to have relatively lower levels of
employment income. This constraint limits their ability to generate a
cash reserve for emergencies in the short term. If such clients want
to invest in a mutual fund, then you should direct them to highly
liquid mutual funds (e.g., money market funds) in case they require
cash for emergencies. Other types of funds will likely have too
much volatility to make them acceptable candidates for an
emergency cash reserve. This is a responsible approach to take
for such clients.
INVESTMENT KNOWLEDGE
Over the course of your career, you are going to meet clients with
different financial and personal circumstances, goals and
objectives, and who will have varying degrees of financial market
investment knowledge. This will be one of the most interesting, and
at times challenging, parts of your role as a mutual fund sales
representative.
Investment knowledge differs widely from person to person and
is an important determinant of how much investment risk a client
can bear. Knowledgeable investors tend to have a better
understanding of risk, as well as their own ability to bear that risk. In
addition, knowledgeable investors:
• understand the risk/return trade-off of securities and mutual
funds
• know how these tradeoffs should be reflected in their
investment portfolios
Experienced clients usually are easier to deal with, since they
know what they want in investments and are aware of the risks.
RISK PROFILE
A client’s risk profile requires an understanding of their willingness
to accept risk (risk tolerance) and their ability to endure a potential
financial loss (risk capacity). The risk profile for a client should
reflect the lower of the client’s willingness to accept risk and their
ability to endure potential financial loss.
DETERMINING AN INVESTOR’S WILLINGNESS TO ACCEPT

RISK
Figuring out how a client defines risk and exactly how much risk
they are willing to accept involves asking the right types of
questions during interviews and on questionnaires. Because it is
hard to get a client to put their attitudes toward risk into words, one
of the primary goals of a questionnaire is to pinpoint how the client
defines risk and how much of it they are willing to accept to
achieve their goals.
Questionnaires should contain, behavioural questions that seek to
model actual client actions in different circumstances, along the
lines of “if this happened, what would you do?” Typically, the
answers to risk-based questions allow the assignment of different
degrees of willingness to accept risk.
Once a client has completed an investor questionnaire, the
answers can be used to determine the client’s willingness to
accept risk, usually by applying a scoring system. A point value is
assigned to each potential answer.
No single question can determine a client’s willingness to accept
risk, as clients respond differently to different situations. However,
with the completed questionnaire, a mutual fund representative can
determine a client’s overall willingness to accept risk by adding up
the points for each response and placing the client into a risk
tolerance category according to the questionnaire answer key.
DETERMINING AN INVESTOR’S ABILITY TO ENDURE

POTENTIAL FINANCIAL LOSS
Assessing a client’s capacity for loss involves the representative
having an understanding of other factors such as the client’s
financial circumstances, including liquidity needs, debts, income,
and assets. Another consideration in determining risk capacity is
how much of a client’s total investments an account or a particular
securities position represents. Age and life stage can also be
important considerations when assessing a client’s ability to endure
potential financial loss.
Once these elements have been determined, a client’s ability to
endure potential financial loss can be fine-tuned by finding out how
important their goals are and how serious the consequences will
be if one or more of them are not met. If all of the goals are very
important to the client, and they believe the repercussions of not
meeting the goals will be severe, then the client’s ability to endure
potential financial loss is lower. On the other hand, if the
consequences of not meeting one or a few of the goals are not
serious, the client’s ability to endure potential financial loss is
higher.
ESTABLISHING A RISK PROFILE

A client’s risk profile represents the combination of their willingness
to accept risk and their ability to endure potential financial loss. As
noted earlier, according to NI 31-103, a client’s risk profile should
reflect the lower of their willingness to accept risk and their ability to
endure potential financial loss.
If both willingness to accept risk and ability to endure potential
financial loss are low, then the client’s risk profile is low. If both
aspects are high, then the client’s risk profile is high.
A client’s expectations for returns in line with their investment
needs and objectives may conflict with the level of risk they are
willing and able to accept. A desire to meet unrealistic expectations
may lead such clients to ask the representative to invest in higher-
risk products that are unsuitable for them. A detailed discussion of
the relationship between risk and return may be necessary to
reconcile such conflicts and establish more realistic expectations.
A representative should not override the risk a client is willing and
able to accept on the basis that the client’s expectations for returns
cannot otherwise be met given the risk profile associated with their
KYC responses. The representative should identify any
mismatches between the client’s investment needs and objectives,
risk tolerance, and capacity for loss. The questions at the source of
this conflict should be revisited with the client. If the client’s goals
or return objectives cannot be achieved without taking greater risk
than they are able or willing to accept, alternatives should be
clearly explained, such as saving more, spending less, or retiring
later.
Sometimes, after discussion, it is determined that the client does
not have the capacity or tolerance to sustain the potential losses
and volatility associated with a higher-risk portfolio. In such cases,
the advisor should explain to the client that their need or
expectation for a higher return cannot realistically be met, and,
therefore, the higher-risk portfolio is unsuitable. The interaction with
the client and the resulting decisions should be properly
documented.
DID YOU KNOW?
The M utual Fund Dealers Association provides a sample

investor questionnaire that, in part, demonstrates how to
establish a client’s risk tolerance and risk capacity. For
more, please navigate to www.mfda.ca and use the search
box to locate the sample investor questionnaire.
INVESTMENT KNOWLEDGE
Over the course of your career, you are likely to encounter clients
with varying degrees of investment knowledge. Some clients may
have never invested before, while others may be highly
experienced sophisticated investors. Investment knowledge differs
widely from person to person and is an important determinant of
how much investment risk a client can bear. Knowledgeable
investors tend to have a better understanding of risk, as well as
their own ability to bear that risk.
SUITABILITY OF INVESTMENTS
Once you have all of the needed client information, you can begin
determining the suitability of various investments. If the client
already has an investment portfolio, then you can evaluate if the fit
is appropriate. If the client does not have an investment portfolio,
then you can help him to decide on an appropriate asset
allocation or mix of investments among cash, fixed-income
securities, and equities.
Setting personal financial goals and objectives is a difficult task.
Your client must objectively assess personal strengths and
weaknesses as well as realistically review career potential and
earnings potential. Some may consider this in-depth review to be
tedious and perhaps unnecessary, but it is not possible to set
realistic financial goals without considering how to reach that goal.
While many clients dream of striking it rich in the financial markets,
those who actually reach that goal have done so by design, not by
chance.
Since mutual funds are selected to suit individual needs, it is
essential to develop a clear client profile. Only by studying all
factors that potentially affect a client can suitable recommendations
be made or an individual’s investment strategy be designed.
RECOMMENDING STRATEGIES TO MEET

GOALS
After collecting and analyzing the information, a plan of action must
be developed for the client to follow. This plan of action may
require the input of other professionals. If this is the case, the
advisor should prepare a list of instructions for these professionals
as well. Clearly defined goals and tasks, as well as a schedule for
achievement can be of enormous benefit to the client. The financial
plan should be simple, easy to implement and easy to maintain.
It is important to implement a financial plan in a timely manner.
Once the preparatory work of collecting, analyzing, determining and
calculating is finished, it is up to the client to decide to put all the
carefully thought-out ideas and strategies in motion.
At this point the client should review the plan, the goals, the
objectives and the risk profile. The client should be in agreement
with them before any potential solutions are implemented. The
investment advisor must ensure that the client understands each
product chosen and is aware of the potential risks as well as the
potential rewards.
IMPLEMENTING RECOMMENDATIONS
At this stage, the advisor may help clients implement the
recommendations. Some recommendations may be immediate,
such as applying for insurance or paying down debt. Other
recommendations will be implemented over a longer term, such as
making periodic investments, contributing funds to an RRSP, etc.
If necessary, the advisor may refer clients to a business partner
such as a lawyer, tax adviser, investment adviser, real estate
broker, retirement specialist or insurance representative.
CONDUCTING A PERIODIC REVIEW OR

FOLLOW-UP
The last step in this whole process is the review. A financial plan
should never remain static. Just as investments rise and fall in
market value, a person’s financial situation can change. As well,
economic changes, tax increases and health issues all can
threaten even the “best-laid plans.” While there is no set time
frame for such a review, an annual review is the minimum required.
M ini reviews may be necessary depending on the circumstances
(i.e., changing tax, economic or employment status). In extreme
circumstances, such as a job loss, it may be necessary to devise a
completely new financial plan.
Revisions can include reviewing a will, changing beneficiaries and
ensuring that the client is continuing to take advantage of all tax
savings techniques. Recommendations can be simple – no
changes are necessary – or could entail a great number of
changes. It is important that the advisor follow up with the client to
ensure that suggestions are carried out.
This overview of the financial planning process provides the client
with the structure of a basic financial plan but does not deal with
specialized issues such as trusts, estate freezes, the need for
insurance, etc. To complete a thorough analysis of investment
needs and requirements, these areas must be addressed as well;
however, it is beyond the scope of this text to do so. A more
thorough discussion of these topics is provided in more advanced
courses offered by CSI.
GATHERING INFORMATION
How do you gather information and assess client needs to

prepare a financial plan? Complete the online learning
WHAT IS THE LIFE-CYCLE HYPOTHESIS?

To add perspective to getting to know a client, it can be helpful to
think in terms of a client’s typical investing life cycle. The basic idea
behind the life-cycle hypothesis is that as people age, their
objectives, financial and personal circumstances, investment
knowledge, and risk profile change as well. When dealing with
clients, you can make the general assumptions that:
• Older clients tend to be more risk averse than younger clients.
• Younger clients tend to focus on shorter term financial goals —
such as saving for major purchases, such as a home.
• Older clients tend to focus more on retirement and estate-
building.
The life-cycle hypothesis, developed during the 1950s by several
North American and European economists, has great potential
benefit to a mutual fund professional. It suggests that if you know
the age of your client, then you can infer a number of investor
characteristics, such as goals, circumstances and risk profile.
Certainly, if the life-cycle hypothesis is valid, it should make
“knowing your client” an easier task.
The good news is that the life-cycle hypothesis works for many
clients. The bad news is that it does not work for all of them. In
getting to know a particular client, a good strategy is to assume
that the life-cycle hypothesis holds. However, you must be
sensitive to the fact that you may have to change your mind as
you obtain more information about a particular client. Special
circumstances require an individualized approach.
THE STAGES IN THE LIFE-CYCLE

There are five stages in the life-cycle:
1. Early earning years – to age 30
2. Family commitment years – 25 to 35
3. M ature earning years – 30 to 50
4. Nearing retirement – 45 to 65
5. Retired – 50 and onwards
In general, each stage corresponds to an age grouping. As you can
see, the age of a client does not unambiguously indicate a position
in the life cycle. There is a considerable amount of overlap to
account for the fact that every client is unique. For example, a 30-
year-old client could be in any one of the first three stages. You will
need additional information about this client to pin down the stage.
STAGE 1: THE EARLY EARNING YEARS – TO AGE 30

The early earning years generally start when an individual begins to
work and ends when family commitments or other commitments
start to impose financial demands. Stage 1 investors, in general,
are free of the family and financial commitments of the next stage.
They are interested in saving, but their goals are usually short
term. Car purchases and vacations are two typical goals. These
clients tend not to have life insurance and probably do not need it,
since no one else depends on the continuity of their earnings.
By age 30, if a client has not yet begun a family, it is likely that they
nevertheless have made some of the same major financial
commitments that their married counterparts have made, such as
buying a house. It is possible, however, that even after the age of
30, some people would still be considered Stage 1 investors.
Because these investors are young, often they are psychologically
prepared to tolerate a substantial amount of investment risk. This
might lead them to invest in riskier types of assets with volatility
characteristics more suitable for investors with longer investment
time horizons. Certainly, if Stage 1 clients decide to invest for the
long term, they will likely allocate their investments to riskier
assets.
The action of allocating assets into investments that have different
levels of risk is called “asset allocation” and will be discussed in
detail later in this course. A typical asset allocation for long-term
goals might be 80% equity funds, 10% bond funds and 10% money
market funds.
EXAMPLE
Henry is 28 and graduated from college a few years ago with a
degree in broadcasting. He rents an apartment in the city and is
saving for a down payment on a house. He recently bought a
used car that required a small bank loan. Although he has only a
small amount to invest, most of his money is held in two equity
mutual funds and two conservative funds.
How he invested his money—80% in equity funds; 10% in a bond

fund; 10% in a money market fund—reflects the higher risk profile
of a typical Stage 1 investor.
STAGE 2: THE FAMILY COMMITMENT YEARS – 25 TO

35
The difference between people at Stage 2 and those at Stage 1 is
the level of commitments and responsibilities that have to be
assumed. A typical Stage 2 client is fairly young and married with
children. M arriage itself does not necessarily result in a change of
stage, especially if a couple does not plan to have children or buy a
home. In most cases, however, marriage will result in a shift in
financial goals.
There is little doubt that the arrival of a child has a major impact on
goals and the ability to attain them. It might become more difficult to
save because of the added expenses. Also, saving for post-
secondary education is likely to become an important goal.
One of the distinguishing characteristics of Stage 2 clients is their
lack of liquidity. They generally have mortgage and car payments.
M any dual-income couples see their disposable incomes decline
with the arrival of children because of substantial daycare costs or,
in some cases, the complete or partial elimination of one salary.
Life insurance becomes a requirement rather than a discretionary
expenditure.
The lack of liquidity has a significant impact on the savings pattern
of Stage 2 clients. First, although they might identify long-term
goals, such as retirement saving, they can barely manage to save
enough for more pressing short-term goals. This is particularly true
for younger Stage 2 clients. As salaries increase with job
experience, more savings can be deployed into medium-term goals
such as the children’s education. It is typically difficult for Stage 2
clients to save for the long term.
EXAMPLE
Isabelle recently married M arcus, her partner of four years. In

their early thirties, they have good careers and this makes their
mortgage and car payments each month quite manageable.
They have also shown good discipline in setting up automatic
savings plans each month. They consider themselves long term
investors and so far have invested primarily in domestic and
foreign equity funds. Upcoming life challenges: Isabelle and
M arcus would like to start a family in the next couple of years
and are starting to consider how this may impact their
The asset allocation for this stage reflects the nature of investment
goals as well as a changing ability to bear risk psychologically. A
client who was highly risk tolerant when single is likely to be less
risk-tolerant when married with children. If a client had an allocation
of 80% equity funds, 10% bond funds and 10% money market
funds when in Stage 1, that allocation might shift to reflect both the
shorter investment time horizons of the new goals as well as a
greater degree of risk aversion. A new allocation might be 50%
equity funds, 20% bond funds and 30% money market funds. The
move from the riskier asset allocation to the new, more
conservative, one would likely be accomplished gradually. This
means that most of the new investments for a Stage 2 client will be
in the lower-risk fund categories.
STAGE 3: THE MATURE EARNING YEARS – 30 TO 50
It is difficult to say exactly when Stage 3 takes over from Stage 2.
For some clients, the transition will occur early. For others, it will
occur far later in life. The critical factor determining the transition is
almost certainly the family’s level of disposable income. A two
professional income family will have a short Stage 2. A single blue-
collar income family might never leave Stage 2.
Stage 3 clients may be able to save for all of the goals they have
identified. In many cases, they have already made provision for
both short- and medium-term goals and they focus their attention
primarily on retirement savings. They are probably not much more
risk averse than they were in Stage 2.
The asset allocation for Stage 3 clients is likely to shift back toward
a higher weighting for equity funds. The first reason for this shift in
comparison to Stage 2 is the longer investment time horizon for
retirement saving. A second reason for the shift to equities is the
result of a need to minimize taxes. These clients are often in the
highest marginal tax bracket. Investments in bond and money
market funds will generate interest income that is fully taxed. Equity
funds, on the other hand, generate returns in the form of dividends
and capital gains, both of which are taxed at lower rates than
interest income.
The asset allocation for Stage 3 clients will depend on the range of
investment goals identified.
EXAMPLE
Sophia and Hank are in their late 40s and have two children in
their early teens. Hank was recently promoted to a senior
position at his company and Sophia’s consulting business is
thriving. Although these changes allow them to save more of
their earnings, the challenges they face include savings for their
children’s education and shifting some of their saving focus to
their own retirement planning. How they are planning to allocate
their investments: 40% equity growth funds, 30% equity funds,
20% bond funds, and 10% in money market funds.
It is worth repeating, however, that the goals of Stage 3 clients will

determine the asset allocation. That allocation can be very
different, therefore, from client to client.
STAGE 4: NEARING RETIREMENT – 45 TO 65

There are two key differences between clients in Stage 4 and
Stage 3. First, Stage 4 clients have fewer family commitments.
Children may already have left home to go to school or are married.
Second, Stage 4 clients have come to the realization that in a few
years they will have to rely on their savings in order to maintain
their standard of living. This tends to make them more risk averse
than investors in Stage 3. Clients in this stage are generally in their
peak earning years.
EXAMPLE
Nigel and Grace are in their early 50s and are empty nesters.
Their son lives on his own and has a career of his own. Nigel
runs his own home-based business while Grace works in health
care. Although they saved regularly, Nigel admits that saving for
retirement was not a priority; paying their mortgage and putting
their son through school took priority. Challenges: Nigel and
Grace want to begin to save aggressively for retirement so that
they can maintain the lifestyle they are comfortable living.
As a result of these changes, Stage 4 clients are likely to still want

tax minimization, but they might shift their portfolios away from
equity growth funds while maintaining a substantial equity
component. However, their growing risk aversion will tend to make
this equity component shrink as time goes on.
STAGE 5: RETIRED
Retired clients are faced with a conflict. On the one hand, they rely
on their retirement savings to maintain a certain standard of living.
On the other hand, they need to keep their remaining funds
invested in order to generate a good enough return on which to
live. The problem is that better returns can be earned only with
riskier investments, but these investors cannot readily accept a
high level of risk with retirement savings. In addition, they are less
able to bear risk psychologically.
Stage 5 clients also have another possible concern not shared with
those in Stage 4: if they have sufficient retirement savings, they
also tend to focus on estate building and wealth transfer. They
want to leave something for children and grandchildren.
The asset allocation for retirees will most likely shift toward less
risk. Therefore, the equity component will decline in favour of less
volatile fixed income and safety investments.
EXAMPLE
M arge and Vince retired several years ago after working for over
40 years. Although comfortable with their level of retirement
income, they watch their money very closely. After retiring, Vince
shifted most of the couple’s mutual fund investments to money
market funds. However, he did keep about 10% of their
investments in equity funds. Challenges: M aintaining their
lifestyle is a key priority. They have also promised to help fund
the education costs for their four grandchildren.
SUMMARIZING THE LIFE CYCLE

You can summarize the features of the life-cycle hypothesis by
looking at how investment goals, personal circumstances, financial
circumstances, investment knowledge and risk profile change as
people age. Table 4.1 summarizes these factors.
Table 4.1 | Implications of the Life-Cycle Hypothesis

Investment Personal Financial
Goals Circumstances Circumstances
Stage 1 Generally Generally light. Small

Early earning short term investment
years – but could portfolios, but
to age 30 also have a growing,
longer-term financial
component. commitments,
such as car
payments.
Stage 2 Shorter term Become Financial

Family with a heavier. burdens, such
commitment medium- as mortgage
years – term payments,
component. childcare
25 to 35
expenses,
increase. They
tend to have
little liquidity.
Stage 3 M edium These Circumstances

M ature earning term with a commitments have greatly
years – substantial have improved. It is
30 to 50 long-term moderated to a during this
component. certain extent. stage that most
of the increase
in a client’s
wealth will
occur. M ore
attention must
be devoted at
that point to
attaining an
asset allocation
in keeping with
the client’s risk
profile.
Stage 4 With Family Clients have

Nearing retirement commitments substantial
retirement – approaching, are once again investment
45 to 65 goals tend light. portfolios with
to shift to little in the way
the medium of day-to-day
term. liquidity
requirements.
Stage 5 Goals are Could see an Retired clients’

Retired – medium term increase in financial
50 and onwards in the sense family commitments
that the commitments to are light and
existing help their portfolios
investment grandchildren. must be able to
portfolio maintain living
must standards.
continue to
earn income
over the
medium
term.
The table does not include columns for investment knowledge or

risk profile, because changes in both can apply across the entire
life cycle:
• Investment knowledge is likely to increase as the client ages.
However, some Stage 1 investors have formal training in
finance, and many Stage 3 clients have never invested in
anything other than bank deposits.
• Risk profile also changes with age. Young people are more
psychologically able to bear risk. This willingness to bear risk
probably declines with age.
Asset allocations vary with each changing stage and are affected
by all the constraints indicated above. However, it is important to
note that the single most important determinant of clients’ asset
allocations at any stage is their psychological willingness to bear
risk. Some retirees have a very high tolerance for risk, and some
25-year-olds do not. As a result, some retirees have investment
portfolios containing a substantial equity fund component, while
some much younger investors refuse to invest in anything other
than money market funds or GICs.
Explanatory models can be useful because they extract the key
features of a complicated concept and make it easier to
understand. However, no model can be applicable in every case. In
most cases, when you know some key basic personal data about
a client and estimate the client’s life-cycle stage, you will be exactly
right. However, in some other cases, you will obtain personal data
and find that the client does not fit smoothly into any of the defined
life-cycle stages. In these cases, it is important not to force people
into a particular stage. You should use the life-cycle hypothesis as
a broad tool to help you understand a client’s overall needs.
LIFE CYCLE HYPOTHESIS
What are the characteristics of the various life stages

according to the life cycle hypothesis? Complete the online
learning activity to assess your knowledge.
THE PLANNING PYRAMID

Your understanding of the financial planning approach to managing
a person’s wealth benefits both you and your clients. Financial
planning involves an analysis of the client’s age, wealth, career,
marital status, taxation, estate considerations, risk profile,
investment objectives, and legal and other matters. This
information provides a comprehensive view of the client’s
circumstances and future goals. In addition, the discipline and self-
analysis required to create a personal financial plan helps the client
to better understand his or her goals, improving the chances of
achieving them.
The financial planner puts together the plan, coordinating the
advice solicited from other experts in various fields. You may be
one of those experts. That is, your role as a mutual fund sales
representative could be one part of the overall plan for a client
through the advice you provide on mutual fund investments. You
must restrict yourself to giving advice only for the services you are
licensed to provide or in which you are an expert. For example, you
should not give advice on the legal aspects of an estate plan; a
lawyer is best suited to do that and to draft documents such
as wills.
Exhibit 4.1 | The Financial Planning Pyramid
One other tool to help the client and advisor to both clarify the
client’s current situation and identify planning needs is the financial
planning pyramid. Although the financial planning pyramid may
appear simplistic, it often helps for the advisor to use visual aids in
dealing with clients. The financial planning pyramid helps the
advisor and the client alike visualize goals and objectives and
review investment strategy.
If the client is interested in precious metals for example, but lacks a
Will and the proper insurance coverage, it is obvious that, by
starting at the top with precious metals, the groundwork has not
been done and the plan will be unstable. The client must have a
good strong base from which to work to successfully reach the
goals and objectives set.
Case Study | Winston’s Pyramid: A Wealth of Choices (for

Financial advisor Paul is meeting with his wealthiest client,

Winston, who has contacted Paul for advice on investing a large
sum of money. Winston, 60 years old, is a successful business
owner who was widowed two-years ago. He has three children,
now all adult-aged and self-sufficient. He has excellent cash flow
from his business and investments. His home, cottage and Florida
condominium are all paid for. He has no personal debt.
Through the years, Paul helped Winston and his wife build up their
wealth, at first helping them maximize their savings through RRSPs
for their retirement and RESPs for their children’s education.
Eventually, through Winston’s business success, they were able
to grow their personal real estate holdings while over time paying
off all associated mortgage debt.
Paul has helped Winston grow his portfolio over the years through
the use of ever-more sophisticated investments, including stocks,
bonds and commodities. As his taxable income has risen, Paul has
helped Winston establish investment tax shelters and used tax-
effective investments, like corporate class funds, to reduce his tax
bite.
Today, with more funds to invest, Paul refers to the Financial
Planning Pyramid to assist in determining the best investment
options for the new funds. With such a secure financial situation,
Winston can afford to be very aggressive with his investment
choices, taking advantage of the unique tax and return
opportunities of the top level of the pyramid.
Referring to the pyramid, Winston has no desire to invest in IPOs,
over-the-counter (OTC) securities or precious metals directly, even
though his financial circumstances would allow him to do so. So,
with estate planning in mind, Paul recommends that Winston
consider establishing a real estate investment portfolio to produce
rental income and achieve long-term capital appreciation. He
suggests Winston consider purchasing a rent-producing property
for each of his children, owning them jointly. With their tax
advantages and potential price appreciation, a long-term investor
like Winston can easily deal with the ups and downs of the real
estate market. He can pass along the capital appreciation of the
properties to his children while providing them with additional cash
flow today.
FINANCIAL PLANNING PYRAMID
Can you visualize the goals and objectives of the financial

planning pyramid? Complete the online learning activity to
SUMMARY
1. Describe the client communication and planning process.
◦ A mutual fund sales representative evaluates investment
suitability usually on the basis of a client’s predetermined
financial goals and objectives.
◦ Client information provides you with a comprehensive view
of client circumstances and future goals.
◦ One tool to help clarify a client’s current situation and identify
planning needs is the financial planning pyramid.
2. Summarize the six steps of the planning process, and describe
how to apply them to client scenarios.
◦ Gathering information properly fulfills legal requirements and
allows an advisor to plan effectively for the client.
◦ The six steps in the financial planning process are:
– Establishing the Client-Advisor relationship
– Collecting data and information
– Analyzing data and information
– Recommending strategies to meet goals
– Implementing recommendations
– Conducting a periodic review or follow-up
3. Describe and differentiate between the five stages of the life-
cycle hypothesis.
◦ The basic idea behind the life-cycle hypothesis is that as
people age, their objectives, financial and personal
circumstances, investment knowledge, and risk profile
change as well.
◦ The life-cycle suggests that if you know the age of your
client, then you can infer a number of characteristics, such as
goals, circumstances and risk profile. If valid the life-cycle
hypothesis makes knowing your client an easier task.
◦ The early earning years in Stage 1 generally start when an
individual begins to work and ends when family commitments
or other financial commitments start to impose demands.
◦ During the family commitment years in Stage 2, personal
commitments and responsibilities generally increase as
family dynamics change; for example, having children and
buying a home. Lack of liquidity has a significant impact on
clients in this stage.
◦ The critical factor determining the transition from Stage 2 to
Stage 3 is almost certainly the family’s level of disposable
income. Stage 3 clients may be able to save for all of the
goals they have identified.
◦ Stage 4 clients have fewer family commitments. Stage 4
clients have also come to the realization that in a few years
they will have to rely on their savings in order to maintain
their standard of living. Clients in this stage are generally in
their peak earning years.
◦ Stage 5 clients in retirement are generally faced with a
conflict. On the one hand, they rely on their retirement
savings to maintain a certain standard of living. On the other
hand, they need to keep their remaining funds invested in
order to generate a good enough return on which to live.
REVIEW QUESTIONS

Behavioural Finance 5
CONTENT AREAS
Investor Behaviour
How do Representatives Apply Bias Diagnoses when

Structuring Asset Allocations?
LEARNING OBJECTIVES
1 | Define behavioural finance and the most common

behavioural biases.
2 | Differentiate between cognitive and emotional biases.
3 | Explain how these biases can be used to better

understand client attitudes toward finance and
KEY TERMS

availability bias
behavioural biases
behavioural finance
best practical allocation
biases
cognitive bias
emotional bias
endowment bias
hindsight bias
January Effect
loss aversion
overconfidence
regret aversion
representativeness bias
status quo bias
INTRODUCTION
So far in this course you’ve learned that attaining financial
objectives depends to a large degree on a client’s ability and
willingness to bear risk. A client is able to bear risk when financial
and personal circumstances permit. His or her willingness to bear
risk depends on psychological makeup and past experience.
Because there are so many combinations of personal factors,
financial factors, psychological factors and financial goals, you may
never meet two clients with identical profiles. Each client is unique
and must be treated as such. However, some general aspects of
investment behaviour are common to all clients. These common
aspects have to do with age and psychological make-up.
The focus of this chapter is providing you with the tools to better
recognize the needs of your clients by understanding their different
personality and life-cycle characteristics. Having a better
appreciation of personal motivations for investment decisions will
allow you to provide better service and meet clients’ needs more
closely.
INVESTOR BEHAVIOUR
Even though each individual client is different, research has shown
that people tend to make important investment decisions in ways
that are not always consistent with most traditional theories of
investment management. M any of these approaches have to do
with how an individual defines risk, and you should be aware of
these approaches when developing recommendations for a client.
You can also use personality profiling to understand why clients
make the decisions they do. Personality typing assigns a client to
a specific type characterized by certain attitudes and behaviours.
You cannot, however, rely too much on the results of such a test; it
should only be used as a general guide to how the client might
make a decision or react in a certain situation.
Financial decision making is not always entirely rational.
Behavioural finance is a field of study that combines psychology
and economics to explain why and how investors act and how that
behaviour affects financial markets.
BEHAVIOURAL FINANCE
Over the past twenty-five years, human psychologists have made
significant contributions to further our understanding of how
investors behave. Behavioural finance theory challenges much of
what economists and investment theorists, who study what is
sometimes called traditional or standard finance, have to say about
how individuals make investment decisions.1
Behavioural finance theory contends that as human beings,
investors are not necessarily rational or logical creatures. They are
subject to personal beliefs and biases that may lead to irrational or
emotional choices and decisions. Behavioural finance is commonly
defined as the application of psychology to understand human
behaviour in finance or investing.
M any students of the securities markets are taught that markets
are, or should be, efficient. However, researchers have uncovered
abnormal market behaviours, such as the January Effect, where
stocks in general, and small stocks in particular, move abnormally
higher during the month of January, that demonstrate that human
behaviour influences securities prices and markets.
Standard theories of finance and investing assume that investors
are:
• Risk averse
• Rational in their decision-making abilities
Theories from behavioural finance, on the other hand, suggest that
investors:
• Can be risk averse or risk seeking, depending on the situation
• Can act irrationally, thus creating market opportunities
Standard finance is characterized by rules about how investors
should behave rather than by principles describing how they
actually behave. Behavioural finance, in contrast, identifies with and
learns from human behaviour that individual investors demonstrate
in financial markets. Standard finance grounds its assumptions in
idealized financial behaviour, in other words, whereas behavioural
finance is based on observed financial behaviour.
A mutual fund sales representative who understands how investor
psychology can affect an individual investor’s decisions, and
consequently investment outcomes, will have insights that can only
benefit the advisory relationship. A key result of a behavioural
finance-enhanced relationship is a portfolio that the client can live
with during up markets and down markets. A client who
understands his or her investing behaviour — learned through
working with the representative — will develop a stronger
relationship with the representative.
BEHAVIOURAL BIASES
In the investment world, behavioural biases are defined as
systematic errors in financial judgment or imperfections in the
perception of economic reality. Researchers have identified a long
list of investor biases, categorizing them according to a meaningful
framework. Some refer to biases as simple, efficient rules of thumb;
others call them beliefs, judgments or preferences. Other
researchers have classified biases along cognitive (relating to
conscious intellectual activity such as thinking, reasoning and
remembering) or emotional (relating to emotional responses
to stimulus).
Behavioural biases fall into two broad categories, cognitive and
emotional, with both yielding irrational judgements. This section
introduces some of the most common ones.
A cognitive bias can be technically defined as basic statistical,
information processing or memory errors that are common to all
human beings. They can be thought of also as “blind spots” or
distortions in the human mind. One of the most common cognitive
biases is anchoring bias. Here, clients get anchored to the price of
a stock or the level of the market and hold on to that price before
being willing or able to make an investment decision.
Cognitive biases do not result from emotional or intellectual
predisposition toward a certain judgement, but rather from
subconscious mental procedures for processing information.
Investors are subjected to large volumes of information and data,
and to make sense of it all, they opt for simplified information
processing when making investment decisions. A good example of
this is evaluating a class of mutual funds, say U.S. small
capitalization. Even using a research service such as M orningstar,
which helps clients screen funds, the information flow is so
immense that they inevitably rely on shortcuts such as “best 12-
month return” to make a fund choice. Because cognitive biases
stem from faulty reasoning, better information and advice can often
correct them.
On the opposite side of the spectrum from illogical or distorted
reasoning are the emotional biases. An emotion is a mental state
that arises spontaneously, rather than through conscious effort.
Emotions are physical expressions, often involuntary, related to
feelings, perceptions or beliefs about elements, objects or relations
between them, in reality or in the imagination.
Individuals feeling emotions may wish to control them but often
cannot. Investors can be presented with investment choices, and
may make sub-optimal decisions by having emotions affect these
decisions. Often, because emotional biases originate from impulse
or intuition rather than from conscious calculations, they are difficult
to correct.
OVERVIEW OF BEHAVIOURAL BIASES

An overview of common biases is presented below. In the next
section, a diagnostic testing example for one bias, loss aversion,
one of the emotional biases, is provided to illustrate how the
assessment process works.
COGNITIVE BIASES
OVERCONFIDENCE
Overconfidence is defined generally as unwarranted faith in one’s
intuitive reasoning, judgements and cognitive abilities. People tend
to overestimate both their predictive abilities as well as the
precision of the information they have been given. Sometimes,
people realize that events they thought were certain to happen did
not occur, but they don’t learn from these mistakes. In the investing
realm, people think they are smarter and have better information
than they actually do. For example, an investor may get a tip from a
contact in the securities industry or read something on the Internet
about an investment opportunity, and then take action (that is,
make the decision to invest) based on her perceived knowledge
advantage.
REPRESENTATIVENESS
Because human beings like to stay organized, they develop, over
time, an internal system for classifying objects and thoughts. When
confronted with new circumstances that may be inconsistent with
existing classifications, they often rely on a “best fit” process to
determine which category should house and form the basis for
understanding the new circumstance. This perceptual framework
provides a practical tool for processing new information by
simultaneously incorporating insights gained from past experiences.
Sometimes, however, new stimuli are representative of elements
that have already been classified, while in reality, there are
differences. In such an instance, the classification reflex is wrong,
and it produces an incorrect understanding of the new element that
often persists and biases future interactions with that element. This
is known as a representativeness bias.
In the investment realm, a client may be presented with an
investment opportunity that contains some elements
representative of a good investment. The client’s desire to
mentally classify the investment opportunity may cause him to
classify what is really a poor investment opportunity as a good
investment opportunity, based on the few elements that are
representative of a good investment opportunity.
HINDSIGHT BIAS
Hindsight bias refers to the belief that the outcome of an event
was predictable, even if it was not. This happens because the
actual outcome is clear in a person’s mind, but the numerous
outcomes that could have occurred but did not are rather fuzzy.
Therefore, people tend to overestimate the accuracy of their own
predictions. For example, a stock goes up and an investor feels
that he “knew it all along,” when in fact the outcome was
unpredictable. Hindsight bias may prevent an investor from
reviewing and learning from past mistakes, leading to a tendency to
make the same mistakes again.
AVAILABILITY
The availability bias allows people to estimate the probability of an
outcome based on how prevalent or familiar that outcome appears
in their lives. People exhibiting availability bias perceive easily
recalled possibilities as being more likely than outcomes that are
harder to imagine or difficult to comprehend. One classic example
cites the tendency of most people to guess that shark attacks
cause fatalities more frequently than injuries sustained from falling
airplane parts. However, the latter has been shown to be thirty
times more likely to occur. Shark attacks are, probably, assumed to
be more prevalent because sharks invoke greater fear, or because
shark attacks receive a disproportionate degree of media attention.
M utual fund advertising is a good example of availability bias.
Investors who see a certain company’s advertisements frequently
may believe that that company is a good mutual fund company,
when it’s possible that a company that does no advertising is
better.
EMOTIONAL BIASES
ENDOWMENT
People who are subject to endowment bias place more value on
an asset they hold property rights to than on an asset they do not
hold property rights to. This behaviour is inconsistent with standard
economic theory, which says that a person’s willingness to pay for
a good or object should be equal to the person’s willingness to sell
the good or object. Psychologists have found that the minimum
selling prices that people state tend to exceed the maximum
purchase prices they are willing to pay for the same good.
Investors continue to hold securities they own rather than
disposing of them in favour of better investing opportunities.
LOSS AVERSION
Loss aversion bias states that people generally feel a stronger
impulse to avoid losses than to acquire gains. The possibility of a
loss is, on average, twice as powerful a motivator as the possibility
of making a gain of equal magnitude. That is, a loss-averse person
might demand, at minimum, a two-dollar gain for every one dollar
placed at risk. In this scenario, risks that don’t “pay double” are
unacceptable. Loss aversion can prevent people from unloading
unprofitable investments, even when they see little to no prospect
of a turnaround. Some industry veterans have coined a diagnosis,
“get-even-itis”, to describe this condition whereby a person waits
too long for an investment to rebound following a loss.
REGRET AVERSION
People who are subject to regret aversion bias avoid making
decisions because they fear, in hindsight, that whatever they
decide to do will result in a bad decision. An example of regret
aversion is observed when investors hold on to losing positions
too long in order to avoid admitting errors and realizing losses.
When investors experience negative investment outcomes, they
feel instinctually driven to sell – not to press on and snap up
potentially undervalued stocks. However, periods of depressed
prices often present the greatest buying opportunities. People
suffering from regret aversion bias, therefore, hesitate most at
moments that actually may merit aggressive behaviour.
STATUS QUO
Status quo bias is an emotional bias that predisposes people,
when faced with a wide variety of options, to choose to keep
things the same (that is, to maintain the status quo). The scientific
principle of inertia, which states that a body at rest shall remain at
rest unless acted upon by an outside force, is a similar concept.
Status quo bias can cause investors to hold securities with which
they feel familiar or emotionally fond. This behaviour can
compromise financial goals, however, because a subjective comfort
level with a security may not justify holding onto it despite poor
performance.
IDENTIFYING BEHAVIOURAL BIASES IN CLIENTS

Some mutual fund representatives are naturally good at identifying
irrational behaviours in their clients. Others need some assistance.
A diagnostic test for loss aversion, below, provides an
understanding of how a bias is diagnosed.
Question 1: You are asked to choose between the following two
outcomes:
a. An assured gain of $475
b. A 25% chance of gaining $2,000, and a 75% chance of gaining
nothing
Question 2: You are asked to choose between the following two
outcomes:
a. An assured loss of $750
b. A 75% chance of losing $1,000, and a 25% chance of losing
nothing
How is the loss-averse client likely to respond?
SCORING GUIDELINE
Question 1: The rational response is b, but loss-averse investors
are likely to opt for the assurance of a gain in a.
Question 2: The rational response is a. Loss-averse investors are
more likely to select b.
The logical question at this point is: “Fine, so I know what biases
my client has... what do I do with this knowledge?” By the end of
this chapter, this question will be dealt with, in a discussion on how
the mutual fund sales representative goes about creating a
behaviourally adjusted portfolio, one that moderates or adapts to a
client’s biases. First, though, consider the equally intriguing
question below of gender differences that may affect an investor’s
decision-making behaviour.
GENDER AND BEHAVIOURAL FINANCE

Gender and behavioural finance is a potent subject. M en and
women behave quite differently when it comes to investing, and it
is important to understand and remember these differences.
With regard to gender differences:
• Women believe that random sequences with no automatic
correlation display positive correlation in reality. For example,
many basketball coaches and players believe that a player who
has made several shots in a row is more likely than usual to
make the next shot; that is, they see patterns where perhaps
none exist.
• M en are more overconfident and optimistic than women.
• Women are more likely to buy and hold.
• M en are one-third more risk tolerant than women.
Some studies concluded that women are less optimistic or more
skeptical than men, and they are also generally less risk tolerant
than men. In November 2005, Alexandra Niessen and Stephan
Ruenzi from the University of Cologne completed a study entitled
“Gender and M utual Funds”.2 They examined all single managed
U.S. equity mutual funds from 1994–2003. In the study, 10% of fund
managers were women. They found that female managers take
less risk, follow less extreme investment styles (i.e., execute more
consistent styles), are less overconfident and trade less. Women
who are less risk tolerant and trade less tend to balance out men
who tend to be aggressive in these areas. M utual funds
representatives should listen to both the male and the female
partner, and attempt to arrive at a risk assessment that reflects a
balance between them.
Figure 5.1 provides a summary of major male and female biases.
Generally, men are more susceptible to cognitive biases and
women are more susceptible to emotional biases.
Figure 5.1 | Typical Biases Men and Women Are Susceptible to
Men are susceptible to: Women are susceptible to:
Overconfidence bias (Cognitive) Endowment bias (Emotional)
Loss aversion bias (E) Status quo bias (E)
Availability bias (C) Representativeness bias (C)

Hindsight bias (C) Regret aversion bias (E)
So, people are neither perfectly rational nor perfectly irrational, but
possess diverse combinations of rational and irrational
characteristics. M ost individuals can benefit from a mutual fund
sales representative’s help in balancing and overcoming their
biases, perceptions and irrational approaches to investing.
HOW DO REPRESENTATIVES APPLY BIAS

DIAGNOSES WHEN STRUCTURING ASSET
ALLOCATIONS?
M any mutual fund sales representatives, when designing an asset
allocation program for a client, typically first administer a risk profile
questionnaire, then discuss the client’s financial goals and
constraints, and then recommend an asset allocation. Less-than-
optimal outcomes are often a result of this process because the
client’s psychological biases may not be accounted for.
Instead, investors may be better served by adjusting risk and
return levels depending upon their behavioural tendencies. This is
called a client’s best practical allocation. A best practical
allocation may slightly underperform over the long term and have
lower risk, but is an allocation that the client can comfortably adhere
to over the long run. M any clients, in response to a market
downturn, want to sell in a panic. Conversely, a client’s best
practical allocation might contradict their natural psychological
tendencies, and these clients may be well served to accept risks in
excess of their individual comfort levels in order to maximize
expected returns because, for example, they risk outliving their
assets. The ability to create best practical allocations is what
mutual fund sales representatives should gain from this section.
The following has been adapted from an article that M ichael
Pompian and John Longo originally published in the M arch 2005
Journal of Financial Planning. It sets forth two principles for
constructing a best practical allocation, in light of client behavioural
biases:
• M oderate biases in less-wealthy clients; adapt to biases in
wealthier ones.
• M oderate cognitive biases; adapt to emotional ones.
These principles are not intended as prescriptive absolutes, but
rather should be used along with other data on the client’s risk
profile, financial goals, asset class preferences and so on. The
principles are also general enough to fit almost any client situation.
When considering behavioural biases in asset allocation, mutual
fund sales representatives must first determine whether to
moderate or adapt to “irrational” client preferences. This decision
basically involves weighing the rewards of sustaining a calculated,
profit-maximizing allocation against the outcome of potentially
affronting the client – whose biases might position him or her to
favour a different portfolio structure entirely. Here are guidelines for
resolving the puzzle of when to moderate and when to adapt.
MODERATE BIASES IN LESS-WEALTHY CLIENTS;

ADAPT TO BIASES IN WEALTHIER ONES
A client outliving his assets constitutes a far graver investment
failure than his inability to accumulate the greatest possible wealth.
If an allocation performs poorly because it conforms, or adapts, too
willingly to a client’s biases, then a less-wealthy client’s standard of
living could be seriously jeopardized. The most financially secure
clients, however, would likely continue to reside in the 99.9th
socioeconomic percentile. In other words, if a biased allocation
could put a client’s way of life at risk, moderating the bias is the
best response. If only a highly unlikely event such as a market
crash could threaten the client’s day-to-day security, then
overcoming the potentially sub-optimal impact of behavioural bias
on portfolio returns becomes a lesser consideration. Adapting is,
then, the appropriate course of action.
MODERATE COGNITIVE BIASES; ADAPT TO

EMOTIONAL ONES
As already seen, behavioural biases fall into two broad categories,
cognitive and emotional, with both yielding irrational judgements.
Because cognitive biases stem from faulty reasoning, better
information and advice can often correct them. On the other hand,
because emotional biases originate from impulse or intuition rather
than conscious calculation, they are difficult to rectify. In some
cases, heeding these two principles simultaneously yields a
blended recommendation. For instance, a less-wealthy client with
strong emotional biases should be both adapted to and moderated.
Figure 5.2 illustrates this situation. Additionally, these principles tell
us that two clients exhibiting the same biases should sometimes
be advised differently.
Figure 5.2 | A Visual Depiction of Best Practical Allocation
Source: Pompian, M. and Longo, J. “Incorporating Behavioral Finance Into Your

Practice.” Journal of Financial Planning, March 2005, 58–63.
Understanding clients’ risk profile is extremely important to the

success of both the mutual fund sales representative and the
client. This chapter has provided much detail about the relatively
new field of behavioural finance and its impact on clients’
investment behaviour and performance. Clients are susceptible to
numerous behavioural biases, and some of the most common
ones have been described.
Case Study | “Doctor” Diane: Helping Clients through Their

Emotional Traps (for information purposes only)
Financial advisor Diane is meeting with her long-time clients, Pierre

and M ichelle, for an investment portfolio review. Both have
substantial Registered Retirement Savings Plan (RRSP) portfolios.
They are in their mid-forties, have solid incomes, no children and
are on track to pay off their home mortgage by age fifty. They will
rely primarily on their RRSPs and eventually other investment
savings to fund their retirement. They do not expect to stop
working until at least 60 years of age, possibly longer.
During a recent financial market downturn, Diane met with the
clients to discuss their RRSP mutual fund portfolios. Both
expressed a high degree of fear over their portfolios’ negative
returns. Diane explained to M ichelle and Pierre that while equity
markets are volatile and do move through periods of correction
from time-to-time, they have historically regained their pre-crisis
levels and moved higher overtime, providing investors solid long-
term returns.
M ichelle, despite her long-term investment time horizon and
established medium risk profile, decided that she was unable to
sleep at night with the volatility. She directed Diane to cash out her
equity-based investments and move them to money market funds.
Pierre, while uncertain but worried about losing his nerve, remained
in his growth portfolio.
Each year as they reviewed their portfolios together, Dianne was
unable to convince M ichelle to move back into a more growth-
orientated portfolio to help achieve her goals. Despite the sharp
bounce back in equity values, she remained convinced that the
market would tumble downwards again. Though in obvious
discomfort, Pierre refused to adjust his portfolio, choosing to wait
until it had regained its pre-crisis level.
At today’s meeting, with markets having soared and surpassed
their pre-crisis levels, M ichelle expresses regret about having
missed the turnaround and is now fearful of missing out on further
gains. She directs Diane to invest all of her funds into a growth
portfolio. Pierre, now feeling emboldened by the increasing value of
his portfolio, directs Diane to re-balance into aggressive growth
investments.
Diane, believing that both M ichelle and Pierre are reacting
emotionally and losing sight of basic investment fundamentals, re-
establishes the couple’s goals with them, what their required rate
of return is to meet their goals, and takes them through the
process of determining their risk profiles. Having done so, she
helps M ichelle by reaching agreement to gradually moving her
cash into a balanced investment portfolio; with Pierre, she shows
him how, over time, a balanced growth portfolio will help him reach
his goals without having to take on the risk he is suggesting. She
suggests he establish a small self-directed account to play with 5%
of his portfolio as he wishes, keeping the other 95% in a proper
portfolio.
COGNITIVE AND EMOTIONAL BIAS
How well do you know the different cognitive and emotional

biases? Complete the online learning activity to assess your
knowledge.
SUMMARY
Define behavioural finance and the most common behavioural
1. biases.
◦ Behavioural finance is commonly defined as the application
of psychology to understand human behaviour in finance or
investing.
◦ The theory contends that investors are human beings, rather
than rational, logical creatures, and are therefore subject to
personal beliefs and biases that may lead to irrational or
emotional choices and decisions.
2. Differentiate between cognitive and emotional biases.
◦ Behavioural biases are defined as systematic errors in
financial judgment or imperfections in the perception of
economic reality.
◦ A cognitive bias can be technically defined as basic
statistical, information processing or memory errors that are
common to all human beings.
◦ An emotional bias is a mental state that arises
spontaneously, rather than through conscious effort.
3. Explain how these biases can be used to better understand
client attitudes toward finance and investment decisions.
◦ Investors may be better served by adjusting risk and return
levels depending upon their behavioural tendencies. This is
called a client’s best practical allocation.
◦ A best practical allocation may slightly underperform over the
long term and have lower risk, but is an allocation that the
client can comfortably adhere to over the long run.
◦ There are two principles for constructing a best practical
allocation, in light of client behavioural biases: M oderate
biases in less-wealthy clients and adapt to biases in
wealthier ones; and moderate cognitive biases and adapt to
emotional ones.
REVIEW QUESTIONS

1 Source: Amos Tv ersky, “The Psy chology of Decision Making,” Behav ioral Finance and
Decision Theory in Investment Management. Charlottesv ille, Association for
Investment Management and Research, 1995.
2 Source: Niessen, A and Ruenzi, S. “Sex Matters: Gender and Mutual Funds.”
Department of Finance, Univ ersity of Cologne, Germany, Nov ember 2005.
Tax and Retirement Planning 6
CONTENT AREAS
How does the Canadian Taxation System Work?
What are the Main Pension Plans in Canada?
What are Tax Deferral Plans?
LEARNING OBJECTIVES
1 | Differentiate among the ways that interest income,

foreign dividends, Canadian-source dividends and capital
gains are taxed.
2 | Identify and describe the features of the government

pension plans available to Canadians citizens.
3 | Describe and differentiate between the most common

employer-sponsored registered pension plans.
4 | Describe the features of registered retirement savings

plans (RRSP) and calculate the annual contribution limit
to an RRSP.
5 | List and describe the features of tax-free savings

accounts (TFSA).
6 | Describe the features of registered education savings
plans (RESPs) and explain how RESPs can be
enhanced with Canada Education Savings Grants
(CESGs).
KEY TERMS

Canada Education Savings Grants (CESG)
Canada Pension Plan (CPP)
capital gain
capital loss
career average plan
carry forward
contribution in kind
contribution room
deemed disposition
defined benefit plan
defined contribution (money purchase) plan
dividend tax credit (DTC)
earned income
final average plan
fiscal year
flat benefit plan
life annuity
life income fund
Locked-In Retirement Account (LIRA)
locked-in RRSP
marginal tax rate
money purchase plan
Old Age Security (OAS)
over-contribution
Pooled Registered Pension Plan (PRPP)
Québec Pension Plan (QPP)
Registered Education Savings Plan (RESP)
Registered Pension Plan (RPP)
Registered Retirement Income Fund (RRIF)
Registered Retirement Savings Plan (RRSP)
spousal RRSP
Tax-Free Savings Account (TFSA)
INTRODUCTION
While the “know your client” rule involves understanding your
client’s current financial and personal situation, objectives, risk
profile, and so on, other important elements must be taken into
consideration to come up with relevant investment
recommendations to clients. Two of those important elements are
the planning of the retirement years and the impact of taxes on
investments.
It is important for mutual fund sales representatives to have an
excellent understanding of the rules that apply to retirement plans.
This chapter explores the details of each type of plan and also
looks at some deferred tax plans, such as Registered Retirement
Savings Plans (RRSPs), Registered Education Savings Plans
(RESPs) and Tax-Free Savings Accounts (TFSAs).
Taxes are a reality of life for Canadians and they affect many
personal and investment decisions. Complicating matters is the
differential tax rates for income, dividends, and capital gains, not to
mention continually changing legislation announced each year in
the Federal Budget. The taxation of investment income also affects
retirement planning through tax-favoured investments such as
RRSPs and TFSAs.
Investors and mutual funds sales representatives must have a
working knowledge of the taxation of investment income. This does
not mean, however, that you need to become a tax expert. M ost
mutual funds sales representatives rely on the professional input of
accountants and tax experts when a decision on a specific tax
matter is needed. It is important nevertheless that you have a clear
understanding of how taxes impact returns on investments and
what vehicles are available to reduce tax burdens.
HOW DOES THE CANADIAN TAXATION
SYSTEM WORK?
This section discusses the fundamentals of taxation in Canada
only. Individuals seeking advice or information should seek
assistance from the Canada Revenue Agency (CRA,
www.canada.ca/en/revenue-agency).
Proper tax planning should be a part of every investor’s overall
financial strategy. The minimization of tax, however, must not
become the sole objective nor can it be allowed to overwhelm the
other elements of proper financial management. The investor must
keep in mind that it is the after-tax income or return that is
important. Choosing an investment based solely on a low tax
status does not make sense if the end result is a lower after-tax
rate of return than the after-tax rate of return of another investment
that is more heavily taxed.
While all investors wish to lighten their individual tax burden, the
time and effort spent on tax planning must not outweigh the
rewards reaped. Tax planning is an ongoing process with many
matters being addressed throughout the year. The best tax
advantages are usually gained by planning early and planning often,
allowing reasonable time for the plan to work and to produce the
desired results.
While the tax authorities do not condone tax evasion, tax
avoidance by one or more of the following means is completely
legitimate:
• Full utilization of allowable deductions;
• Conversion of non-deductible expenses into tax-deductible
expenditures;
• Postponing the receipt of income;
• Splitting income with other family members, when handled
properly; and
• Selecting investments that provide a better after-tax rate of
return.
Although this discussion will highlight some of the taxation issues
that affect taxpayers, none of the suggestions made here should
be considered specific recommendations. As tax plays a significant
part in the overall financial plan and can affect the choice of
investments greatly, every attempt should be made to keep
abreast of the ever-changing rules and interpretations.
THE INCOME TAX SYSTEM IN CANADA

The federal government imposes income taxes by federal statute
(the Income Tax Act, often referred to as the ITA). All Canadian
provinces have separate statutes which impose a provincial
income tax on residents of the province and on non-residents who
conduct business or have a permanent establishment in that
province. The federal government collects provincial income taxes
for all provinces except two:
• Quebec, which administers its own income tax on both
individuals and corporations; and
• Alberta, which administer their own income tax on corporations.
Canada imposes an income tax on world income of its residents as
well as certain types of Canadian source income on non-residents.
Companies incorporated in Canada under federal or provincial law
are usually considered resident of Canada. Also, foreign companies
with management and control in Canada are considered resident in
Canada and are subject to Canadian taxes.
TAXATION YEAR
All taxpayers must calculate their income and tax on a yearly basis.
Individuals use the calendar year while corporations may choose
any fiscal year, as long as this time period is consistent year over
year. No corporate taxation year may be longer than 53 weeks.
CALCULATION OF INCOME TAX
Calculating income tax involves four steps:
• Calculating all sources of income from employment, business
and investments
• M aking allowable deductions to arrive at taxable income
• Calculating the gross or basic tax payable on taxable income
• Claiming various tax credits, if any, and calculating the net tax
payable
Once total income has been determined, there are a number of
allowable deductions and exemptions that may be made in
calculating taxable income.
TYPES OF INCOME
There are four general types of income. Each is treated differently
under Canadian tax laws.
Employment Employment income is taxed on a gross receipt

income basis. This means that the taxpayer cannot deduct
for tax purposes all the related costs incurred in
earning income as a business does. However,
employees are permitted to deduct a few
employment-related expenses such as pension
contributions, union dues, child care expenses and
other minor items.
Capital Includes assets purchased solely for investment

property purposes, such as stocks, bonds, and mutual
income funds. The income from these investments –
dividends and interest for example – is considered
income from capital property.
Business Business income arises from the profit earned from

income producing and selling goods or rendering services.
Self-employment income falls in this category.
Business income is taxed on a net-income basis.
Capital A capital gain or capital loss is the gain or loss

gains and resulting from the sale of capital property. A capital
losses gain occurs when the property is sold at a price
higher than its original cost (or lower than its cost
in the case of a capital loss). Costs of the sale or
disposition are also included in arriving at a capital
gain or capital loss.
CALCULATING INCOME TAX PAYABLE

Basic tax rates are applied to taxable income. Rates of federal tax
applicable to individuals in 2021 (excluding tax credits) are as
follows:
Table 6.1 | Federal Income Tax Rates For 2021 – (For information
purposes only)
Taxable Income: Tax

• On the first $49,020 of taxable income 15%
• On the next $49,020 of taxable income over $49,020 20.5%

and up to $98,040
• On the next $53,939 of taxable income on the portion 26%
over $98,040 and up to $151,978
• On the next $64,533 of taxable income on the portion 29%

over $151,978 and up to $216,511
• On taxable income over $216,511 33%

Source: Adapted from Canada Rev enue Agency
Note: The Canada Rev enue Agency website (www.canada.ca/en/rev enue-agency)
should be consulted for current tax related information.
Currently, all provinces levy their own tax on taxable income.

Provincial amounts are calculated in essentially the same way as
federal tax.
Adding the provincial rate to the federal rate gives the taxpayer’s
combined marginal tax rate. The marginal tax rate is the tax rate
that would have to be paid on any additional dollars of taxable
income earned.
Given an investor’s marginal tax rate, the tax consequences of
certain investment decisions can be estimated. In this way an
advisor can respond to a client’s need to minimize taxes and select
securities for the portfolio that offer the investor a higher after-tax
rate of return.
TAXATION OF INVESTMENT INCOME

As long as the investment is held in a registered plan (discussed
later in this chapter), tax does not apply on revenues generated by
the investment. However, for investments not held in registered
plans taxpayers are required to report income on an annual basis.
There are three different forms of revenues that can be generated
from mutual funds and each of them are taxed differently:
• Interest income is generated by the fixed-income securities
held in the mutual fund;
• Dividends are generated by the preferred shares and some
common shares held in the mutual fund;
• Capital gains are generated when the mutual fund and/or a
security held in the mutual fund is sold for more than its cost
(i.e., the selling price is higher than the cost price).
INTEREST INCOME
Taxpayers are required to report interest income (from such
investments as CSBs, GICs and bonds) on an annual accrual
basis, regardless of whether or not the cash is actually received.
Interest income is taxed as regular income and is not subject to
any preferential tax treatment.
DIVIDENDS FROM TAXABLE CANADIAN

CORPORATIONS
Individual taxpayers receive preferential tax treatment on dividends
received from Canadian corporations. The preferential treatment
reflects the fact that corporations pay dividends from after-tax
income—i.e., from their profits. The amount included in a taxpayer’s
income is ‘grossed-up’ to equal approximately what the corporation
would have earned before tax. The taxpayer then receives a tax
credit that offsets the amount of tax the corporation paid.
FOR INFORMATION PURPOSES ONLY
There are two types of dividend tax credits available to

Canadian corporations—one for privately-held and one for
publicly-traded corporations. We discuss the dividend tax credit
available to most Canadian publicly traded companies in this
course.
Eligible Canadian dividends are grossed-up by 38% to arrive at the

taxable amount of the dividend and then the taxpayer receives a
federal dividend tax credit (DTC) of 15.02% on this amount.
Dividend tax credits are also available at varying provincial levels.
EXAMPLE
An individual receives a $300 eligible dividend from a Canadian

corporation. The individual would report $414 ($300 × 38% plus
$300 or 138% of $300) in net income for tax purposes. The
additional $114 is referred to as the gross up and the $414 is the
taxable amount of the dividend.
The taxpayer calculates net income using the $414 amount, and
can then claim a federal dividend tax credit in the amount of
15.02% of the taxable amount of the dividend, which is $62.18 in
this example (15.02% × $414).
If the individual is taxed at 26%, the tax payable on the taxable
amount of the dividend is $107.64 ($414 × 26%) and the net tax
payable is $45.46 ($107.64 – $62.18).
CAPITAL GAIN
Capital gains are also subject to a preferential tax treatment. In fact,
only 50% of the capital gain is taxable.
EXAMPLE
An individual receives a $300 capital gain. The individual would

report $150 ($300 × 50%) in net income for tax purposes.
The taxpayer calculates net income using the $150 amount and
pays tax only on this amount.
If the individual is taxed at 26%, the tax payable on the capital
gain is $39 ($300 x 50% x 26 %, or $150 x 26%).
DIVIDENDS FROM FOREIGN CORPORATIONS

Foreign dividends are generally taxed as regular income, in much
the same way as interest income. Individuals who receive
dividends from non-Canadian sources usually receive a net amount
from these sources, as non-resident withholding taxes are applied
by the foreign dividend source. Such investors may be able to use
foreign tax credits to offset the Canadian income tax otherwise
payable. The allowable credit is essentially the lesser of the foreign
tax paid or the Canadian tax payable on the foreign income, subject
to certain adjustments. Details on what foreign tax is allowed as a
deduction are available from the CRA.
When mutual funds are held outside a registered plan (discussed
later in this chapter), the unitholder is sent a T3 form or a T5 form
by the fund. This form reports the types of income distributed that
year – foreign income and Canadian interest, dividends and capital
gains, including dividends that have been reinvested. Each is taxed
at the fund holder’s personal rate in the year received.
MINIMIZING TAXABLE INVESTMENT INCOME

Dividends from taxable Canadian corporations (but not foreign
corporations) are subject to less tax than interest income.
Accordingly, a shift from interest bearing investments into dividend-
paying Canadian stocks may reduce taxes and improve after-tax
yield.
Depending on the tax rate, the tax on Canadian dividends can be
higher or lower than the tax payable on capital gains. This is
illustrated in Tables 6.2 and 6.3. At a marginal federal tax rate of
29%, federal taxes owed on capital gains are lower than tax owed
on the same amount of Canadian dividends. But at a marginal tax
rate of 15%, the taxes owed on dividends is nil compared to taxes
owing on the same amount of capital gains. In both cases, there is
a substantial difference between the tax owed on interest and the
tax owed on capital gains and dividends.
Table 6.2 | Comparison of Tax Consequences of Investment

Income in a 29% Marginal Tax Bracket
Interest Canadian Capital

Income Dividend Gains
Income Income
Income Received $1,000.00 $1,000.00 $1,000.00

Taxable Income $1,000.00 $1,380.00 $500.00
(Grossed up by (50% of
38%) $1,000)
Federal Tax (29% of $290.00 $400.20 $145.00

taxable income)
Less Dividend Tax – $207.28 –
Credit (15.02%)
Federal Tax Owed $290.00 $192.92 $145.00
Table 6.3 | Comparison of Tax Consequences of Investment

Income in a 15% Marginal Tax Bracket
Interest Canadian Capital

Income Dividend Gains
Income Income
Income Received $1,000.00 $1,000.00 $1,000.00
Taxable Income $1,000.00 $1,380.00 $500.00

(Grossed up by (50% of
38%) $1,000)
Federal Tax (15% of $150.00 $207.00 $75.00

taxable income)
Less Dividend Tax – $207.28 –
Credit (15.02%)
Federal Tax Owed $150.00 $0.00 $75.00
Case Study | Taxed by Tax: Ted and Justine (for information

purposes only)
Financial advisor John is meeting with his clients, Ted and Justine,
to review their portfolios. It’s early M ay, and the couple has just
filed their taxes for the previous year. Ted makes a mid-six-figure
income from his job, while Justine has taken a career hiatus and is
a stay-at-home mom to the couple’s two young children. At the
meeting, Ted expresses to John his frustration over the sizable tax
bill he has just had to pay, a substantial portion of which was
because of investment income. Justine, on the other hand,
received a refund. Ted has a substantial RRSP portfolio, while
Justine’s is relatively modest. They have a substantial emergency
cash reserve in GICs and money market funds.
John examined the couple’s holdings in preparation for the
meeting. First, he assures the clients that they are wisely taking
advantage of RRSPs to build their retirement income savings. He
explains that they are benefitting by receiving the tax deduction
benefits today based on their contributions, while also sheltering
their savings and benefitting from long-term tax-deferred
compounding to grow their investments faster.
As for the children’s education needs, the couple is taking
advantage of the tax-deferred compounding of RESPs, along with
the added benefit of generating the maximum CESG each year.
While the income will be taxed upon withdrawal, they will be taxed
in the beneficiary’s hands, not those of Ted and Justine.
John identifies a few opportunities for the couple to save on taxes.
Ted is paying taxes on investment income from his employer-
sponsored share purchase plan. As a listed company, his firm’s
shares are paying dividends, which, while tax-advantaged by the
Dividend Tax Credit, are still increasing Ted’s taxable income. Ted
also sold some shares to pay for a new extension on the couple’s
house, which generated a substantial capital gain. John suggests
that Ted move his shares into a TFSA to shelter the dividend
income and future capital gains and switch the share purchase plan
to be TFSA sheltered.
In future, any expenses should be funded by cash on hand,
avoiding capital gains on the sale of existing non-sheltered share
holdings. Also, any excess cash on hand should be sheltered in
the couple’s TFSAs to avoid the top-marginally taxed interest
income they are generating.
Ted is expecting a pension income from his company’s defined
benefit plan. John recommends that Ted should maximize his
RRSP contributions, as he has a high-level of income. However,
for long-term planning purposes, John suggests that Ted contribute
to a spousal RRSP for Justine. While it will not result in an
immediate tax reduction, when the two retire it will work to even
out their retirement incomes and reduce the amount of tax that Ted
would otherwise have paid.
TAX-DEDUCTIBLE ITEMS RELATED TO

INVESTMENT INCOME
CARRYING CHARGES
Tax rules permit individuals to deduct certain carrying charges for
tax purposes. Acceptable carrying charge deductions include:
• Interest paid on funds borrowed to earn investment income
such as interest and dividends.
• Fees for certain investment advice.
• Fees paid for management, administration or safe custody of
investments.
• Accounting fees paid for the recording of investment income.
The following charges cannot be deducted from investment
income:
• Interest paid on funds borrowed to buy investments that can
generate capital gains only.
• Brokerage fees or commissions paid to buy or sell securities.
Instead, these fees or commissions affect the cost base of the
investment.
Interest paid on funds borrowed to contribute to a registered
•
retirement savings plan, a registered education savings plan, a
registered disability savings plan, or a tax-free savings account
(TFSA).
• Administration, counselling and trustee fees for regular or self-
directed registered retirement savings plan or registered
retirement income fund.
• Fees paid for advice such as financial planning.
• Safety deposit box charges.
BORROWED FUNDS
A taxpayer may deduct the interest paid on funds borrowed to
purchase securities if:
• The taxpayer has a legal obligation to pay the interest
• The purpose of borrowing the funds is to earn income
• The income produced from the securities purchased with the
borrowed funds is not tax exempt
If the interest earned on a fixed-income debt security is greater
than the rate paid to borrow the funds used to purchase the
security, the interest amount paid for the borrowed funds is
generally deductible. However, in the case of convertible
debentures, normally all carrying charges are deductible since the
debentures may be converted into common shares which could
theoretically pay unlimited dividends.
WHAT ARE THE MAIN PENSION PLANS IN

CANADA?
There are two main types of pension plans in Canada: Government
pension plans and Employer-Sponsored plans. Government
pension plans include the Canada and Québec pension plans and
Old Age Security. In an Employer-Sponsored Plan, both the
employer and the employee make regular contributions into an
account on behalf of the employee. The individual may begin to
make Government and Employer Sponsored plan withdrawals only
after retirement.
GOVERNMENT PENSION PLANS

Every resident in Canada earning income from employment or self-
employment is required to contribute to one of two government
sponsored pension plans, depending on their province of
residence. Residents of all provinces except Quebec contribute to
the Canada Pension Plan (CPP) and residents of Quebec
contribute to the Québec Pension Plan (QPP). Contributions to
CPP or QPP are automatic and the right to a pension based on
years of contribution is irrevocable and is paid out even if the
contributor leaves Canada.
CPP and QPP contributors may choose to receive a monthly
retirement pension for life beginning at the age of 65. You can also
apply to receive your pension starting at age 60, but the amount
received is reduced by a certain percentage for each month by
which you are under the age of 65. You can also postpone
receiving your pension until age 70. In this case, the amount of the
monthly pension is increased by a certain percentage for each
month by which you are over the age of 65.
EXAMPLE
Bill has just turned 60 years old and has retired. He chooses to
receive his CPP payments early. For purposes of this example,
his pension payments would have been $500 a month at age 65
but he will receive $320 a month instead.
For many retirees, the CPP or QPP amount must be supplemented

with other retirement savings. For this reason, Canadians are
encouraged to provide for their retirement needs by saving
throughout their working years, joining a company pension plan and
contributing to a retirement savings plan, such as a registered
retirement savings plan (RRSP).
In addition to the CPP and QPP, the Old Age Security (OAS)
pension is payable to all Canadian citizens and legal residents who
have reached a minimum age.
Pensioners qualify for a full pension if they were:
• Resident in Canada for at least 40 years after reaching the age
of 18; and
• Resident in Canada for an uninterrupted 10 years immediately
preceding application for an OAS pension.
If OAS candidates did not live in Canada for the last 10 years, they
could still qualify for a full pension if:
• They lived in Canada for the full year immediately before the
application was approved, and;
• They lived or were present in Canada for at least three years
for each year of absence during that 10-year period.
Since OAS benefits are not paid until application has been made
and approved by the federal government, applicants for the OAS
pension should apply six months prior to eligibility. Proof of age and
legal residence status are required. Pension benefit payments
normally begin in the month following the month the applicant
meets the age and residence requirements. In cases of late
application, payments may be made retroactively for up to
12 months.
A provision exists in the Income Tax Act (ITA) for higher income
Canadians to repay all or part of the social benefits they receive in
any year. This repayment is referred to as a “clawback”, and OAS
payments are a social benefit that falls into this category.
EXAMPLE
For the 2021 income year, the clawback level starts at an
income threshold of $79,845. Repayment is based on the
difference between your income and the threshold amount for
the year. You must pay back 15% of every dollar above this
threshold. Additionally, the government sets a maximum income
level for receiving OAS benefits. If an OAS recipient has a net
income of approximately $129,260, then all OAS benefits are
paid back.
EMPLOYER-SPONSORED PLANS
Employer-sponsored plans are called registered pension plans
(RPPs) and include both defined benefit and defined contribution
plans. The employer’s role in contributing to these plans
distinguishes them from both government pension plans and
registered retirement savings plans (RRSPs).
A registered pension plan (RPP) is a trust, registered with
Canada Revenue Agency (CRA) or the appropriate provincial
agency, established by a company to provide pension benefits for
its employees when they retire. Both employer and employee
contributions to the plan are tax-deductible.
Two types of RPPs are defined benefit plans (DBP) and defined
contribution plans (DCP). In a DBP the benefits are
predetermined based on a formula including years of service,
income level and other variables, and the contributions are
designed to match the predetermined plan benefits. In a DCP (also
known as a money purchase plan) the contributions to the plan
are predetermined and the benefits, at retirement, will depend on
how the contributions were invested.
DEFINED BENEFIT PLANS

In a defined benefit plan, you know in advance how much your
pension will be at retirement. Three types of defined benefit plans
are:
• flat benefit plans
• career average plans
• final average plans
These plans differ only in the criteria chosen to calculate benefits.
FLAT BENEFIT PLANS

The flat benefit plan is the simplest type of defined benefit plan.
The monthly pension is a specified dollar amount of pension for
each year of service. Thus, a formula of $15 per month per year of
service, after 30 years of service, would produce a pension of $450
per month ($15 × 30 years). This type of pension is common
among unionized employees where wage levels are generally
uniform. Figure 6.1 summarizes the advantages and disadvantages
of flat benefit plans.
Figure 6.1 | Evaluating Flat Benefit Plans
Advantages • The plan is normally funded entirely by the

employer.
• The level of benefits usually increases as a
result of ongoing employee-employer
negotiations.
• The plan’s formula is easy to understand.
• A flat benefit pension paid is in addition to OAS
and CPP/QPP benefits.
Disadvantages • The flat benefit plan does not differentiate
among the earnings levels of plan participants.
• The pension amount must be continually
renegotiated to keep pace with inflation.
The flat dollar pension amount paid by the plan is established in
terms of today’s dollar values. If the pension amount is not
regularly increased by negotiation, then the pension payable at
retirement could be insufficient due to inflation.
EXAMPLE
Jennifer participates in a flat benefit pension plan that provides

her with a flat benefit of $25 per month per year of service. What
will be Jennifer’s monthly pension when she retires after she
has worked 30 years for her employer?
Jennifer’s total pension at retirement will be $750 per month ($25
× 30).
CAREER AVERAGE PLANS

For career average plans, the pension is calculated as a
percentage of an employee’s earnings over the course of her
career (while in the plan). Employees may contribute a fixed
percentage of their salary (such as 5%) to this type of plan.
Employer contributions required to fund the defined benefit are not
fixed: they vary according to factors such as investment yield,
mortality and employee turnover.
For example, an employee may accumulate a career average
pension of 2% of averaged annualized salary (before deductions)
for each year of service while in the plan. If the employee has 30
years of service and average monthly earnings of $1,000 over the
30 years, then the pension payable at retirement would be $600
per month (2% × $1,000 × 30 years).
Figure 6.2 | Evaluating Career Average Plans
Advantages • Career average plans are easily integrated

with CPP/QPP benefits by providing a lower
percentage of benefit on earnings up to the
average maximum under the CPP/QPP plan
and a higher percentage on earnings over the
maximum.
• The career average plan gives equal weight to
the employee’s earnings throughout his or her
service.
• M any companies update career average plan
benefits by updating the base year in the
pension formula. For example, if the base year
is moved forward to 2021, all service prior to
2021 will be based on 2021 earnings instead of
the actual salary received when the service
was performed.
Disadvantages • Similar to the flat benefit plan, the pension
payable at retirement may be eroded by
inflation if regular updates to the plan are not
made.
EXAMPLE
Andrew decides to retire after 30 years of employment with the

same employer. He participated in a career average pension
plan with a defined benefit percentage of 2%. Andrew’s
averaged annual salary (before deductions) was $48,000 over
his 30-year career with his employer.
Andrew’s earned pension will be $28,800 per year ($48,000 ×
2% × 30), or $2,400 per month.
FINAL AVERAGE PLANS

Similar to a career plan, a final average plan bases the pension on
an employee’s length of service and average earnings. Rather than
basing the earnings over the lifetime of service, however, final
average plans use a stated period of time. Often this is the
average of the best five consecutive years of earnings in the last
10 years of employment, or the average of the best three
consecutive years of earnings over the last five years of
employment.
Using the best average years is preferred to using the last few
years, in case earnings experience a drop close to retirement.
Employees often contribute a percentage of their salary to final
average plans. Again, employer costs are variable.
Figure 6.3 | Evaluating Final Average Plans
Advantages • Final average plans are easily integrated with

CPP/QPP benefits.
• By providing a pension based on earnings near
retirement, these plans provide better
protection against inflation at least up to
retirement.
• Final average pension plans usually pay a
higher pension than a career average plan.
Disadvantages • If the contributor’s earnings decline as
retirement approaches, then a lower pension
payment may result.
EXAMPLE
Chris worked for 30 years with the same employer that offered a
final average pension plan. Over the last five years, his best
three years of income were: $52,000, $54,000 and $56,000, for a
3-year average of $54,000. His pension formula is 1.5% of final
average earnings.
What pension amount will Chris receive at retirement?
His earned pension will be $24,300 per year ($54,000 × 1.5% ×
30), or $2,025 per month.
For defined benefit plans, the full benefit may only be available to
those who have achieved a minimum level of service, such as 25
years. Depending on the plan, employees who leave their
employer before the minimum level of service may receive a lump
sum that is usually transferred into what is a called a locked-in
retirement account or LIRA. Amounts transferred into a LIRA are
locked-in and cannot be withdrawn; they can only be used for
retirement income.
DEFINED CONTRIBUTION PLANS

In defined contribution plans, the employer contributes a fixed
percentage based on the employee’s annual earnings. Often the
employees contribute a percentage of their salary and the
company matches it. Pension income is based on the amount of
money a plan member has in his or her individual account at
retirement. This amount will vary depending on the amount
contributed and the investment return over the life of the plan.
The pension at retirement is whatever amount the contributions,
plus interest, will purchase, often in the form of an annuity.
Figure 6.4 | Evaluating Defined Contribution Plans
Advantages • Popular with small employers as it is easy to

understand, easy to administer and has fixed
annual costs.
• The regulations surrounding these plans are
not as onerous as those for defined benefit
plans.
• Employees can usually direct the funds to their
choice of investment vehicles.
Disadvantages • The final pension amount is unknown until
retirement.
• The final pension may be smaller than
expected if the investment performance has
been poor.
• M embers retiring under similar circumstances
may receive substantially different pensions
depending on investment return over the life of
the plan.
The combined employer/employee contributions to a defined
contribution pension plan cannot exceed the lesser of the following
amounts:
• 18% of an employee’s current year compensation; and
• The defined contribution limit for the year, which is $29,210 in
2021, (the contribution limit is indexed annually to inflation).
WHAT ARE TAX DEFERRAL PLANS?

The principle of tax deferral plans is to encourage Canadians to
save for retirement by enabling them to reduce taxes paid during
high earning (and high taxpaying) years. Tax payment is deferred
until retirement years when income and tax rates are normally
lower. The most common tax deferral vehicles are explained below.
REGISTERED RETIREMENT SAVINGS PLANS

(RRSPS)
Registered Retirement Savings Plans (RRSPs) are available to
individuals to defer tax and save for retirement years. Annual
contributions are tax-deductible up to allowable limits. Income
earned in the plan accumulates tax-free as long as it remains in the
plan.
Essentially there are two types of RRSPs: Single Vendor RRSPs
and Self-Directed RRSPs. There are no limits as to the number of
plans a person can hold. Funds can be transferred tax-free from
plan to plan if the taxpayer/investor so desires. This is
accomplished by completing a transfer document with the trustee of
the new plan. The documents are then forwarded to the original
plan’s trustee.
Single In these plans, the holder invests in one or more of a

Vendor variety of GICs, segregated pooled funds or mutual
Plans funds. The investments are held in trust under the plan
by a particular issuer, bank, insurance company, credit
union or trust company. To qualify as acceptable
investments for an RRSP (either Single Vendor or Self-
Directed), pooled funds must be registered with the
CRA. In Single Vendor RRSPs, no day-to-day
investment decisions are required to be made by the
holder. There may be a trustee fee charged for this
type of plan in addition to any costs incurred for
purchasing the investments themselves.
Self- In these, holders invest funds or contribute certain

Directed acceptable assets such as securities directly into a
Plans registered plan. The plans are usually administered for
a fee by a Canadian financial services company. One
advantage of Self-Directed RRSPs is that investors
can make all investment decisions. Another advantage
is that, while there are rules with respect to allowable
content, a full range of securities may be held in these
plans, including GICs, money market instruments,
bonds, equities and mutual funds. Investors may also
hold direct foreign investments in these RRSPs.
There are special features that the investor should understand

about an RRSP account. First, an RRSP is a trust account
designed to benefit the owner at retirement. Withdrawals from an
RRSP are subject to a graduated withholding tax and such
withdrawals must be included in income in the year withdrawn.
M ore tax may be payable at year-end, depending on the income
level of the taxpayer. Second, an RRSP cannot be used as
collateral for loan purposes.
CONTRIBUTIONS TO AN RRSP
There is no limit to the number of RRSPs an individual may own.
However, there is a restriction on the amount that may be
contributed to RRSPs on a per-year basis. The maximum annual
tax-deductible contributions to RRSPs an individual can make is the
lesser of:
• 18% of the previous year’s earned income; and
• The RRSP dollar limit for the year.
From the lesser of the above two amounts:
• Deduct the previous year’s Pension Adjustment (PA) and the
current year’s Past Service Pension Adjustment (PSPA).
(Note: the PA and PSPA are a result of being part of an
employer-sponsored RPP. The PA and PSPA are reported by
the plan member’s administrator. The PA and PSPA reduces
the amount an individual can contribute to a RRSP to ensure
the maximum annual contribution on all pension and tax deferral
plans combined is not exceeded.)
• Add the taxpayer’s unused RRSP contribution room at the
end of the immediately preceding taxation year.
The RRSP dollar contribution limit is $27,830 for the 2021 taxation
year. The limit is indexed to inflation each year. The contributions
must be made in the taxation year or within 60 days after the end
of that year to be deductible in that year.
Individuals can carry forward unused contribution limits indefinitely.
Earned income for the purpose of RRSP contributions may be
simply defined as the total of:
• Total employment income (less any union or professional dues)
• Net rental income and net income from self-employment
• Royalties from a published work or invention and research
grants
• Some alimony or maintenance payments ordered by a court
• Disability payments from CPP or QPP
• Supplementary Employment Insurance Benefits (SEIB), such
as top-up payments made by the employer to an employee
who is temporarily unable to work (for parental or adoption
leave, for example), but not the Employment Insurance (EI)
benefits paid by Human Resources and Social Development
Canada
Planholders who make contributions to RRSPs in excess of the
amount permitted by legislation may be subject to a penalty tax.
Over-contributions of up to $2,000 may be made without penalty.
A penalty tax of 1% per month is imposed on any portion of over-
contribution that exceeds $2,000.
A planholder may contribute securities already owned to an RRSP.
According to the CRA, this contribution is considered to be a
deemed disposition at the time the contribution is made.
Consequently, in order to calculate the capital gain or loss, the
planholder must use the fair market value of the securities (The fair
market value is the price at which the property would sell for on the
open market) at the time of contribution as the proceeds from
disposition. Any resulting capital gain is included in income tax for
the year of contribution. Any capital loss is deemed to be nil for tax
purposes. This type of contribution is called a contribution in kind.
EXAMPLE
M r. Wu bought 100 mutual fund units of Growth Fund Inc. at a
price of $10 for a total value of $1,000. Two years later, the units
have increased in value to $20 per share.
M r. Wu decides to contribute the units to his self-directed RRSP
when the net asset value of the units is $20.
• The contribution to the RRSP would be the net asset value
of the fund. So, the contribution would be $2,000 to his
RRSP. His RRSP would now hold the units.
• Because M r. Wu had an accrued capital gain of $1,000
($2,000 net asset value – $1,000 cost = $1,000 gain), he
must include that capital gain in his taxes for the year, even
though he still owns the units.
SPOUSAL RRSPS
A taxpayer may contribute to a spousal RRSP, which is an RRSP
registered in the name of a spouse or common-law spouse, and
still claim a tax deduction. If the taxpayer is also a planholder, he or
she may contribute to the spouse’s plan only to the extent that the
contributor does not use the maximum contribution available for his
or her own plan.
EXAMPLE
Sofie and Nigel are married and contribute to RRSPs. Sofie has
a maximum contribution limit of $11,500 for her own RRSP, but
contributes only $10,000, she may contribute $1,500 to Nigel’s
spousal RRSP. Nigel’s RRSP contribution limits are not affected
by the spousal RRSP, which is a separate plan. (Therefore,
Nigel, in this example, would have two plans: one for personal
contributions and one for contributions made by Sofie on his
behalf.)
Unless converted to a Registered Retirement Income Fund (RRIF)
or used to purchase certain acceptable annuities, the withdrawal
from a spousal plan is taxable income to the spouse – not the
contributor – since the spousal RRSP belongs to the spouse in
whose name it is registered. However, any withdrawals of
contributions to a spousal plan claimed as a tax deduction by a
contributing spouse made:
• In the year the contribution is made, or
• In the two calendar years prior to the year of withdrawal,
are taxable to the contributor in the year of withdrawal rather
than to the planholder.
Example: In each of six consecutive years, a husband
contributes $1,000 to his wife’s RRSP, which he claims as tax
deductions. In the seventh year there are no contributions, and
the wife de-registers the plan. Thus, for the seventh taxation
year:
• The husband includes as taxable income in his tax return the
sum of $2,000 (contributions: 7th year – nil; 6th year – $1,000;
5th year – $1,000); and
• The wife includes as taxable income in her tax return the sum
of $4,000 (i.e., contributions to the plan made in years 1, 2, 3
and 4) plus all earnings that accumulated on the total
contributions of $6,000 in the plan.
OTHER TYPES OF CONTRIBUTIONS

Some pension income can be transferred directly to RRSPs. The
following transfers can be contributed without affecting the regular
tax-deductible contribution limits outlined elsewhere:
• Lump sum transfers from RPPs and other RRSPs, if transferred
to the individual’s RRSP on a direct basis, are not included in
income and no deduction arises.
Allowances for long service upon retirement often known as
• retiring allowances, for each year of service, under very specific
guidelines.
TERMINATION OF RRSPS
An RRSP holder may make withdrawals or de-register the plan at
any time, but mandatory de-registration of an RRSP is required
during the calendar year when an RRSP plan holder reaches age
71.
The following maturity options are available to the plan holder in the
year he or she turns 71:
• Withdraw the proceeds as a lump sum payment which is fully
taxable in the year of receipt;
• Use the proceeds to purchase a life annuity;
• Use the proceeds to purchase a fixed term annuity which
provides benefits to a specified age;
• Transfer the proceeds to a Registered Retirement Income
Fund (RRIF) which provides an annual income; or
• A combination of the above.
RRIFs, fixed-term annuities and life annuities, available from
financial institutions which offer RRSPs, permit the taxpayer to
defer taxation of the proceeds from de-registered RRSPs. Tax is
paid only on the annual income received each year.
Should the annuitant die, benefits can be transferred to the
annuitant’s spouse. Otherwise, the value of any remaining benefits
must be included in the deceased’s income in the year of death.
Under certain conditions, the remaining benefits may be taxed in
the hands of a financially dependent child or grandchild, if named as
beneficiary. The child or grandchild may be entitled to transfer the
benefits received to an eligible annuity, an RRSP or an RRIF.
If a person dies before de-registration of an RRSP, the surviving
spouse may transfer the plan proceeds tax-free into his or her own
RRSP as long as the spouse is the beneficiary of the plan. If there
is no surviving spouse or dependent child, the proceeds from the
plan are taxed in the deceased’s income in the year of death.
ADVANTAGES OF RRSPS
The following are some of the advantages provided by RRSPs:
• A reduction in annual taxable income during high taxation years
through annual tax-deductible contributions;
• Shelter of certain lump sum types of income from taxation
through tax-free transfer into an RRSP;
• Accumulation of funds for retirement, or some future time, with
the funds compounding earnings on a tax-free basis until
withdrawal;
• Deferral of income taxes until later years when the holder is
presumably in a lower tax bracket;
• Opportunity to split retirement income (using spousal RRSPs)
which could result in a lower taxation of the combined income
and the opportunity to claim two, $2,000 pension tax credits.
DISADVANTAGES OF RRSPS
The following are some of the disadvantages provided by RRSPs:
• If funds are withdrawn from an RRSP, the planholder pays
income tax (not capital gains tax) on the proceeds withdrawn;
• The RRSP holder cannot take advantage of the dividend tax
credit on eligible shares that are part of an RRSP;
• If the plan holder dies, all payments out of the RRSP to the
planholder’s estate are subject to tax as income of the
deceased, unless they are to be received by the spouse or,
under certain circumstances, a dependent child or grandchild;
• The assets of an RRSP cannot be used as collateral for a loan.
JOHN AND BETTY’S RRSP DECISIONS
Can you help John and Betty with the potential

consequences of their RRSP decisions? Complete the
online learning activity to assess your knowledge.
REGISTERED RETIREMENT INCOME FUNDS

(RRIFS)
As explained previously, a registered retirement income fund
(RRIF) is one of the tax deferral vehicles available to RRSP
holders who wish to continue the tax sheltering of their plans. The
planholder transfers the RRSP funds into a RRIF. Each year
(beginning with the year following acquisition of the RRIF) the
planholder must withdraw and pay income tax on a fraction of the
total assets in the fund, the “annual minimum amount”. The assets
are composed of capital plus accumulated earnings. The annual
amount is determined by a table designed to provide benefits to
the holder until death. The term of the RRIF may be based on the
age of the holder’s spouse (if younger) instead of the planholder’s
own age to extend the term, and reduce the amount of the required
withdrawal.
While there is a minimum amount that must be withdrawn each
year, there is no maximum amount.
Before the RRIF holder reaches age 71, the annual minimum
amount that must be withdrawn is a percentage based on the
person’s age. The percentage is calculated as follows: 1 ÷ (90 –
age). At age 71, plans use a percentage prescribed by CRA. The
RRIF withdrawal factor at age 71 is 5.28% and increases until age
95, when it is set at 20%.
A taxpayer can own more than one RRIF. Like a RRSP, a RRIF
may be self-directed by the holder through instructions to the
financial institution holding the RRIF, or it may be managed. A wide
variety of qualified investment vehicles within the Canadian content
framework are available for self-directed plans including stocks,
bonds, investment certificates, mutual funds and mortgages.
LOCKED-IN RETIREMENT ACCOUNTS

As a general rule, vested funds from a registered pension plan are
not available to the employee prior to retirement. However, from
time to time, registered plans are terminated, or employees leave
an employer to work elsewhere. In such cases, registered pension
plan funds may be transferred into a locked-in RRSP. This type of
RRSP differs from the standard RRSP in that the holder of a
locked-in plan cannot withdraw any of the money until the holder
reaches a particular age, depending on the province of residence
and the provisions of the plan. At that time, termination options are
generally limited to a Life Income Fund (LIF) or a Life Annuity.
(Saskatchewan residents have access to a Prescribed Registered
Retirement Income Fund instead of a LIF.)
LIFs are similar to RRIFs in that they both have minimum annual
withdrawal requirements. LIFs also have maximum annual
withdrawals limits. A life annuity, on the other hand, is an
insurance product that features a predetermined periodic payout
amount until the death of the retiree. These products are most
frequently used to help retirees budget their money after
retirement. Typically, an individual pays into the annuity on a
periodic basis while he or she is still working or buys the annuity in
one large purchase. When the person retires, the annuity makes
periodic (usually monthly) payouts. When a triggering event (such
as death) occurs, the periodic payments from the annuity usually
cease.
TAX-FREE SAVINGS ACCOUNTS (TFSA)

The Tax-Free Savings Account (TFSA) is an entirely new kind of
savings vehicle. Since coming into existence at the start of 2009,
TFSAs have been welcomed by commentators as the most
exciting financial planning and wealth management tool for individual
Canadians since RRSPs were introduced in 1957. That’s primarily
because income earned within a TFSA will not be taxed in any way
throughout an individual’s lifetime. In addition, there are no
restrictions on the timing or amount of withdrawals from a TFSA,
and the money withdrawn can be used for any purpose.
BASIC RULES
Any resident of Canada who is at least 18 years of age can open a
TFSA. You don’t have to have earned any income in the preceding
or current year to be able to contribute to a TFSA. The money you
contribute can come from a tax refund, a bequest, savings, a gift, or
earnings from employment or business. Whenever you don’t make
the full annual contribution, you can carry forward that “contribution
room” and use it any time in the future.
Table 6.4 shows the TFSA annual contribution limit per year since
its inception.
Table 6.4 | Tax-Free Savings Account Annual Contribution

Limit 2009–2021
TFSA Annual Contribution limit
2009 to 2012 $5,000
2013 and 2014 $5,500
2015 $10,000
2016 through 2018 $5,500
2019 through 2021 $6,000

Total $75,500
TAXES
While the money contributed to a TFSA is not tax-deductible, there
is no tax payable on the income earned in the TFSA – whether it
be interest, dividends or capital gains.
QUALIFIED INVESTMENTS
Individuals can invest the amounts in a TFSA in a wide variety of
products such as GICs, savings accounts, stocks, bonds or mutual
funds. The kinds of investments you can put in a TFSA are
basically the same as the ones you can put in an RRSP. These are
called “qualified investments.”
CONTRIBUTIONS
Your contribution room every year consists of the TFSA dollar limit
for that year plus any withdrawals you made in the preceding year,
along with any unused contribution room. Based on information
provided by the issuer, the Canada Revenue Agency (CRA) will
determine the TFSA contribution room for each eligible individual.
Your current contribution room is available online or by phone with
the CRA. If you contribute more than your contribution room allows,
you will be taxed at the rate of 1% of the excess contribution
every month.
WITHDRAWALS
Withdrawals can be made from a TFSA at any time. There is no
limit to how much may be withdrawn and there is no penalty or tax
on withdrawals. If you wish, you can later replace/re-contribute the
money you have withdrawn, but you don’t have to. If you have
unused TFSA contribution room, you could replace/re-contribute
the amount you withdrew in the same calendar year (up to the
amount of unused TFSA contribution room available). If you do not
have unused TFSA contribution room then you must wait until the
next calendar year to replace/re-contribute the amount you
withdrew. If you do want to replace/re-contribute the money you
withdrew, there’s no deadline for doing so.
A TFSA is a versatile and user-friendly type of account that makes
it appealing to save, because the income earned in the account is
never taxed, there is a lot of flexibility in making contributions and
withdrawals and all residents over the age of 18 can set one up.
Because the rules let you withdraw money and then replace/re-
contribute it (in a future calendar year if you currently do not have
unused TFSA contribution room) without being taxed, a TFSA is a
good way to save for a variety of expenditures at different stages
of a person’s life: tuition fees, repayment of student loans, a
wedding, a holiday, a new car, a house, or even increasing the
value of the estate you leave to your heirs. Basically, a TFSA can
benefit you through your entire adult life cycle. Also, you could put
aside the maximum yearly contribution as an emergency fund.
REGISTERED EDUCATION SAVINGS PLANS

(RESPS)
Registered Education Savings Plans (RESPs) are tax-deferred
savings plans intended to help pay for the post-secondary
education of a beneficiary. Although contributions to a plan are not
tax-deductible, there is a tax-deferral opportunity since the income
accumulates tax-deferred within the plan. On withdrawal, the portion
of the payments that were not original capital will be taxable in the
hands of the beneficiary or beneficiaries, provided that they are
enrolled in qualifying or specified educational programs. The
assumption is that, at the time of withdrawal, the beneficiaries or
beneficiary would be in a lower tax bracket than the contributor.
Consequently, withdrawals from the plan should be taxed at a
lower rate.
There is no maximum amount that can be contributed in a single
calendar year for each beneficiary. However, there is a lifetime
maximum contribution of $50,000 per beneficiary. Contributions can
be made for up to 31 years but the plan must be collapsed within
35 years of its starting date. This time limitation requires
contributors to decide when would be the best time to start the
plan.
There are two types of RESPs, pooled plans and self-directed
plans. As their name suggests, pooled or group plans are plans to
which a number of subscribers make contributions for their
beneficiaries. The pooled funds are managed, usually
conservatively, by the plan administrators. Annual contributions are
generally pre-set. Under group plans, the administrator determines
the amount paid out to beneficiaries.
Self-directed plans are administered by a number of institutions
including banks, mutual fund companies, and investment brokers.
Contributions tend to be more flexible and contributors can
participate in both the investment and distribution decisions.
M ore than one beneficiary can be named in any particular plan.
These “family” plans are often used by families with more than one
child. If one of the named beneficiaries does not pursue post-
secondary education, all of the income can be directed to the
beneficiaries who do attend.
The contributor (versus the beneficiary) can withdraw the income
from an RESP provided that the plan has been in existence more
than 10 years and that none of the named beneficiaries has started
qualified post-secondary programs by age 21 or all of the named
beneficiaries have died.
If the beneficiaries do not attend qualifying programs, contributors
are allowed to transfer a maximum of $50,000 of RESP income to
their RRSPs. This is dependent on there being sufficient
contribution room remaining in the RRSP. No taxes are charged on
contributions that were made to the RESP when they are
withdrawn, but revenues earned on the contributions made to the
plan will be taxed at the contributor’s regular income tax level, plus
an additional penalty tax of 20%.
If the contributor (as opposed to the beneficiary) starts to withdraw
income from the RESP, the plan must be terminated by the end of
February of the following year.
CANADA EDUCATION SAVINGS GRANTS (CESGS)

Canada Education Savings Grants (CESGs) provide further
incentive to invest in RESPs. Under this program, the federal
government makes a matching grant of 20% of the first $2,500
contributed each year to the RESP of a child under 18. Depending
on family income, an additional CESG is available over and above
the basic CESG amount.
Worth between $500 and $600 per year (enhancements have been
made to the program—see below), this grant is forwarded directly
to the RESP firm and does not count towards the contributor’s
lifetime contribution limit. The lifetime grant a beneficiary can
receive is $7,200. However, CESGs must be repaid if the child
does not go on to a qualifying post-secondary institution.
Table 6.5 provides an example of the CESG program.
Table 6.5 | Canada Education Savings Grants Program
Basic CESG Total

CESG
Contribution % $
All families $2,500 20% $500 $500
Additional CESG Total
CESG
Families earning* On the First % $
Up to $49,020 $500 20% $100 $600
M ore than $49,020 and less $500 10% $50 $550
than $98,040
* For 2021.
Source: Canada Rev enue Agency
Thus, a family earning under $49,020 that contributes $2,500 per

beneficiary in a year will receive a CESG of $600 a year per
beneficiary — 20% on the $2,500 from the basic CESG and an
additional 20% on the first $500 invested in the program ($2,500 ×
20% + $500 × 20%).
POOLED REGISTERED PENSION PLANS

(PRPPS)
Pooled Registered Pension Plans (PRPPs) are a new type of
retirement savings plan proposed by the federal government.
PRPPs are designed to address the gap in employer pension plan
coverage by providing Canadians with an accessible, large-scale
and low-cost pension plan. PRPPs will hold assets pooled
together from multiple participating employers, allowing workers to
take advantage of lower investment management costs that result
from membership in a large pooled pension plan. PRPPs will be
administered by eligible financial institutions such as banks and
insurance companies. This design reduces the risk and cost that
employers would normally bear when offering a retirement plan for
employees.
Participation in a PRPP includes:
• those employed or self-employed in the North West Territories,
Nunavut or Yukon;
those who work in a federally regulated business or industry for
• an employer who chooses to participate in a PRPP; or,
• those who live in a province that has the required provincial

standards legislation in place.
A PRPP can be designed to permit members to make their own
investment decisions, or to select from investment options,
provided by the plan administrator, that include varying levels of risk
and reward based on investor profiles.
M uch like an RRSP, contributions to a PRPP are limited to
available contribution room based on earned income, and
contributions are tax deductible.
TAX-DEFERRAL PLANS
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advantages of using such plans? Complete the online
SUMMARY
1. Differentiate among the ways that interest income, foreign
dividends, Canadian-source dividends and capital gains are
taxed.
◦ Interest income is treated the same way for tax purposes as
income from employment: there is no special treatment for
interest income, and investors pay taxes on interest income
at their marginal tax rate.
◦ Dividends from taxable Canadian corporations receive
preferential tax treatment in the form of the dividend tax
credit.
◦ Eligible Canadian dividends are grossed-up by 38% and
then the taxpayer receives a federal dividend tax credit in
the amount of 15.02%.
◦ Dividends from foreign corporations do not qualify for tax
credit.
◦ A capital gain is the result of selling a security for more than
its purchase price. Only 50% of capital gains is taxed; the
other 50% of a capital gain is tax free.
◦ A capital loss is the result of selling a security for less than
its purchase price. Capital losses cannot be applied to
reduce other sources of income like dividends, interests or
employment income.
2. Identify and describe the features of the government pension
plans available to Canadians citizens.
◦ Government pension plans include the Canada and Québec
pension plans and Old Age Security.
◦ Contributions to CPP or QPP are automatic and the right to
a pension based on years of contribution is irrevocable and
is paid out even if the contributor leaves Canada.
◦ OAS is payable to most Canadians 65 years of age who
meet the Canadian legal status and residence requirements.
◦ A provision exists in the Income Tax Act (ITA) for higher
income Canadians to repay all or part of the social benefits
they receive in any year. This repayment is referred to as a
“clawback”, and OAS payments are a social benefit that falls
into this category.
3. Describe and differentiate between the most common
employer-sponsored registered pension plans.
◦ Employer-sponsored plans are called registered pension
plans (RPPs) and include both defined benefit and defined
contribution plans.
◦ A RPP is a trust, registered with Canada Revenue Agency
(CRA) or the appropriate provincial agency, established by a
company to provide pension benefits for its employees
when they retire.
◦ In a defined benefit plan (DBP) the benefits are
predetermined based on a formula including years of service,
income level and other variables, and the contributions are
designed to match the predetermined plan benefits.
◦ In a defined contribution plan (DCP) the contributions to the
plan are predetermined and the benefits, at retirement, will
depend on how the contributions were invested.
◦ In a flat benefit plan, the monthly pension is a specified
dollar amount of pension for each year of service.
◦ In a career average plan, the pension is calculated as a
percentage of an employee’s earnings over the course of
her career (while in the plan).
◦ In a final average plan, the pension is based on an
employee’s length of service and average earnings. Rather
than basing the earnings over the lifetime of service,
however, final average plans use a stated period of time.
4. Describe the features of registered retirement savings plans
(RRSP) and calculate the annual contribution limit to an RRSP.
◦ An RRSP is an investment vehicle that allows you to defer
tax and save for retirement. Annual contributions are tax
deductible up to allowable limits.
◦ RRSPs only defer the payment of taxes. Eventually all funds
contributed to, and earned within, RRSPs will be taxed.
◦ The advantage of an RRSP is that a retiree will likely pay
income taxes on RRSP funds at a lower tax rate than would
have been paid at the time of contribution.
◦ Contributions can be made up to and including the year in
which you turn 71. At the end of that calendar year, you must
terminate all RRSPs.
◦ There is no limit to the number of RRSPs an individual may
own. However, there is a limit on the amount per year that
you can contribute to an RRSP.
◦ The maximum annual tax-deductible contributions to RRSPs
an individual can make is the lesser of 18% of the previous
year’s earned income; and the RRSP dollar limit for the year.
◦ A RRIF is one of the tax deferral vehicles available to RRSP
holders who wish to continue the tax sheltering of their
plans.
5. List and describe the features of tax-free savings accounts
(TFSA).
◦ Came into existence at the start of 2009.
◦ Income earned within a TFSA will not be taxed in any way
throughout an individual’s lifetime.
◦ There are no restrictions on the timing or amount of
withdrawals from a TFSA, and the money withdrawn can be
used for any purpose.
◦ The current annual contribution limit is $6,000.
◦ Withdrawals can be made from a TFSA at any time.
6. Describe the features of registered education savings plans
(RESPs) and explain how RESPs can be enhanced with
Canada Education Savings Grants (CESGs).
◦ RESPs are tax-deferred savings plans intended to help pay
for the post-secondary education of a beneficiary.
◦ Contributions to a plan are not tax-deductible, there is a tax-
deferral opportunity, since the income accumulates tax-
deferred within the plan.
On withdrawal, the portion of the payments that were not
◦ original capital are taxable in the hands of the beneficiary or
beneficiaries, provided they are enrolled in qualifying or
specified educational programs.
◦ There is no maximum amount that can be contributed in a
single calendar year for each beneficiary.
◦ There is a lifetime maximum of $50,000 per beneficiary.
◦ Contributions can be made for up to 31 years, but the plan
must be collapsed within 35 years of its starting date.
◦ Under CESGs, the federal government makes a matching
grant of at least 20% of the first $2,500 contributed each
year to the RESP of a child under 18.
REVIEW QUESTIONS

SECTION 3
UNDERSTANDING INVESTMENT
7 Types of Investment Products and How They Are

Traded

SECTION 3 | UNDERSTANDING
INVESTMENT PRODUCTS
AND PORTFOLIOS
In Section 1, we examined the role of the mutual fund sales
representative, the financial marketplace and completed an
overview of the mutual fund industry. Then we concentrated our
learning on “knowing the client.” In the upcoming Sections 3 and 4,
our focus will be on knowing your product and understanding
mutual funds and elements of a mutual fund investment portfolio.
Remember, providing excellent client service requires both
excellent client knowledge as well as excellent product knowledge.
It is important to understand securities such as stocks and bonds,
even though your mutual fund licence does not permit you to
advise clients on these investments. They are important because
mutual funds are really just portfolios or pools of investments made
up of different securities. We cannot understand mutual funds
unless we have some basic knowledge and understanding of the
securities of which they are composed.
We begin in Chapter 7 with our first detailed look at the individual
securities that make up most mutual funds: bonds, preferred
shares, common shares, and derivatives.
In Chapter 8 we introduce the concept of risk and return so that
you can use your knowledge of individual products to better
understand how portfolios of securities are constructed. Of
importance to the mutual fund sales representative is how to
calculate returns and understand the concepts of price volatility of
equities and bonds. We also explain how a portfolio of securities is
managed and introduce fundamental and technical analysis.
Chapter 9 provides an overview of financial statements and the
type of analysis portfolio managers use to assess the suitability of
an investment within a portfolio.
Types of Investment
Products and How They Are 7
Traded
CONTENT AREAS
What are Fixed-Income Securities?
What are the Fundamentals of Bond Pricing and Properties?
What are Equity Securities?
How are New Securities Brought to Market?
What are Derivative Securities?
LEARNING OBJECTIVES
1 | Describe and distinguish between the characteristics

and features of the different types of fixed-income
securities such as Governments bonds, T-bills,
corporate bonds, bankers’ acceptances and commercial
paper.
2 | Describe the various measures of yield and explain the

relationship between bond prices and interest rates.
3 | Describe the features and characteristics of common

and preferred shares.
4 | Differentiate among the various market transactions that

investors can undertake in the equities market.
5 | Compare and contrast the basic features and

characteristics of derivative securities and the various
market transactions investors can carry out in the
derivatives markets.
KEY TERMS

arrears
bankers’ acceptance
call
call option
call premium
cash account
collateral
commercial paper
common share
convertible bond
corporate bond
coupon
coupon rate
cumulative
current yield
debentures
default risk
derivative securities
discount
dividend yield
extra dividend
fixed-income security
futures contract
government bond
Guaranteed Investment Certificate
hard retraction
hedging
instalment debenture
interest rate risk
leverage
limit order
long position
margin
margin account
market order
marketable government bond
material fact
maturity date
non-cumulative
odd lot
option contract
option premium
par value
pari passu
preferred shares
premium
prospectus
redemption
regular dividend
retraction
secured bond
serial bond
shelf registration
short selling
soft retraction
standard trading unit
Treasury bill
underwriting
yield curve
yield to maturity
INTRODUCTION
Investment instruments were briefly introduced in Chapter 2. It is
important to understand securities such as stocks and bonds in
some depth, even though your mutual fund licence does not permit
you to advise clients on these investments. They are important
because mutual funds are really just portfolios or pools of
investments made up of securities such as stocks and bonds. You
cannot understand mutual funds unless you have some basic
knowledge and understanding of the securities of which they are
composed.
This chapter examines:
• individual securities
• fixed-income securities, including bonds
• equity securities, including common and preferred shares
• derivative securities
• the markets in which the different securities trade
• specific types of transactions that investors undertake in the
financial markets
WHAT ARE FIXED-INCOME SECURITIES?

Fixed-income securities are debt issued by an entity in the
financial market and sold to investors. These securities represent
the debt of the issuing entity and investors become creditors of the
issuing organization. In most cases, fixed-income securities pay, or
are expected to pay, a fixed amount of return on a regular basis to
investors. The most common types of fixed-income securities are
government and corporate bonds, guaranteed investment
certificates (GICs), Treasury bills (T-bills), bankers’ acceptances,
and commercial paper.
The terms of a fixed-income security include a promise to repay
the maturity value or principal on the maturity date, and to pay
interest at stated intervals over the life of the security. These
regular payments made from the issuer to the holder of the debt
are called coupons.
Corporations and governments borrow money by issuing bonds
and other types of fixed-income securities for a variety of reasons.
One reason is to finance their operations and fill any shortfalls in
cash they are experiencing. Another reason is to use the proceeds
to finance expansion and growth plans.
Corporations also borrow to take advantage of leverage. If a
corporation believes they can earn a greater return on cash
invested in their business than it would cost to borrow money, they
can increase the return on the business by borrowing money.
Bonds are considered loans that investors make to governments
and corporations. The borrower (the government or corporation)
agrees to make regular interest payments (coupon payments) and
pay back the principal or par value (original amount issued) on the
bond’s maturity date.
Almost all bonds promise to make semi-annual (every six months)
coupon payments to the bondholders. The amount of the coupon
payment depends on the bond’s annual coupon rate. This rate is
usually fixed over the entire life of the bond at issuance—for
example, 6% of the par value over the term of the bond.
EXAMPLE
The Government of Canada issues a $10,000,000 bond with a

coupon rate of 4% for a term of 20 years. Over the next 20
years, the government will pay coupons of $400,000 per year (or
$200,000 every six months) to bondholders. At maturity, the
government will repay the principal amount of $10,000,000 to all
bondholders. If a mutual fund manager bought $1,000,000 of this
issue for her mutual fund when the bond was first issued, the
fund will receive $40,000 of interest revenue every year (or
$20,000 every six months) over the next 20 years and would
receive the $1,000,000 principal investment back upon maturity.
The coupon represents the “fixed” income the bondholder receives

from holding the bond, and is also referred to as interest income,
bond income or coupon income. To calculate the semi-annual
coupon payment, the bondholder multiplies the par value of the
bond by the annual coupon rate and then divides the result by two
to arrive at the semi-annual payment amount.
EXAMPLE
Sophie buys an ABC $10,000, 8% semi-annual coupon bond

that matures M ay 1, 2030. The bond will pay her $400 every six
months, on M ay 1 and November 1 of each year to maturity:
(8% x $10,000) ÷ 2.
The maturity date is the date at which the bond matures or

expires. On this date, the bondholder expects to get the par value
or principal of the bond paid back.
EXAMPLE
Sophie bought the ABC bond at the par value of $10,000 when
the bond was first issued. On the maturity date of M ay 1, 2030,
she receives her final coupon payment of $400 plus the return of
the par value in the amount of $10,000.
Bonds can be purchased only in specific denominations. The most

commonly used denominations are $1,000 or $10,000. After being
issued, bonds are bought and sold between investors in the
secondary market at a stated price and a quoted yield.
Bond prices are quoted using an index with a base value of 100. A
bond trading at 100 is said to be trading at face value, or par. A
bond trading below par, say at a price of 98, is said to be trading at
a discount (the 98, based on the index of 100, indicates the bond
is trading at 98% of par). A bond trading above par, say at a price of
104, is said to be trading at a premium.
EXAMPLE
If you buy a bond with a $10,000 face value at a price of 95, it
will cost you $9,500. This is equal to the face value ($10,000)
multiplied by the price divided by 100 (95 ÷ 100 = 0.95). If you
paid 105 for the bond, it would cost you $10,500, or $10,000
multiplied by (105 ÷ 100).
There are several varieties of bonds. To start, some types of

bonds are issued by different levels of governments and other
types of bonds are issued by corporations. In addition, different
bond issues can have distinctive features and those features can
have an impact on the bond’s risk and return profile.
M ost of the fixed -income securities presented below may be part
of mutual funds.
GOVERNMENT BONDS
Government bonds are issued by the federal, provincial and
municipal governments in order to finance public spending. In the
Canadian market, a bond can be short-term, for example, with a
three-year maturity or less, or very long-term, with a maturity up to
30 years.
There is an active secondary market for marketable government
bonds on the over-the-counter (OTC) market. Because these
bonds are issued by the federal or provincial governments, they
are considered to have virtually no default risk. Default risk is the
risk that the issuer would not be able to repay the coupon over the
life of the bond or the principal at maturity. Government bonds are
considered to have virtually no default risk because the
governments can simply increase taxes to make good on the
promise to make the coupon payment or repay the par value at
maturity. Credit rating agencies, the companies that examine the
risk characteristics of bonds, rate the default risk of provincial bonds
a little higher than that of federal government bonds, but below the
default risk of municipal bonds.
TREASURY BILLS
Treasury bills are short-term government obligations. They are
offered in denominations from $1,000 up to $1 million and have
traditionally appealed to large institutional investors such as banks,
insurance companies, and trust and loan companies, and to some
wealthy individual investors. When the government started offering
T-bills in denominations as low as $1,000, their appeal broadened
to retail investors with smaller amounts of money to invest. They
are particularly popular when their yields exceed the yield on
Canada Premium Bonds and other retail instruments, such as
commercial paper.
Treasury bills do not pay interest. Instead, they are sold at a
discount (below par) and mature at 100. The difference between
the issue price and par at maturity represents the return on the
investment, instead of interest. Under the Income Tax Act, this
return is taxable as income, not as a capital gain.
Every two weeks, T- bills are sold at auction by the M inister of
Finance through the Bank of Canada. These bills have original
terms to maturity of approximately three months, six months and
one year.
PROVINCIAL AND MUNICIPAL GOVERNMENT

SECURITIES
Provincial bonds, like Government of Canada bonds, are actually
debentures. Debentures are simply promises to pay, and their
value depends on the issuer’s ability to pay interest and repay
principal. No assets are pledged as security. All provinces have
statutes governing the use of funds obtained through the issue of
bonds. Although these securities are in fact debentures, in practice
they are referred to as bonds.
Provincial bonds are second in quality only to Government of
Canada direct and guaranteed bonds because most provinces
have taxation powers second only to the federal government.
Different provinces’ direct and guaranteed bonds trade at differing
prices and yields, however.
Bond quality is determined by two primary factors: credit quality and
market conditions. The credit quality of a province – that is, the
degree of certainty that interest will be paid and the principal repaid
when due – depends on several factors. They include the amount
of existing debt in the province per capita, the level of federal
transfer payments, the stability of the provincial government, and
the wealth of the province in terms of natural resources, industrial
development, and agricultural production.
GUARANTEED BONDS
M any provinces also guarantee the bond issues of provincially
appointed authorities and commissions.
EXAMPLE
The Ontario Electricity Financial Corporation’s 8.5% notes, due

M ay 26, 2025, are “Irrevocably and Unconditionally Guaranteed
by the Province of Ontario.” Provincial guarantees may also be
extended to cover municipal loans and school board issues. In
some instances, provinces extend a guarantee to industrial
concerns, usually as an inducement to a corporation to locate
(or remain) in that province. M ost provinces (and some of their
enterprises) also issue T-bills. Investment dealers and banks
purchase them, both at tender and by negotiation, usually for
resale.
In addition to issuing bonds in Canada, the provinces (and their

enterprises) also borrow extensively in international markets.
Unlike the federal government, whose policy is to borrow abroad
largely to maintain exchange reserves, the provinces resort to
foreign markets to take advantage of lower borrowing costs, based
on the foreign exchange rate and financial market conditions.
Issues sold abroad are underwritten by syndicates of dealers and
banks similar to those that handle foreign financing for federal
government Crown Corporations. In recent years, issues have
been sold, for example, payable in Canadian dollars, U.S. dollars,
euros, Swiss francs and Japanese yen.
PROVINCIAL SECURITIES
Some provinces offer their own savings bonds. There are certain
characteristics that distinguish these instruments from other
provincial bonds and make them suitable as savings vehicles:
• They can be purchased only by residents of the province.
• They can be purchased only at a certain time of the year.
• They are redeemable every six months (in Quebec, they can
be redeemed at any time).
Some provinces issue different types of savings bonds. For
instance, there are three types of Ontario Savings Bonds (OSBs):
a step-up bond (interest paid increases over time), a variable-rate
bond, and a fixed-rate bond.
MUNICIPAL SECURITIES
Today, the instrument that most municipalities use to raise capital
from market sources is the instalment debenture or serial bond.
Part of the bond matures in each year during the term of the bond.
EXAMPLE
A debenture of $1 million may be issued so that $100,000

becomes due each year over a 10-year period. The municipality
is actually issuing 10 separate debentures, each with a different
maturity. At the end of 10 years, the entire issue will have been
paid off.
Instalment debentures are usually non-callable: the investor who
purchases them knows beforehand how long he or she may expect
to keep funds invested. Also, if the money is needed at future
specific dates, it can be invested in an instalment debenture so
that it will be available when it is needed.
Broadly speaking, a municipality’s credit rating depends upon its
taxation resources. All else being equal, the municipality with many
different types of industries is a better investment risk than a
municipality built around one major industry.
CORPORATE BONDS
Corporate bonds are issued by corporations to finance the
acquisition of equipment and other purposes. Companies issue
corporate bonds to raise capital, as an alternative to issuing new
shares – i.e., debt financing versus equity financing. Like
government bonds, corporate bonds are subject to interest rate
risk. Corporate bonds may, however, have a number of additional
features that affect the return investors expect to earn as well as
their risk.
First, corporate bonds have much more default risk than
government bonds. Credit rating agencies use scales to indicate
the quality of corporate bonds, with AAA (or A++) bonds having the
best protection against default. M any corporate bonds include a
promise to turn over an asset to the bondholders for liquidation if
the corporation fails to make its coupon payments or pay the par
value at maturity. These bonds are said to be secured bonds by a
pledge of collateral (the asset) in the case of default (the failure to
pay).
Not all bonds are secured. Some bonds promise to pay based on
the ability of the corporation to generate earnings. These
unsecured bonds are called debentures.
Corporate bonds usually include a call or redemption feature. This
feature allows the issuing corporation to redeem, or pay back, the
bondholders before the stated maturity date. In exchange for
forcing bondholders to give up their bonds, the corporation will
likely be required to pay them a call premium.
Note that the call feature is always a disadvantage to the
bondholder, as the corporation usually calls a bond for redemption
when interest rates have fallen below the coupon rate on
outstanding bonds. When bondholders reinvest the par value plus
the premium, they are faced with lower coupon rates.
Another common type of bond is a convertible bond. Convertible
bonds are bonds that can be converted or exchanged into a given
number of common shares, generally of the same company.
Convertible bonds have features of both bonds and common
shares; when the value of the firm’s shares is high, the convertible
bond’s value is directly linked to the value of the shares. If, on the
other hand, the value of the shares is very low, then the value of
the convertible bond is based on its value as a bond only.
GUARANTEED INVESTMENT CERTIFICATES

(GICS)
Guaranteed investment certificates offer fixed rates of interest for a
specific term (longer than a term deposit). Both principal and
interest payments are guaranteed. They can be redeemable or
non-redeemable. Non-redeemable GICs cannot be cashed before
maturity, except in the event of the depositor’s death or extreme
financial hardship. Interest rates on redeemable GICs are lower
than standard GICs of the same term, as they can be cashed
before maturity.
Recently, banks have been customizing their GICs to provide
investors with more choice. For instance, investors can choose a
term of up to ten years, depending on the amount invested (for
less than a month, it must be a large amount). Investors can also
choose the frequency of interest payments (monthly, semi-annual,
annual or at maturity) and other features. M any GICs offer
compound interest.
Note that the Canada Deposit Insurance Corporation (CDIC) does
not cover GICs of more than five years. Also, not all GICs are
eligible for RRSPs. GICs can be used as collateral for loans,
however, can be automatically renewed at maturity, and can be
sold to another buyer privately or through an intermediary.
GICs with special features include the following.
Escalating- The interest rate increases over the GIC’s term.

rate GICs
Laddered The investment is evenly divided into multiple term

GICs lengths (for example, a five-year $5,000 GIC can be
divided into one-, two-, three-, four- and five-year
terms of $1,000 each). As each portion matures, it
can be reinvested or redeemed. This diversification
of terms reduces interest rate risk.
Instalment An initial lump sum contribution is made, with further

GICs minimum contributions made weekly, bi-weekly or
monthly.
Index- These guarantee a return of the initial investment

linked upon expiry and some exposure to equity markets.
GICs They are insured by the CDIC. They may be
indexed to particular domestic or global indexes or
to a combination of benchmarks.
Interest- These offer interest rates linked to the changes in

rate-linked other rates, such as the prime rate, the bank’s non-
GICs redeemable GIC interest rate, or money market
rates.
Some banks have also developed GICs with specialized features,
such as the ability to redeem them in case of medical emergency,
or homebuyers’ plans, where regular contributions accumulate for a
down payment.
BANKERS’ ACCEPTANCES AND

COMMERCIAL PAPER
A banker’s acceptance is a commercial draft (i.e., a written
instruction to make payment) drawn by a borrower for payment on
a specified date. A banker’s acceptance is guaranteed at maturity
by the borrower’s bank. As with T-bills, BAs are sold at a discount
and mature at their face value, with the difference representing the
return to the investor. They trade in $1,000 multiples, with a
minimum initial investment of $25,000, and generally have a term to
maturity of 30 to 90 days, although some may have a maturity of up
to 365 days. BAs may be sold before maturity at prevailing market
rates, generally offering a higher yield than Canada T-bills.
Commercial paper is an unsecured promissory note issued by a
corporation or an asset-backed security backed by a pool of
underlying financial assets. Issue terms range from less than three
months to one year. M ost corporate paper trades in $1,000
multiples with a minimum initial investment of $25,000. Like T-bills
and BAs, commercial paper is sold at a discount and matures at
face value. Commercial paper is issued by large firms with an
established financial history. Rating agencies rank commercial
paper according to the issuer’s ability to meet short-term debt
obligations. Commercial paper may be bought and sold in a
secondary market before maturity at prevailing market rates and
generally offers a higher yield than Canada T-bills.
WHAT ARE THE FUNDAMENTALS OF BOND

PRICING AND PROPERTIES?
As explained previously, bonds are issued at par, pay fixed interest
over their lifespan and repay the principal at maturity. However,
during their life, bonds are bought and sold among investors in the
secondary market and their prices fluctuate. They are rarely bought
or sold at par in the secondary market and instead will typically
trade at a price above or below par.
Bonds trade at a quoted price. Recall that a bond trading at a
quoted price of 100 is said to be trading at face value, or par. A
bond trading below par, say at a price of 98, is said to be trading at
a discount (the 98, based on the index of 100, indicates the bond is
trading at 98% of par). A bond trading above par, say at a price of
104, is said to be trading at a premium.
If you buy $10,000 of a 5% bond that trades at 98, you will pay
$9,800 for that bond (98% of $10,000). The bond is said to be
sold at a discount. You will receive a coupon of $500 every year
(usually paid $250 every six months) for the life of the bond. If
you keep your bond until maturity, you will receive $10,000. You
have made $500 per year of interest and a $200 capital gain at
maturity (bought at $9,800, sold at $10,000).
If you buy $10,000 of a 5% bond that trades at 104, you will pay
$10,400 for that bond (104% of $10,000). The bond is said to be
sold at a premium. You will receive a coupon of $500 every year
(usually paid $250 every six months) for the life of the bond. If
you keep your bond until maturity, you will receive $10,000. You
have made $500 per year of interest and experienced a $400
capital loss at maturity (bought at $10,400, sold at $10,000).
Bond prices are affected by a number of factors, including economic

conditions and changes but one of the most important factors in
bond pricing is interest rates. Fixed income securities generally
react differently to economic factors than do equities, and it is
important to understand the impact of events that affect these
securities.
This course will not present bond pricing calculations in detail.
These quotes are calculated by professionals, and bonds are
generally traded by institutional investors like mutual fund managers
This topic is beyond the scope of this course. However, since
mutual funds are built from these securities (and equities, that will
be discussed later in the chapter), there are some basics that
mutual fund representatives must understand about fixed-income
securities pricing.
The most important bond pricing characteristics you must
understand about the volatility of mutual funds are:
• The inverse relationship between bond prices and interest
rates
• The impact of maturity and coupon on price volatility
THE INVERSE RELATIONSHIP BETWEEN

BOND PRICES AND INTEREST RATES
The most important bond pricing relationship to understand is the
inverse relationship between bond prices and interest rates (or
bond yields)—as interest rates rise, bond prices fall and as interest
rates fall, bond prices rise.
It is important to note that discount rate, interest rate, yield and
yield to maturity are often used to refer to the same thing.
However, the yield of a bond should not be confused with the
coupon rate; they are two different things. While the coupon rate,
along with the face value and maturity date, do not change, the
price and yield of a bond fluctuates from day to day. Given the yield
and the coupon rate, the following relationships hold:
• If the yield is greater than the coupon rate, the bond is trading
at a discount.
• If the yield is equal to the coupon rate, the bond is trading at
par.
If the yield is lower than the coupon rate, the bond is trading at
• a premium.
Fixed income mutual funds are impacted by interest rates. When

the general interest rates in the economy rise, the value of fixed
income mutual funds decrease. Conversely, when general
interest rates drop, the value of fixed income mutual funds
increase.
THE IMPACT OF MATURITY AND COUPON

ON PRICE VOLATILITY
The term to maturity and the percentage of the coupon also have
an impact on the volatility of bonds.
Longer-term bonds are more volatile in price percentage change
than shorter-term bonds for the same yield change.
A mutual fund that includes long-term bonds will drop more in

price if general interest rates in the market rise from 4% to 5%
than another mutual fund that holds bonds with shorter terms to
maturity. Thus, knowing the average maturity date of fixed
income funds is important when assessing its volatility due to
changes in interest rates.
As a bond approaches its maturity over the years, it will become

less volatile. For example, a bond originally issued with a ten-year
maturity will, seven years later, have a three-year term, and will be
priced as and behave like a three-year bond at that time.
Our next pricing relationship states that lower-coupon bonds are
more volatile in price than high coupon bonds for the same yield
change.
When yields rise, all bonds drop in price, but, for the same yield
change, low coupon bonds drop more than high coupon bond.
The larger the difference between coupons, the more significant
the difference in volatility.
As you can see, bonds are subject to a potentially high degree of

price volatility. This is known as interest rate risk, which is the risk
that changes in interest rates will adversely affect the value of the
investment. M utual funds that include fixed-income products in their
portfolio of investments are subject to interest rate risk.
Bonds are also subject to other types of risk. For example, if there
is some doubt about the borrower’s ability to pay interest and
repay principal, the default risk on that particular bond would be
considered high. Credit rating agencies examine the default risk of
bond issuers and make this default information available to
investors.
BOND YIELD CALCULATIONS

Bond yields can be calculated in different ways for different
purposes. The following presents two simple ways to calculate
bond yields. The yields of fixed income mutual funds are generally
given by the mutual funds so the calculation of fixed-income
portfolios will not be discussed here.
CURRENT YIELD
We can calculate the current yield of any investment, whether it is
a bond or a stock, using the following formula:
In this case, the annual cash flow is the coupon paid by the bond.
As previously discussed, coupons are fixed for the life of the bond,
so the annual cash flow is simply the total coupon paid.
Note that current yield looks only at cash flows and the current
market price of the investment, not at the amount that was
originally invested.
EXAMPLE
A 4-year, 9% bond, trading at a price of 96.77, would have a

current yield of:
Current yield ignores the time until maturity of the bond and the
repayment of the principal. Current yield is used to compare the
short-term return of a bond to the short-term returns of other
bonds.
CALCULATING THE YIELD TO MATURITY ON A BOND

Unlike a current yield, where the yield is calculated as the coupon
income divided by current price, the yield to maturity (YTM )
calculation assumes that the investor will be repaid the par value of
the investment at maturity.
Therefore, YTM not only reflects the investor’s return in the form
of coupon income; it also includes any capital gain from purchasing
the bond at a discount and receiving par at maturity, or any capital
loss from purchasing the bond at a premium and receiving par at
maturity.
M anually calculating YTM is a difficult task. The easy way to solve
for YTM is to use a financial calculator.
EXAMPLE
Continuing with the 4-year, semi-annual 9% bond, trading at a

price of 96.77, we can find the semi-annual YTM in the following
way:
Type 8 Press N
Type 4.50 press PM T
Type 96.77 press +/- press PV (minus sign in front of 96.77
denotes an outflow of funds from investor)
Type 100 press FV
Press COM P press I/Y
Answer: 4.9997% or 5%
The semi-annual YTM on this bond is 5.0%. The annual YTM is

10% (5% × 2), which makes sense because the bond is trading at
a discount to par. If you buy this bond today at the price of $96.77
and hold it to maturity you would receive 8 payments of $4.50 plus
$100 at maturity. The YTM calculation factors in the $3.23 gain on
this bond ($100 – $96.77), the coupon income, plus the
reinvestment of the coupon income at this YTM .
A financial calculator makes the YTM calculation quite easy. Exhibit
7.1 shows how to carry out the calculation manually using the
approximate YTM method.
Exhibit 7.1 | Approximate Yield to Maturity—Manual

Calculation
The formula for the approximate YTM is:
We use +/– in the formula to show that you can buy a bond at a
price above or below par. Let’s say you buy a bond at a discount
to par, say at a price of 92, and hold it to maturity. At maturity, the
bond matures at par and you realize a gain on the investment. In
the formula, you would add this price appreciation to the interest
income. The opposite holds if you buy a bond at a premium, say
at 105, and hold it to maturity. In our formula, you would subtract
the price decrease from the interest income.
For example, let’s calculate the yield on the 4-year, semi-annual
9% bond, trading at a price of 96.77 that matures at 100.
• The semi-annual interest or coupon income on this bond is
$4.50.
• What is the annual price change on this bond (based on $100
par)? The present value of the bond is 96.77 and will mature at
100. Therefore, it will increase in value over the remaining life
of the bond by $3.23. Since there are eight compounding
periods remaining in this bond’s term, the bond generates a
gain in price of $0.4038 per period over the remaining eight
compounding periods ($3.23 ÷ 8).
• What is the average price on this bond (based on $100 par)?
The purchase price is $96.77. The redemption or maturity value
is $100. The average price is 98.385, or (96.77 + 100) ÷ 2.
The approximate semi-annual YTM on this bond is:
The annual YTM is 9.9684% (4.9842% x 2).

You will notice that this result is very close to the YTM found using
the calculator method. For accuracy, a financial calculator provides
a more precise amount.
THE YIELD CURVE

Not only do bond prices fluctuate due to yield changes, but the
relationship between short-term and long-term bond yields also
tends to fluctuate. This relationship is easily plotted on a graph for
similar long-term and short-term bonds and results in a line called a
yield curve. The yield curve shows the relationship between
interest rates and the time to maturity for a given borrower. In
normal conditions, the longer the term to maturity, the higher the
interest rate. While a yield curve can be drawn for any issuer with
multiple bond issues outstanding, the yield curve most often used
by investors is the one representing the YTM on benchmark
national government bonds.
Figure 7.1 represents an example of the yield curve of Government
of Canada bonds.
Figure 7.1 | Short-and long-term government of Canada

security yields
In normal conditions, short-term interest rates are typically lower

than longer-term interest rates. There are two common
explanations for this. First, there is greater uncertainty with longer-
term maturities, which means greater risk. Because you should be
compensated for the risk you take, longer-term bonds should yield
more. Second, the market may anticipate a rise in interest rates. If
interest rates are to rise, long-term investors would require today a
higher yield to compensate for the expected rise in interest rates.
Let’s assume that 3-year Government bonds yield 2.5% and 30-
year Government bonds yield 5%. According to the yield curve,
if interest rates rise by 1% across all terms, the 3-year
Government bonds will now yield 3.5% and the 30-year
Government bonds will now yield 6%.
BOND TERMINOLOGY REVIEW
How familiar are you with bond terminology? Complete the

online learning activity to assess your knowledge.
Case Study | The Balmers: Aren’t Bond Funds Guaranteed

Never to Lose? (for information purposes only)
Joanne is meeting with her retired clients, Beth and Dave Balmer.
In their mid-seventies, the Balmers have a sizable portfolio of bond
funds that generate considerable income for the couple. But with
interest rates having steadily fallen to their near-historic lows
today, the Balmers are also drawing down some of the principal of
their portfolio to supplement the interest income it generates.
Joanne has read a number of recent reports from her firm’s chief
economist that argue that interest rates are poised to rise in the
coming months, so she is concerned that the Balmers may begin
to suffer negative returns on their bond portfolio. As conservative
investors, she wants to meet with the Balmers to explain this
concern to them and to help them better understand the exposure
they have to rising interest rates.
Joanne begins by reviewing the Balmers’ investment goals and re-
confirming their investment profile. The Balmers are very happy
with their portfolio. Despite generating a lower income flow as
interest rates, yields and coupon rates have dropped over the
years, the offsetting rise in the value of their bond portfolio has
allowed them to draw down their capital without eroding too much
of the portfolio’s value.
Joanne agrees that the long-term trend of falling interest rates over
the past 20-plus years has worked very well for fixed-income
investors. However, she explains to the Balmers that the trend is
expected to reverse in the near future, with interest rates and bond
yields expected to rise. She explains that, as interest rates rise
and bond yields rise, generally the value of bonds fall. The Balmers
are confused, as they believed that bonds and bond funds really
couldn’t lose money – aren’t bonds guaranteed? Joanne explains
that in fact, yes, they can lose value as yields rise because:
• The coupons on existing bonds are set at the market interest
rates that prevailed when they were issued and remain the
same throughout the term of the bond; so, when yields rise,
the now lower-than-market coupon rates of existing bonds will
be lower than newer bonds priced with coupons at the higher
prevailing market interest rates.
• The older bonds and their lower-than-market coupons must
now lower their prices to be more attractive to buyers who are
looking for a total return– price appreciation and coupon
payments – of their bonds to be within the range of prevailing
yields.
• Also, bond mutual fund owners are potentially exposed to
further negative returns as unit holders – now exposed to
losses as yields rise – sell their holdings. This increase in
mutual fund redemptions may force bond fund manager to sell
bonds before their maturity in order to raise cash to meet
redemption requests, thereby increasing losses for unit
holders.
Finally, Joanne explains to the Balmers that the longer the term to
maturity of the bond fund’s holdings, the more sensitive the fund’s
bonds are to changes in yields. While the Balmers, now aware of
their exposure, are pleased that Joanne informed them, they are
confident that over time, their fund manager will manage the
situation, and offset their capital losses with higher coupon
payments from new issues as yields rise.
WHAT ARE EQUITY SECURITIES?
Equity securities, particularly common stocks or shares, are an
important part of most investors’ portfolios. History has shown that
the return on stocks has exceeded the return on bonds over the
long term. In addition, long-term common stock returns have
consistently outpaced inflation, providing long-term protection from
a loss of purchasing power.
Common shares form the backbone of many investment portfolios
and are a major component of pension funds, mutual funds, and
hedge funds. Unlike many other types of investments, there are a
number of inherent rights, advantages, and disadvantages of
common share ownership with which you must be familiar.
COMMON SHARES
Common shareholders are the owners of a company and initially
provide the equity capital to start the business.
If the venture prospers, the shareholders benefit from the growth in
value of their original investment and the flow of dividend income.
The prospect of a small investment growing to many times its
original value attracts investors to common shares.
On the other hand, if the business fails, the common shareholders
may lose their entire investment. This possibility of total loss
explains why common share capital is sometimes referred to as
venture or risk capital.
Summary of Common Shares
Position Senior creditors (such as banks), bond and

on asset debenture holders and preferred shareholders all
claims in have prior claims on the company’s assets in case
case of of bankruptcy. Common shares, therefore, have a
bankruptcy relatively weak position on asset claims.
Dividends Unlike debt interest, common share dividends are
payable at the discretion of the board of directors.
There is no guarantee of dividend income.
Evidence Shares are most often registered in street certificate

of form, meaning they are registered in the name of the
ownership securities firm rather than the beneficial owner. This
increases the negotiability of the shares, making
them more readily transferable to a new owner.
Clearing CDS Clearing and Depository Services Inc (CDS)

and offers computer-based systems to replace
settlement certificates as evidence of ownership in securities
transactions. This system almost eliminates the
need to handle securities physically.
Trading Stocks trade in uniform lot sizes on stock

units exchanges. A standard trading unit is a regular
trading unit which has uniformly been decided upon
by the exchanges. The usual unit of trading for most
stocks is 100 shares. A group of shares traded in
less than a standard trading unit is called an odd
lot.
BENEFITS OF COMMON SHARE OWNERSHIP

The right to buy or sell common shares in the open market at any
time is an attractive feature and a relatively simple matter with few
legal formalities.
When a company first sells its shares to investors, the proceeds
from the sale go to the company. When these outstanding shares
are subsequently sold by their holders, the selling price is paid to
the seller of the shares and not to the corporation. Shares,
therefore, may be transferred from one owner to another without
affecting the operations of the company or its finances. From the
company’s point of view, the effect of a sale is simply that a new
name appears on its list of shareholders.
The following are some of the benefits of common share
ownership:
• Potential for capital appreciation
• The right to receive any common share dividends paid by the
company
• Voting privileges, including the right to elect directors, to
approve financial statements and auditor’s reports, and vote on
other important issues
• Favourable tax treatment in Canada of dividend income and
capital gains
• M arketability – shareholdings can easily be increased,
decreased or sold, for most public companies
• The right to receive copies of the annual and quarterly reports,
and other mandatory information pertaining to the company’s
affairs
• The right to examine certain company documents such as the
by-laws and register of shareholders at specified times
• The right to question management at shareholders’ meetings
• Limited liability
CAPITAL APPRECIATION
For many investors, and for mutual fund portfolio managers, the
prospect of capital appreciation is the main attraction of common
shares. Common shares may increase in value, making the stock
more attractive to investors. Increasing profits and increasing
dividend payments can also result in a higher demand for the stock,
thereby leading to the stock’s capital appreciation.
It is important to keep in mind that not all common shares fulfill
these expectations, and even those that increase shareholder
equity, earn profits and increase dividend payments will not
necessarily increase in value every year. There are many other
factors that can affect a company’s stock price, and careful analysis
is required by the fund manager to ensure a profitable investment.
DIVIDENDS
A company’s net earnings are available for distribution as
dividends, or they may be retained within the company and
reinvested in the business, or a combination of the two.
Dividend policy is determined by the board of directors, who are
guided primarily by the goals of the company, the size of the
company, the industry in which it participates, and the financial
position of the company. For example, mature companies, such as
banks, may pay out a substantial percentage of their earnings as
dividends to shareholders, while growing companies such as those
in the technology field may need to keep a high proportion of
earnings within the company to fund the large amount of research
and development that are crucial to their success.
To maintain its operations and finance future growth opportunities,
most companies will retain a portion of earnings each year. In the
long run, this policy may work to the benefit of shareholders if it
results in increased earnings.
Reductions or omissions of dividends do occur, particularly in poor
economic times, and although they may be temporary, they do
emphasize the risks of common share investment.
REGULAR AND EXTRA DIVIDENDS

Some companies paying common share dividends designate a
specified amount that will be paid each year as a regular dividend.
The term regular indicates to investors that payments will be
maintained, barring a major collapse in earnings.
Some companies may also pay an extra dividend on the common
shares, usually at the end of the company’s fiscal year. The extra
is a bonus paid in addition to the regular payout – but the term
extra cautions investors not to assume that the payment will be
repeated the following year.
COMMON SHARE CHARACTERISTICS
How familiar are you with common share characteristics?

knowledge.
PREFERRED SHARES
Preferred shares are issued by corporations to raise capital for
investment projects. They are issued in the primary market (the
new issue market) at a par value. That value can be different for
different issues, but a par value of $25 per share is common. In
addition to a par value, preferred shares have a stated dividend
amount or, alternatively, a stated dividend yield.
For example, a preferred share may have a $25 par value and may
pay an annual dividend of $2.50. This means that the dividend yield
is $2.50 ÷ $25, or 10%.
Fixed-rate perpetual preferred shares are an example of preferred
shares that pay a fixed quarterly dividend. Not all preferred shares,
however, have fixed rates. Floating-rate preferred shares, for
example, pay a dividend that adjusts, or floats, based on either a
percentage of the Canadian Bank Prime Rate or the yield on 3-
month Government of Canada T-Bills plus some spread. Fixed-
reset preferred shares, on the other hand, are preferred shares
with fixed dividend rates that periodically reset according to a
formula or process outlined at the time the shares are issued.
There is also a secondary market for preferred shares. Some trade
on the OTC market and some on an organized exchange.
Generally, when a firm’s common shares are listed for trading on an
exchange, its preferred shares are listed on the same exchange as
well.
Preferred shareholders are usually entitled to a regular dividend
payment, subject to the discretion of the board of directors.
Because of this income stream, most preferred shares are treated
by investors like a type of fixed-income security. However,
preferred shareholders are not in the same category as creditors
holding typical fixed-income securities, such as bonds and
debentures. As part owners of a company, along with common
shareholders, preferred shareholders rank behind creditors in their
claim to assets. Preferred shareholders do, however, have priority
status over common shares in the event of bankruptcy or
dissolution of the company.
Some companies issue more than one class or series of preferred
shares. When this occurs, each class or series is identified
separately. If the rank of various outstanding preferred share
issues is equal as to asset and dividend entitlement, the shares
are described as ranking pari passu.
PREFERRED SHARE FEATURES

Preferred shares have several features that reflect their unique
position relative to common shares and bonds and debentures, as
described below.
PREFERENCE AS TO ASSETS
Preferred shareholders rank ahead of common shareholders but
behind creditors and debtholders in their claim to assets. Preferred
shareholders are therefore better protected than common
shareholders, but less protected than creditors and debtholders.
Because preferred shareholders usually have no claim on earnings
beyond the fixed dividend, it is fair for their position to be
buttressed by a prior claim on assets, ahead of the common
shares. The common shareholder must be content with anything
that is left after all creditor, debtholder, and preferred shareholder
claims have been met.
PREFERENCE AS TO DIVIDENDS
Preferred shares are usually entitled to a fixed or floating dividend
expressed either as a percentage of the par or stated value, or as
a stated amount of dollars and cents per share.
Dividends are paid from earnings, either current or past. However,
unlike interest on a debt security, dividends are not obligatory; they
are payable only if declared by the board of directors. If the board
omits the payment of a preferred dividend, there is little the
preferred shareholders can do about it. However, in almost all
cases the charters of companies provide that no dividends are to
be paid to common shareholders until preferred shareholders have
received full payment of the dividends to which they are entitled.
Directors have the right to defer the declaration of preferred
dividends indefinitely. In practice, however, dividends are paid if
they are justified by earnings. Failure to declare an anticipated
preferred dividend has unfavourable repercussions. Besides
weakening investor confidence, the general credit and future
borrowing power of the company will suffer.
Because most preferred shares can be considered fixed-income
securities, they do not offer the same potential for capital
appreciation that common shares provide for investors. When
interest rates decline, preferred share prices tend to increase in
price, much like a bond. However, good corporate earnings will
have no effect on a preferred share’s dividend or claim to assets.
Therefore, the preferred share dividend rate is of prime importance
to the preferred shareholder.
OTHER FEATURES
Beyond their place in the capital structure and entitlement to
dividends, the following features can be built into a preferred share,
either to strengthen the issuer’s position or to protect the
investor’s position.
Figure 7.2 | Special Features of Preferred Shares
Cumulative Preferred share dividends can be cumulative or non-

or non- cumulative. If a company’s board of directors votes
cumulative not to pay one or more preferred share dividends
dividends when due, and the preferred share has a cumulative
dividend feature, the unpaid dividends accumulate in
what is known as arrears. All arrears of cumulative
preferred dividends must be paid before common
share dividends are paid or before the preferred
shares are redeemed.
With a non-cumulative dividend feature, arrears do
not accrue, and the preferred shareholder is not
entitled to catch-up payments if dividends resume.
M ost preferred shares in Canada have a non-
cumulative dividend feature.
Term to M ost preferred shares have no stated maturity date.

maturity Depending on the specific features of a preferred
share, investors may not have the ability to force the
repayment of the par value; therefore, a preferred
share can be outstanding for an indefinite period.
Callable Almost all preferred shares are callable, meaning they

feature can be called or redeemed by the issuer at a stated
time and stated price. Depending on when a preferred
share is called, it may provide for the payment of a
small premium above the issue price. The premium is
compensation to the investor whose shares may be
called for redemption.
Retraction A preferred share with a retraction feature gives
feature shareholders the right to force the company to buy
back the shares on a specified date at a specified
price. Some are issued with two or more retraction
dates. The holder of a preferred share with a
retractable feature can create a maturity date for the
preferred by exercising the retraction privilege and
tendering the shares to the issuer for redemption.
With a hard retraction feature, the company must
pay the redemption value in cash. A soft retraction
feature allows the company to pay the redemption
value in cash or common shares of the issuer.
Voting Virtually all preferred shares are non-voting if

privileges preferred dividends are paid on schedule. However,
after a stated number of preferred dividends have
been omitted, it is common practice to assign voting
privileges to the preferred shares.
RISKS OF INVESTING IN PREFERRED

SHARES
Preferred shares can be attractive investments to many investors,
but they are not risk free; in fact, their risks are similar to those of
fixed-income securities.
Interest Because they represent a claim on a stream of

rate risk dividends, preferred shares are sensitive to the
general level of interest rates. When interest rates
rise, the prices of fixed-rate preferred shares tend to
fall because the fixed dividend will be worth less to
investors in a higher-rate environment. The reverse
also holds true.
Credit Because preferred shareholders rank below all

risk creditors and bondholders in the even of bankruptcy,
preferred share prices can be quite sensitive to
changes in perceived creditworthiness, especially
when that perception goes down.
Call risk Because almost all preferred shares are callable at the
option of the issuer, investors are subject to call risk.
Call risk is the risk that the investors will be forced to
give up their preferred shares when it is not in their
best interest, which usually occurs when the shares
are trading at a premium to their par value.
Extension A corollary to call risk is extension risk. If a preferred

risk share does not have a retraction feature, the issuer
has the sole ability to determine when it will return the
par value to investors. It can effectively keep
extending the repayment date by simply not calling the
preferred share for redemption. Investors can always
sell their preferred shares in the market, but if the
market price is below the par value, then there is a
strong possibility it will not be redeemed at the next
redemption date.
Liquidity The total market value of preferred shares in Canada

risk is a fraction of the market value of common shares and
of bonds and debentures. As a result, the value that
changes hands each day through trading on Canadian
exchanges is also small. Furthermore, the fact that a
good portion of many preferred shares are held by
individual investors means that the liquidity in any
individual preferred share is low.
PREFERRED SHARE SPECIAL FEATURES
What are the special features of preferred shares?

knowledge.
HOW ARE NEW SECURITIES BROUGHT TO

MARKET?
The process of bringing new securities to market is known
generally as underwriting. The financial intermediary acting as the
underwriter is a securities dealer. For the issuance of new
corporate securities such as corporate bonds, common and
preferred shares, the underwriter provides two distinct services.
First, it advises the issuing corporation in the preparation of the
prospectus—the document that provides a complete description
of the firm and the securities to be offered. Second, the underwriter
often arranges for the purchase of the new issue and bears the risk
that some of the securities might remain unsold at the specified
price.
The prospectus is the single most important source of information
for potential investors concerning the new issue. The prospectus
must be registered with each provincial securities commission in
every province in which the underwriter intends to solicit offers to
purchase. The securities commissions merely ensure that the
prospectus provides the necessary information. They do not
comment in any way on the investment merits of any security,
which the individual investor must determine. Nor does the
registration of the prospectus imply that the securities commissions
have verified the information contained in it. If it contains errors or
misrepresentation of material fact or omits a material fact, then the
issuing corporation is legally liable. A material fact is a fact that, if
correctly stated, would likely lead investors to change their
purchase decision.
M ost corporate issuers must produce a new prospectus each time
they make a new offer of securities to the public. This is true even
when a company is only issuing additional common shares.
However, frequent issuers of securities are not always required to
produce a full prospectus containing all relevant company
information, as they are already well known to the investing public.
Instead, these firms are permitted to issue a simplified prospectus
for new issues, sometimes referred to as shelf registration.
M utual funds, as continuous issuers of new securities, are
permitted to file simplified prospectuses. They must provide
investors with the fund facts disclosure document before the
investors purchase the mutual funds, and they must provide the
simplified prospectus to investors upon request. In contrast to
corporate issues, government bonds are not underwritten by an
investment dealer. Instead, investment dealers bid for the bonds
that the government is issuing in the expectation of selling them to
the investing public at a profit.
TRADING SECURITIES
The trading of Canadian equity securities (common and preferred
shares) takes place on a stock exchange. Typically, investors
contact their stockbroker and give an order to buy or sell a certain
number of shares of a corporation. When the stockbroker receives
the order, it is forwarded electronically to the exchange. If the order
is to buy or sell at the current market price, then the order is known
as a market order. M any other types of orders are possible. For
example, an investor may put in an order to buy one standard
trading unit of common stock if that stock should fall to a certain
price. This type of order is known as a limit order.
Once an order has been received by the exchange it will be filled
immediately if it is a market order; if it is a limit order, then it will go
into the exchange’s consolidated electronic order book. In the
book, the limit order is visible to all dealer members who can
execute it at the first best possible price. When the order is filled,
the information is conveyed back to the stockbroker who initiated
the transaction on behalf of the client. The client then receives a
confirmation with the details of the transaction: the security traded,
the number of shares bought (or sold), the price, the date of the
trade and the amount of the commission.
Note that the broker acts as an agent of the investor in exchange-
based trading. In this case, the broker does not itself own the
securities at any time during the transactions. The broker’s profit is
the agent’s commission charged for each transaction.
TYPES OF MARKET TRANSACTIONS

The simplest type of market transaction is the buying or selling of a
security. For fixed-income securities, investors expect to earn
regular income (from interest or from preferred dividends).
Decreases in market interest rates can also result in capital gains
since the market values of fixed-income securities will increase as
interest rates fall. Common shares are bought on the expectation
of earning some combination of dividend income and capital gains.
There are, however, transactions other than the simple buying and
selling of securities that investors may use to earn a return on
movements in security prices. Investors may buy securities using
money borrowed from a stockbroker. This type of brokerage
account is called a margin account. In a margin account, the client
can buy securities on credit and initially pay only part of the full
price of the purchase. In these types of transactions, the securities
firm lends the remainder of the purchase amount to the client and
charges interest on this amount. If a client opens a margin account,
the securities firm will grant credit to the client based on the market
value and quality of the securities in the margin account.
A margin account contrasts with an account in which no borrowing
is permitted, called a cash account. In a cash account, the client is
expected to make full payment for purchases on or before the
required settlement date—usually two business days after the
transaction date. When a client opens a cash account with a
broker, they are not granted credit and the understanding is that the
client will make full payment by the settlement date.
Investors also may undertake a transaction to benefit from a fall in
the price of a security. This type of transaction is called a short
selling.
Short selling is defined as the sale of securities that the seller
does not own. Profits are made whenever the initial sale price
exceeds the subsequent purchase cost. With long positions, an
investor purchases a security and then holds it in the hope of
selling it later at a higher price. With short selling, the order of the
transactions is reversed. The investor sells the security first, and
then waits in the hope of buying it back later at a lower price. Since
the seller does not own the securities sold, the seller in effect
creates a “deficit” or short position where he or she owes
securities, and the subsequent purchase covers or “repays” this
deficit.
Short selling is generally carried out in the belief that the price of a
stock is going to fall. The short seller feels bearish toward a
particular security and sells it short, hoping to buy it back later at a
lower price. If the sale is made at a higher price than the
subsequent purchase, the investor has made a profit.
Note that buying on margin and selling short are allowed only by full
brokerage firms who are licenced to do so on behalf of their clients.
M utual funds are prohibited from buying on margin and selling
securities short.
WHAT ARE DERIVATIVE SECURITIES?

Derivative securities are securities whose value depends on the
value of another security or asset. They are contracts created
between two investors: a buyer and a seller. If the derivative is an
option to buy shares at a fixed price, then as those shares
increase in value, the option contract should increase in value as
well. Similarly, futures contracts, either on commodities such as
wheat or oil, or on financial assets such as a stock market index,
will change value depending on the price change in the underlying
asset.
The fundamental risk and return characteristic of derivatives is that
they provide exposure to the underlying asset for a small fraction of
the value of the asset. This characteristic is known as leverage.
For example, consider a stock trading at $20. Assume that calls are
traded on the stock. A call option gives its owner the option of
buying shares (usually 100 shares per option contract) at the fixed
exercise price prior to the call’s expiration date. Assume for this
example that the calls cost the investor $2.00 (the call “option
premium”). If the stock moves up substantially, then the investor
will benefit on a dollar-for-dollar basis with the increase in the stock
price, even after paying a small up-front price to acquire the call
($2.00). If the stock falls, however, then the investor may see the
value of the investment fall to zero.
EXAMPLE
Tanya buys a three-month call option on the shares of XYZ at a

cost of $2. This contract gives her the right to buy the shares at
a specified price—$20 in this example—within the three-month
period. Two-months later, XYZ shares are trading at $25. Tanya
exercises her right to buy the shares at $20, and then
immediately sells the shares at the current market price of $25
for a profit of $5 per share.
Since she paid a $2 premium to buy the call, her profit is $3 per
share ($5 profit from the shares less the $2 premium paid to buy
the call). Her total profit is $300 on the position
(100 shares × $5 profit – $2 premium) or 150% ($300 ÷ $200) of
her initial investment after two months.
If the share price of XYZ had instead fallen over the term of the
contract, Tanya would lose the premium she paid to enter the
contract. In this example, her loss would have been $200
($2 × 100 shares).
Futures contracts share this leverage feature. In a futures contract,

an investor agrees to buy or sell an underlying asset at a
settlement date at some time in the future. To initiate this
agreement, the investor is required to put up only a small fraction of
the futures contract’s underlying value. This amount is called
margin. For example, if you wish to buy a futures contract on long-
term Government of Canada bonds, you will have to put up no
more than $1,750 of margin. But this $1,750 gives you exposure to
an underlying contract value of $100,000 worth of bonds.
The fact is that a relatively small change in the underlying asset
value can either generate a very large return for the owner of the
derivative or virtually wipe out the value of the investment. This
leverage is very attractive to speculators. However, from the
perspective of mutual fund portfolio managers, the charm of
derivatives lies in the strategies they permit for protecting the
mutual fund portfolio from a potentially dramatic decline in value.
Those strategies are known as hedging. Hedging is like buying an
insurance policy for protection from unexpected occurrences. In
addition, futures contracts, in combination with other securities, can
be used to mimic (i.e., synthesize or “clone”) other securities or
portfolios.
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. Recall that derivatives are contracts whose value is
based on the performance of an underlying asset such as a
commodity, a stock, a bond, foreign currency or an index. Options
(puts or calls), futures, forwards, rights, warrants and combination
products are among the permitted derivatives used by mutual fund
managers.
The most prominent applications of derivatives among mutual fund
managers are to hedge against risk and to facilitate market entry
and exit. It is often cheaper and quicker to enter the market using
derivatives rather than purchasing the underlying securities directly.
EXAMPLE
A fund manager may have experienced a rapid growth in the

value of her portfolio, but she is concerned that the market may
fall. To protect herself against a fall in value, she purchases put
options on the iShares S&P/TSX 60 Index Fund. If the market
declines, the fall in value of the portfolio is offset by an increase
in the value of the put options. Other managers may sell call
options on shares they already own in order to enhance the
fund’s income. When fund managers deal internationally, they
may use futures contracts as protection against changes in
currency values.
One focus of National Instrument 81-102 is to allow the use of

derivatives to benefit investors by minimizing overall portfolio risk
while, at the same time, ensuring that portfolio managers do not
use derivatives to speculate with investors’ money. This regulation
covers such topics as:
• The total amount (10% maximum as a percentage of the net
assets of a fund) that can be invested in derivatives
• How derivative positions must be hedged by the assets of the
fund (based on daily portfolio valuations)
• Expiry dates on different option products
• Permitted terms
• The qualifications required by portfolio advisors to trade these
instruments
There are exceptions to these rules. Hedge funds, for example, are
exempted.
The use of permitted derivatives must be described in a mutual
fund’s simplified prospectus. Briefly, the discussion must explain
how the derivative(s) will be used to achieve the mutual fund’s
investment and risk objectives, and the limits of and risks involved
with their planned use.
SUMMARY
1. Describe and distinguish between the characteristics and
features of the different types of fixed-income securities such
as governments bonds, T-Bills, corporate bonds, bankers’
acceptances and commercial paper.
◦ Fixed-income securities are considered loans that investors
make to governments and corporations.
◦ Types of fixed-income securities include government and
corporate bonds, GICs, T-bills, bankers’ acceptances and
commercial paper.
◦ Government bonds have virtually no default risk but are
subject to interest rate risk.
◦ Corporate bonds are subject to both interest rate risk and
default risk.
◦ Bonds can have a number of features including a redemption
(or call) feature. Convertible bonds can be converted into
common shares of the issuing company.
◦ A bankers’ acceptance is a commercial draft (i.e., a written
instruction to make payment) drawn by a borrower for
payment on a specified date.
Commercial paper is an unsecured promissory note issued
◦ by a corporation or an asset-backed security backed by a
pool of underlying financial assets.
2. Describe the various measures of yield and explain the
relationship between bond prices and interest rates.
◦ Interest rate and bond prices have an inverse relationship:
the value of a bond will decrease as interest rates increase,
and vice versa.
◦ This tendency of bonds to change in value with changing
interest rates is called interest rate risk.
◦ Two types of return calculation were presented for bonds:
the current yield and the YTM .
– The current yield is the coupon payment for one year
divided by the market price of the bond.
– The YTM shows the return you would expect to earn
over the life of a bond starting today, assuming you are
able to reinvest the coupons you receive at the YTM .
◦ The yield curve represents the relationship between the
interest rate and the time to maturity for a given borrower.
3. Describe the features and characteristics of common and
preferred shares.
◦ Common shares are issued by corporations and are
expected to earn either dividends or capital gains, or both.
◦ Preferred shares are issued by corporations to raise capital
for investment projects and are generally issued at a fixed
par value per preferred share.
◦ Preferred shares are usually entitled to a fixed or floating
dividend payment.
◦ Preferred shares have preference as to assets and
dividends over common shares. However, preferred shares
rank lower than creditors and debtholders.
◦ Risks of investing in preferred shares include interest rate
risk, credit risk, call risk, extension risk, and liquidity risk.
4. Differentiate among the various market transactions that
investors can undertake in the equities market.
◦ Underwriters aid firms in bringing new securities to market.
Once issued, securities trade on exchanges or over the
counter.
◦ Different types of market transactions exist for different
purposes. The most common transaction is the purchase in
which an investor buys a security in the expectation of a
price increase. In some cases, investors expect prices to
fall. In that case, they may consider a short sale. In addition,
investors may buy securities on margin; that is, they may
borrow a percentage of the value of the investment.
◦ An investor would buy on margin with the expectation that
the price of the underlying securities will rise in price; an
investor would short sell securities with the expectation that
the share price will fall.
5. Compare and contrast the basic features and characteristics of
derivative securities and the various market transactions
investors can carry out in the derivatives markets.
◦ Derivative securities include calls and puts, and futures
contracts.
◦ Puts and calls are exchange-traded options giving the owner
the option to buy (for calls) or to sell (for puts) a number of
shares at a fixed price (the exercise or strike price) at any
time prior to the option’s expiration date.
◦ Futures are contracts that are negotiated to buy or sell
commodities, stock indices or bonds at some future date but
at currently negotiated prices.
◦ All derivatives provide the possibility of leveraged gains and
losses.
◦ M utual fund managers are allowed to incorporate derivatives
as part of their portfolios under certain conditions. The most
prominent applications of derivatives among mutual fund
managers are to hedge against risk and to facilitate market
entry and exit. They are not allowed to use derivatives to
speculate.
REVIEW QUESTIONS

Constructing
8
Investment Portfolios
CONTENT AREAS
What is Risk and Return?
What are the Impacts of Economic Conditions in Comparing

Returns?
How to Calculate a Return
How to Measure Risk
What is Portfolio Analysis?
How are Portfolios Managed?
What are the Methods of Analysis?
LEARNING OBJECTIVES
1 | Describe the basic concepts of return and risk and

explain how they are used to evaluate the risk profile of
mutual fund investments.
2 | Define inflation and purchasing power and the role
taxation plays when comparing the risk and return of
securities.
3 | Calculate the return on a security.
4 | Calculate the risk of a security.
5 | Define portfolio analysis and explain the role of

diversification, describe the concept of correlation, and
describe the tool used to measure risk in a portfolio.
6 | Describe the concept of efficient markets and how

strategic asset allocation is used to determine
an optimal portfolio mix.
7 | Describe how fundamental analysis and technical

analysis are used in the selection of securities.
KEY TERMS

active portfolio management
alpha
arithmetic mean
asset allocation
average
beta
correlation
diversification
dividend tax credit
duration
efficient
fundamental analysis
geometric mean
holding period return
inflation
insider trading
investment portfolio
market risk
market timing
mean
nominal return
passive portfolio management
perfect negative correlation
perfect positive correlation
portfolio manager
purchasing power
real rate of return
return
risk
risk profile
sector weighting
security analysis
standard deviation
strategic asset allocation
systematic risk
technical analysis
variance
volatility
INTRODUCTION
No perfect security exists that meets all the needs of all investors.
If such a security existed, there would be no need for investment
and portfolio management, and no need to measure the return and
risk of an investment. Portfolio managers spend a great deal of
time selecting individual securities, allocating investment funds
among security classes, and managing risks and returns.
Recognizing that there are no perfect securities, we need to look
at the different measures and methods to estimate risk and predict
return. Based on these results, we can then see how portfolios are
constructed to fit the particular needs and circumstances of
individual investors. Building portfolios that correlate to specific
client needs is key to being successful. Generating the highest
returns is not enough; higher returns that require exposure to risky
investments may not be appropriate for you and your clients. The
most fundamental concepts in investing are return and risk. Returns
are why individuals invest. But returns are never entirely
guaranteed. They are always subject to some kind of risk. This
chapter covers the different ways to measure these factors.
So far in the text, when we have discussed the risk and return
characteristics of securities, we have looked at them as “stand-
alone” investments. That is, we have not been concerned with the
impact that grouping different securities together might have on the
risk and return characteristics of the whole package.
In fact, when we construct portfolios of securities into a mutual
fund, the portfolio behaves far differently in terms of risk and return
than the individual securities might suggest that it should. For
example, although bond investments are considered to be less
risky than common stock investments, a portfolio combining both
bonds and common stocks can be less risky than the bond
investments alone. Note that this critically important result is more
than just the idea that you can reduce risk by not having “all of your
eggs in one basket.” One of our goals of this chapter is to explain
why this risk reduction occurs. The other goal is to explain the
different techniques that investors, and professional portfolio
managers, might use in their attempts to obtain the best returns for
the lowest overall level of risk. This will lead us to a discussion of
how securities are selected and how the portfolio, once
constructed, is managed on a day-to-day basis.
WHAT IS RISK AND RETURN?
Risk and return are interrelated. To earn higher returns investors
must usually choose investments with higher risk.
Given a choice between two investments with the same amount
of risk, a rational investor would always take the security with
the higher return. Given two investments with the same
expected return, the investor would always choose the security
with the lower risk.
Each investor has a different risk profile. This means that not all
investors choose the same low-risk security. Some investors are
willing to take on more risk than others are, if they believe there is
a higher potential for returns.
In general, risk can have several different meanings. To some, risk
is losing money on an investment. To others, it may be the
prospect of losing purchasing power if the return on the
investments does not keep up with inflation.
Given that all investors do not have the same risk profile, different
securities and different funds have evolved to service each market
niche. Guaranteed investment certificates (GICs) were developed
for those seeking safety, fixed-income funds were developed for
those seeking income, while equity funds were developed for
those seeking growth or capital appreciation.
Few individuals would invest all of their funds in a single security.
The creation of a portfolio allows the investor to diversify and
reduce risk to a suitable level.
Consider the following possible investments and the types of
return generated:
• An investor who buys Government of Canada bonds expects
to earn interest income (cash flow).
• An investor in common shares expects to see the stock grow
in value (capital gain) and may also be rewarded with dividends
(cash flow).
Returns are rarely guaranteed and that is why returns are often
called “expected returns.”
While an investment may be purchased in anticipation of a rise in
value, the reality is that values can decline. A decline in the value
of a security is often referred to as a capital loss. Therefore, returns
can be reduced to some sort of combination of cash flows and
capital gains or losses.
The following formula defines the expected return of a single
security:
Expected Return
Expected Return =
Where:
Expected Cash Flow = Expected dividends, interest, or any
other type of income
Expected Capital Gain/Loss = Expected Ending Value –
Beginning Value
Beginning Value = The initial dollar amount invested by the
investor
Expected Ending Value = The expected dollar amount the
investment is sold for
PUTTING RISK AND RETURN INTO

PRACTICE
Higher risk must be compensated for by the hope of a higher return
because investors, on average, avoid taking on risk. In most
cases, when investment professionals talk about risk they are
referring to volatility. Compare, for example, Figures 8.1 and 8.2.
Figure 8.1 shows stability in the annual return generated on a
hypothetical money market fund over the past 15-year period. The
return varies little from year to year, with an average annual return
of 4.6%. Stability is the opposite of volatility.
Figure 8.1 | Returns on a Hypothetical Money Market Fund
Figure 8.2, in contrast, shows an average annual return of 10.4%

on a hypothetical equity mutual fund during the same 15-year
period. This is a higher average annual return than in Figure 8.1, but
the returns are highly volatile from year to year.
During Year 3, for example, this investment produced a 45% return.
If you had invested $10,000 at the beginning of Year 3, you would
have had $14,500 at the end of the year. We can find this amount
using the following calculation:
If you had invested $10,000 at the beginning of Year 6, however,

you would have lost 35%, reducing your capital to $6,500. We can
find this amount using the same calculation from above:
Figure 8.2 | Returns on a Hypothetical Equity Mutual Fund
As you can see, the risk profile of the second investment, the
equity mutual fund, is different from that of the money market fund.
Using volatility as the measure of risk, you could state that the
second investment has been riskier than the first. Assuming this
historical pattern continues into the future, you could conclude that
the second investment is the riskier one.
Consider the case of a client with a three-year investment horizon
and $10,000 to invest. Assume that his choices are a money
market fund, a bond fund, and an equity fund. Table 8.1 represents
the risk/return profile of the money market fund presented in
Figure 8.1, assuming the investor bought the money market mutual
fund investment at the beginning of the year and held it for a three-
year period until the end of the third year.
Table 8.1 | Annual Returns on the Money Market Fund from

Figure 8.1
Year Return
Year 1 3.3%
Year 2 3.7%
Year 3 4.3%
If the client had invested the $10,000 at the beginning of Year 1,

the investment would have been worth $11,172.84 by the end of
Year 3. Table 8.2 shows how this result was obtained by calculating
the ending value of the investment for each year and then adding
the next year’s return.
Table 8.2 | Three-Year Returns on the Money Market Fund
Year Value Jan. 1 Add Amount to add Value Dec. 31
Year $10,000.00 3.3% $330.00 $10,330.00

1
Year $10,330.00 3.7% $382.21 $10,712.21

2
Year $10,712.21 4.3% $460.63 $11,172.84

3
In contrast, Table 8.3 represents the risk/return profile of the equity

mutual fund from Figure 8.2 for the same three-year period.
Table 8.3 | Annual Returns on the Equity Mutual Fund from

Figure 8.2
Year Return
Year 1 +20%
Year 2 +30%
Year 3 +35%
M aking the same basic calculations as before, we find that the

investor’s $10,000 investment at the beginning of Year 1 would
have been worth $21,060 by the end of Year 3, as shown in
Table 8.4.
Table 8.4 | Three-Year Returns on the Equity Mutual Fund
Year Value Jan. Add/Subtract Amount to Value Dec.

1 add 31
Year $10,000 +20% $2,000 $12,000

1
Year $12,000 +30% $3,600 $15,600

2
Year $15,600 +35% $5,460 $21,060

3
The fundamental issue here is that risky investments offer the

hope of higher returns, but over short periods (or horizons),
volatility can work for or against a client’s interests. A longer
investment time horizon, such as a six-year period, would have
yielded different results. If the client had invested in the money
market fund in Year 10, for example, and held that investment
through to the end of Year 15, the investment would have been
worth $12,615.90, as calculated in Table 8.5.
Table 8.5 | Six-Year Returns on the Money Market Fund
Year Value Jan. Add Amount to Value Dec.

1 add 31
Year $10,000.00 4.7% $470.00 $10,470.00
10
Year $10,470.00 4.2% $439.74 $10,909.74

11
Year $10,909.74 3.5% $381.84 $11,291.58

12
Year $11,291.58 3.3% $372.62 $11,664.20

13
Year $11,664.20 3.7% $431.58 $12,095.78

14
Year $12,095.78 4.3% $520.12 $12,615.90

15
In contrast, if the client had invested in the equity fund and held
that investment over the same period, he would have done even
better than with the money market fund. His equity fund investment
would have been worth $13,562.64 by the end of Year 15, as
shown in Table 8.6.
Table 8.6 | Six-Year Returns on the Equity Fund
Year Value Jan. Add/Subtract Amount to Value

1 Add/Subtract Dec. 31
Year $10,000.00 -20% $(2,000.00) $8,000.00

10
Year $8,000.00 -30% $(2,400.00) $5,600.00

11
Year $5,600.00 +15% $840.00 $6,440.00

12
Year $6,440.00 +20% $1,288.00 $7,728.00
13
Year $7,728.00 +30% $2,318.40 $10,046.40

14
Year $10,046.40 +35% $3,516.24 $13,562.64

15
Note that despite losing 36% of his original investment in the first
three years, the investor improved his position a great deal by
holding his investment in the riskier equity fund for a longer time. A
few more good years would have yielded an even better
performance for the equity fund in comparison to the money market
fund.
The future is unpredictable, however. Because equity funds are
riskier than money market funds, the equity fund should do better
than the money market fund over the longer term, but not
necessarily over the short term.
WHAT ARE THE IMPACTS OF ECONOMIC

CONDITIONS IN COMPARING RETURNS?
Over the last 50 years, bonds have shown much greater return
volatility than T-bills, which means they have been a riskier
investment than T-bills. On average, however, bond returns have
been higher than T-bill returns, compensating for that risk. This is
not always the case. Expectation of higher returns based on risk
may not result in higher returns, even over the long-term. Equities,
in turn, are even more volatile than bonds. Correspondingly, the
average return for equities is higher than the average annual return
on bonds.
Thus, of the three basic securities, T-bills are intrinsically the least
risky, long-term bonds are riskier but historically have compensated
investors for that additional risk, and equities are the riskiest and
also have provided some risk compensation. In all three, however,
expected returns and realized returns may not coincide. For one
thing, extrinsic factors in the wider economy also have an impact
on returns. Those economic factors include inflation and taxation.
INFLATION
Inflation is a generalized, sustained trend of rising prices. When
prices are rising, money begins to lose its value—that is, more and
more money is needed to buy the same amount of goods and
services. Overall, inflation and rising prices have a negative effect
on living standards.
Inflation has averaged about 4.2% per year in Canada over the
past 50 years. However, inflation has not been much of a problem
in Canada over the last two decades; in fact Canada’s inflation rate
has been less than 3% for much of the past twenty years.
It is important to consider the effects of inflation on investments
because we can isolate the difference between nominal and real
returns. Investors are more concerned with the real rate of return
—the return adjusted for the effects of inflation. A nominal return is
a return that has not been adjusted for the impact of inflation.
The approximate real rate of return is calculated as:
Real Return = Nominal Rate – Annual Inflation Rate
Example: A client earned a nominal return of about 3% on a T-
bill last year when inflation was measured at 2%. Adjusting the
nominal return for the inflation rate yields a real return of about
1% on the T-bills.
For you and your clients, the significance of adjusting for inflation is
that the value of real returns determines purchasing power.
PURCHASING POWER
Purchasing power is the ability to buy goods and services. What
real return is required to maintain the purchasing power of an
investment? An investment’s purchasing power is maintained when
a dollar put aside in an earlier year can still buy the same amount of
goods today. Purchasing power is maintained when your dollar
grows (or generates a nominal return) at a rate that is at least
equal to the rate of inflation. Thus, if inflation is 5% and your
nominal return is 5%, then you will just maintain purchasing power.
Adjusting that 5% nominal return to reflect the 5% inflation rate
means that a real return of 0% is needed to maintain
purchasing power.
You may be asking yourself what value does a real return of 0%
offer? The answer is not much from an investing perspective. The
difference between just keeping up with inflation and generating
positive real returns represents an increase in the investor’s
wealth. Increasing wealth is the goal of investing and that usually
means accepting higher investment risk.
TAXATION
The examples so far have not taken tax into consideration. In most
cases, however, you must pay annual taxes on investment returns.
The tax rate to be paid on investment income depends on the type
of income generated. The three types are interest income, dividend
income, and capital gains.
Type of Investment Sources of Income

Income
Interest Income Treasury bills, bonds, money market

mutual funds
Dividend Income Common and preferred shares

Capital Gains Selling an investment for more than the
price paid
You will pay a different tax rate on income from each of these
sources.
Of the three investment income sources, interest income is the
most highly taxed, because it is taxed at the same rate as income
from employment. Dividend income, so long as it comes from
taxable Canadian corporations, receives the benefit of a tax
reduction known as the Dividend Tax Credit (discussed in
Chapter 6). This credit results in a lower tax rate on dividend
income than on interest income. Capital gains are taxed at a
different rate; only 50% of capital gains are taxed at the ordinary
income rate.
Thus, you and your clients should always be concerned with after-
tax returns.
HOW TO CALCULATE A RETURN
RATE OF RETURN ON A SINGLE SECURITY

Returns from an investment can be measured in absolute dollars.
An investor may state that she made $100 or lost $20.
Unfortunately, using absolute numbers obscures their significance.
Was the $100 gain made on an investment of $1,000 or an
investment of $100,000? In the first example the gain may be
significant, while in the latter it could signal a poor investment
choice.
The more common practice is to express returns as a percentage
or as a rate of return or yield. Within the investment community it is
more common to hear that “a fund earned 8%” or “a stock fell 2%.”
To convert a dollar amount to a percentage, the usual practice is to
divide the total dollar returns by the amount invested.
Rate of Return on an Individual Stock Example
1. If you purchased a stock for $10 and sold it one year later for
$12, what would be your rate of return?
2. If you purchased a stock for $20 and sold it one year later for
$22, and during this period you received $1 in dividends, what
would be your rate of return?
3. If you purchased a stock for $10, received $2 in dividends, but

sold it one year later for only $9, what would be your rate of
return?
The above examples illustrate that cash flow and capital gains or
losses are used in calculating a rate of return. It should also be
noted that all of the above trading periods were set for one year,
and hence the percent return can also be called the annual rate of
return. If the transaction period were for longer or shorter than a
year, the return would be called the holding period return.
Over time, individual holding period returns fluctuate; in some
periods they may be high, while in others they may be low. These
fluctuations can make it hard to compare the returns on different
investments, because it might not be easy to determine which
security or portfolio had the better overall return over the entire
period. One of the most widely used methods to compare the
returns on two investments over many holding periods is to
calculate an average or mean of the holding period returns.
There are two different ways to calculate a mean return: the
arithmetic mean and the geometric mean.
The arithmetic mean is easy to calculate. It is simply the sum of the
individual holding period returns divided by the number of holding
period returns. If, for example, you want to calculate the most
recent five-year arithmetic mean of a mutual fund, simply add up the
fund’s annual returns for the last five years and divide by 5. The
following equation can be used to calculate the arithmetic mean
return.
Where:
AMRi = the arithmetic mean return on security or portfolio i
Ri,t = the holding period return on security or portfolio i for period t
T = the number of holding period returns
The geometric mean calculates the average compound return over
several time periods. It is used to determine the periodic increase
or decrease in wealth from an investment in a security or portfolio
of securities. The following equation can be used to calculate the
geometric mean return.
Where:
GMRi = the geometric mean return on security or portfolio i
Ri,t = the holding period return on security or portfolio i for period t
We will use annual return data for two hypothetical mutual funds
(see Table 8.7) to provide examples of how the arithmetic and
geometric means are calculated.
Table 8.7 | Return Data for Two Mutual Funds

Year Trinity Canadian Alpha Canadian
Equity Fund Return Equity Fund Return
1 49.36% 18.01%
2 15.67% 15.15%
3 –7.17% 4.83%
4 –8.78% –3.68%
5 26.51% 17.93%
At the end of the fifth year, the five-year arithmetic mean return for
each fund is as follows:
At the end of the fifth year, the five-year geometric mean return,
also known as the five-year compound annual return, for each fund
is as follows:
As the previous calculations show, the arithmetic mean and
geometric mean of a security are different, even though they are
based on the same holding period returns. The arithmetic mean will
always be greater than the geometric mean, unless the sub-period
returns are identical, in which case the arithmetic and geometric
means will be the same.
For instance, if a security had a 5% annual return every year for the
past five years, then the arithmetic and geometric means would
both equal 5%. In general, the more volatile the sub-period returns,
the greater the difference between the arithmetic and geometric
means. This can be seen by looking at the returns in Table 8.7.
The geometric mean is the best measure of the historical
performance of a security, because it measures the actual change
in wealth that would have resulted from an investment in that
security. For example, if an investor had bought $1,000 worth of the
Trinity fund at the beginning of the first year and had held it until the
end of fifth year, the investment would have averaged a return of
13.10% per year, growing from $1,000 to $1,850.60 during the
five year period.
Case Study | Compounding Confusion: Helping Investors
Understand Geometric Mean Returns
(for information purposes only)
M ichael is meeting with his client, Paul Parker, to discuss his most
recent investment statement. Paul made a $20,000 investment into
the XYZ U.S. Large Cap Equity Fund (XYZ) five-years ago. Over
that time, Paul experienced a tremendous amount of volatility, as
the U.S. equity markets suffered through the financial crisis
downturn and then moved sharply higher as the markets at first
stabilized then rebounded. Paul was deeply concerned when his
investment in the XYZ fund fell sharply in the first few years. He
realized he did not do so bad on the investment after adding up the
fund’s annual calendar returns and dividing by five, ending up with
an average of 4.8% per year. When he received his most recent
statement, he was surprised to learn that the return he actually
made was lower than the return he calculated himself. He wants to
better understand from M ichael how his investment returns are
calculated.
M ichael explained to Paul that he had used a method called the
arithmetic mean return, and this method of calculating return does
not reflect the average compound return. He also explained that
historical returns are best calculated using the geometric mean
return method, as straight arithmetic mean returns like Paul used
will always be higher than the realized average return.
Here is what M ichael explained to Paul:
You took XYZ’s annual return in each of the last five years:
Year 1: –23%
Year 2: –9%
Year 3: +7%
Year 4: +18%
Year 5: +31%
You added the five single returns and divided by 5 to get the
average.
Based on Paul’s calculations, the fund averaged 4.8% per year

over the five-year period.
M ichael shows Paul how his five-year return was calculated for his
statement:
The fund’s end value was $23,179.24 after 5 years, and the fund
averaged 2.99% over the five-year period.
If we calculate the return on a yearly basis, we get the following
result after five years:
Beginning Return End
Year 1 $20,000.00 –23% $15,400.00
Year 2 $15,400.00 –9% $14,014.00
Year 3 $14,014.00 7% $14,994.98
Year 4 $14,994.98 18% $17,694.08
Year 5 $17,694.08 31% $23,179.24
If we calculate the return using the geometric mean of 2.99%, we
get the same results:
Beginning Geometric mean Return* End
Year 1 $20,000.00 2.99% $20,598.89
Year 2 $20,598.00 2.99% $21,215.72
Year 3 $21,213.88 2.99% $21,851.01
Year 4 $21,848.18 2.99% $22,505.33
Year 5 $22,501.44 2.99% $23,179.24
* the geometric mean has been rounded up to two decimals in the table but the
calculations take into account 2.994454%
M ichael explained to Paul that the result is not exact with the
arithmetic mean. The geometric mean shows the accurate
measure of the historical performance of a security.
RATE OF RETURN ON A PORTFOLIO

The expected rate of return on a portfolio is calculated in a slightly
different manner from the rate of return of a single security. Since
the portfolio contains a number of securities, the return generated
by each security has to be calculated.
Portfolio Returns
The return on a portfolio is calculated as the weighted average
return on the securities held in the portfolio. The formula is as
follows:
Expected Return = R1(W1) + R2(W2) +…+ Rn(Wn)
Where:
R = The expected return on a particular security
W = The proportion (weight or %) of the security held in the
portfolio based on the dollar investment
n = The number of securities in the portfolio
The following example illustrates:
Rate of a Return on a Portfolio
A client invests $100 in two securities: $60 in ABC Co. and $40 in
DEF Co.
The expected return from ABC Co. is 15% and the expected return
from DEF Co. is 12%. To calculate the expected return of the
portfolio, an advisor or investor would look at the rate expected to
be generated by each proportional investment.
Since the total amount invested was $100, ABC Co. represents
60% ($60 ÷ $100) of the portfolio and DEF Co. represents 40%
($40 ÷ $100) of the portfolio. If ABC Co. earns a return of 15% and
DEF Co. earns 12%, the expected return on the portfolio is:
Expected return = (0.15 × 0.60) + (0.12 × 0.40)
= 0.09 + 0.048
= 0.138 (or 13.8%)
This is a good example of how mutual funds calculate the return on
their funds.
HOW TO MEASURE RISK

Although there are many types of risk, risk generally is
synonymous with volatility—the idea that the return on an
investment may be unpredictable: high during one period and low
during another. Every investor’s dream is to be able to get a high
return without incurring any risk. The reality, however, is that risk
and return are directly related. To earn higher returns, investors
usually must select investments that carry higher risk.
As noted earlier in this chapter, given a choice between two
investments with the same amount of risk, a rational investor would
always take the security with the higher return. Given two
investments with the same expected return, the investor would
always choose the security with the lower risk.
MEASURES OF PRICE VOLATILITY OF
EQUITIES
All equities bear risk and this risk can be assessed and measured
with tools developed over time. The three common measures of
risk are variance, standard deviation and beta.
Variance measures the extent to which the possible realized
returns differ from the expected return or the mean. The more likely
it is that the return will not be the same as the expected return, the
riskier the security. When an investor purchases a T-bill, the return
is predictable. The return cannot change as long as the investor
holds the T-bill until maturity.
With other securities (e.g., equities), the outcomes are more
varied. The price could increase, stay the same or decrease. The
greater the number of possible outcomes, the greater the risk that
the outcome will not be favourable. The greater the distance
estimated between the expected return and the possible returns,
the greater the variance. The risk of a portfolio is determined by the
risk of the various securities within that portfolio.
Standard deviation is the measure of risk commonly applied to
portfolios and to individual securities within that portfolio. Standard
deviation is the square root of the variance. The past performance
or historical returns of securities is used to determine a range of
possible future outcomes. The more volatile the price of a security
has been in the past, the larger the range of possible future
outcomes.
The standard deviation, expressed as a percentage, gives the
investor an indication of the risk associated with an individual
security or a portfolio. The greater the standard deviation, the larger
the likely range of possible future outcomes, and therefore the
greater the risk.
EXAMPLE
Comparing Standard Deviation
You are considering an investment in the ABC Equity Fund or
the DEF Equity.
Fund Average 5- Standard Probable Range of

Year Return Deviation Returns
ABC 12% 10% 2% or 22%

Equity
DEF 12% 4% 8% or 16%

Equity
Although both funds have reported the same average return

over the past five years, the DEF fund has a lower standard
deviation in returns. Thus, DEF is considered less risky than
ABC.
To simplify the calculations, we can find the probable range of
returns as follows:
Average Return + Standard deviation = Positive outcome
Average Return – Standard deviation = Negative outcome
Though the returns for either fund can be higher or lower than
the range indicated by the standard deviation, the probable
range of returns for ABC Fund stands between 22% (12% +
10%) and 2% (12% – 10%). The same method is used to find
the probable range on the DEF Fund.
DEF has a narrower probable range of returns; or we can say
that the DEF fund is less risky than the ABC fund.
All other factors being equal (e.g., the economy stays the same,
the fund managers are not replaced, the stock market continues
its current trend, interest rates remain stable, and so on), both
mutual funds could be expected to earn an average annual
return of 12%. But in any given year the fund with the higher
standard deviation could fluctuate much more widely, making it
less attractive as an investment, even over the long-term.
Beta is another statistical measure that links the risk of individual

equity securities or a portfolio of equities to the market as a whole.
The risk that remains after diversifying is market risk. Beta is
important because it measures the degree to which individual
equity securities or a portfolio of equities tend to move up and
down with the market. A higher beta means that the portfolio is
exposed to more risk. The general convention is that the market
has a beta of 1.0. All portfolios can be viewed in terms of how
volatile they are in relation to a market beta of 1.0.
EXAMPLE
The ABC Equity Fund has a beta of 1.5, which means the Fund
is expected to be 1.5 times more volatile than the market as a
whole. If the S&P/TSX Composite Index is used to measure the
performance of the ABC Fund, then if the Index rose by 10%
you would expect to see the ABC Fund rise by 15%
(1.5 × 10%). Similarly, if the S&P/TSX should fall by 20%, then
the Fund should fall by 30% (1.5 × 20%).
The higher the beta, the greater the risk.
MEASURES OF PRICE VOLATILITY OF

BONDS
M easuring the price volatility (or the risk) of bonds and portfolios of
bonds is different than equities. Changes in interest rates represent
one of the main risks faced by investors when holding fixed-income
securities. We already discussed the following relationships:
• The value of a bond changes in the opposite direction to
changes in interest rates—i.e., as interest rates rise, bond
prices fall and as interest rates fall, bond prices rise.
For two bonds with the same term to maturity and the same
•
yield, the bond with the higher coupon is usually less volatile in
price than the bond with the lower coupon.
• For two bonds with the same coupon rate and same yield, the
bond with the longer term to maturity is usually more volatile in
price than the bond with the shorter term to maturity.
As we have seen, it is fairly easy to compare bonds with the same
term to maturity or the same coupon, but how do we compare
bonds with different coupon rates and different terms to maturity?
For example, how can we determine whether a bond with a high
coupon and a long term will be more or less volatile than a bond
with a lower coupon and a shorter term?
A given change in interest rates will impact the price of bonds with
different features, coupons, maturities, protective covenants, etc.
differently. For bondholders, being able to determine the impact of
interest rate changes on bond prices will lead to better investment
decisions.
Fortunately, a calculation exists called duration, which combines
both the impact of the coupon rate and the term to maturity into
one calculation.
Duration is a measure of the sensitivity of a bond’s price to
changes in interest rates. It is defined as the approximate
percentage change in the price or value of a bond for a 1% change
in interest rates. The higher the duration of the bond, the more it
will react to a change in interest rates. Duration is simply an
investment tool that helps investors determine the volatility or
riskiness of a bond or a bond fund – i.e., how much the price of the
bond will move up or down with changes in interest rates. In this
way, a single duration figure for each bond or bond fund can be
compared directly with the duration of every other bond or bond
fund.
Consider a bond with a duration of 10. According to our definition,
the price of this bond will change by approximately 10% for each
1% change in interest rates. Let’s assume that the bond is
currently priced at 105. If interest rates rise by 1% then the price of
the bond will fall by approximately 10% to 94.50. This is calculated
as 105 – (10% × 105).
Since a higher duration translates into a higher percentage price
change for a given change in yield, an investor will realize the
greatest return from an expected decline in interest rates by
investing in bonds with a higher duration. If he does this and
interest rates do fall, he will earn a greater return than if he had
invested in bonds with lower duration. The same is true when
interest rates are expected to rise. To protect a bond portfolio from
a dramatic decline due to an interest rate increase, investors
should invest in bonds with low duration.
We are not constrained to 1% interest rate changes. As long as
the duration of the bond is known, the effect of any range of
interest rate changes can be determined. For example, for a 50-
basis-point or 0.5% change in interest rates, the approximate price
change on our bond with a duration of 10 is 5% (10 × 0.5%); for a
0.25% change in interest rates, the approximate price change on
the bond is 2.5% (10 × 0.25%) etc.
Table 8.8 shows the impact interest rate changes have on bonds
with different durations. As the table shows, the same interest
change of 1% has a greater impact on the price of Bond A
compared with the price change on Bond B.
Table 8.8 | Impact of an Interest Rate Change on Bonds with

Different Durations
Bond A Bond B
Duration = 10 Duration = 5
Both Bond A and Bond B $1,000 $1,000

are priced at
Interest rates rise by 1% $900 $950

• the price of Bond A falls
by 10%
• the price of Bond B falls
by 5%
Interest rates fall by 1% $1,100 $1,050

• the price of Bond A rises
by 10%
• the price of Bond B rises
by 5%
Calculation of a bond’s duration is complicated. M oreover, a bond’s

duration can change over longer holding periods and larger interest
rate swings. Therefore, we have not shown its calculation here.
The duration of bond funds is generally provided by the mutual fund
itself. This is an important measure of volatility that must be taken
into consideration when recommending a bond fund for clients.
As you have seen, securities differ in the returns they are
expected to produce and the risks they present to investors. The
investment features of different securities contribute to differences
in their risk/return profiles. Fixed-income securities, for example,
have different features than equity securities and derivatives.
Figure 8.3 shows how asset classes are positioned in relation to
risk and return.
Figure 8.3 | Risk and Return Relationship

WHAT IS PORTFOLIO ANALYSIS?
An investment portfolio, such as a mutual fund, is simply a
collection of different securities. Securities may be of the same
class, such as a bond portfolio or a common equity portfolio. A
portfolio may also consist of securities of many different classes,
including bonds, stocks and money market securities. Some
portfolios even include derivative securities, such as options and
futures. The fundamental characteristic of an investment portfolio is
that it is a diversified collection of securities.
DIVERSIFICATION AND RISK

Diversification refers to the spreading of investment risk by buying
different types of securities in different companies in different kinds
of businesses and or locations. Portfolios have different degrees of
diversification based on the number of securities, the types of
security, and the industries or countries the securities come from.
Overall, the greater the diversification, the lower the portfolio risk.
EXAMPLE
By investing in securities in more than one industry you avoid

exposure to the risk that any one industry will decline. If you
hold a diversified portfolio from many different countries, you
avoid exposure to the risk of a decline in your home economy.
Portfolios can be diversified in a great many ways.
The important point to recognize is that if you placed all of your

savings or investments in a single security, your entire portfolio is
at risk. However, no matter how well diversified a portfolio is, there
will always remain some amount of risk that cannot be removed.
The risk that cannot be eliminated or reduced by diversification is
called market risk, or systematic risk.
M arket risk is defined as the variability of a stock or a portfolio in
relation to the market as a whole. The process of diversification
cancels out much firm-specific risk, so market risk is less than the
total risk you would calculate if you looked at each stock
separately. M arket risk is also referred to as systematic risk and
arises from such things as inflation, the business cycle, and
interest rates.
Another reason for diversifying is that different classes of
securities, such as bonds and stocks, tend to exhibit different
patterns of returns. Although some of these risks can be eliminated
through diversification, the selection of securities within a portfolio
must be done carefully in order to maximize returns while reducing
risk. Combining any two securities may not diversify the portfolio if
the risk characteristics of the two securities are extremely similar.
This concept of combining securities for maximum benefit is
measured by the correlation between securities.
COMBINING SECURITIES IN A PORTFOLIO
This section brings together the concepts of risk and return.
Portfolio management recognizes the fact that while future returns
are usually beyond the control of an individual or fund manager, risk
to a certain extent can be managed.
Portfolio management stresses the selection of securities for
inclusion in the portfolio based on the securities’ contribution to the
portfolio as a whole. This suggests some synergy or some
interaction among the securities that results in the total portfolio
being somewhat more than the sum of the parts.
If investors place all of their savings in a single security their entire
portfolio is at risk. If the investment consists of a single equity
security, the investment is subject to business risk and market risk.
Alternatively, if all of the investor’s funds are invested in a single
debt security, the investment is subject to default risk and interest
rate risk.
Some of these risks can be eliminated or reduced through
diversification. However, diversification must be done carefully and
the methodology for combining securities must be understood.
Combining any two securities may not diversify the portfolio if the
risk characteristics of the two securities are extremely similar.
CORRELATION
Correlation is the statistical measure of how the returns on two
securities move together over time and, therefore, how a change
to the value of one security can predict the change in value of
another. From a portfolio perspective, we are interested in the way
securities relate to each other when they are added to a portfolio,
and to how the resulting combination affects the portfolio’s total risk
and return.. To illustrate the concept, consider the following:
• An investor takes all of her savings and invests 100% of those
savings in a gold mining stock. If the price of gold rises, the
company does well and the client makes money. If the price of
gold declines, the gold mining company does not do well and
the investor loses money. In order to reduce this risk, the
investor diversifies into another stock, which happens to be
another gold mining company. Has the investor’s portfolio been
diversified?
• The investor’s advisor points out that the portfolio has not
been adequately diversified.
It is clear that the securities in the portfolio are linked – their value
is tied to the fortunes of gold. The portfolio thus has a high
correlation with the fortunes of gold. In fact:
• If the stock prices of the two gold mining companies move in
the same direction and in the same proportion each time, they
would have a perfect positive correlation, which is denoted as a
correlation of +1.
• The investor does not reduce his or her risk by adding
securities that are perfectly correlated with each other.
• Therefore, holding securities with perfect positive correlation
does not reduce the overall risk of the portfolio.
What if the stock prices of two companies moved in opposite
directions? Consider the following example:
• An investor creates a portfolio of two securities – an airline
company stock and a bus company stock. In good economic
times people fly, but in bad economic times they save money
by taking the bus. In good times, the investor’s airline company
shares increase in value. In bad times, the airline stock
declines but the loss is offset by an increase in the price of bus
company shares.
• Since the stock prices move in the opposite direction and in the
same proportion each time (when one rises, the other falls), the
investor earns a positive return with little risk (there is always
the possibility of market risk). These securities have a perfect
negative correlation, denoted as –1.
With perfect negative correlation, there is no variability in the
total returns for the two assets – thus, no risk for the portfolio.
Therefore, the maximum gain from diversification is achieved when
securities held within the portfolio exhibit perfect negative
correlation. In reality, however, it is very difficult to find securities
with such a high level of negative correlation.
Research shows that adding poorly correlated securities to a
portfolio does in fact reduce risk. However, each additional security
reduces risk at a lower rate. Since the securities in the portfolio are
still positively correlated to some degree, the equity portfolio is left
with one risk that cannot be eliminated – systematic or market risk.
Figure 8.4 shows how risk is reduced by adding securities to an
equity portfolio.
Figure 8.4 | Risk in an Equity Portfolio
The total risk of the portfolio falls quite significantly as the first few
stocks are added. As the number of stocks increases, however,
the additional reduction in risk declines. Finally, a point is reached
where a further reduction in risk through diversification cannot be
achieved. Therefore, the main source of uncertainty for an investor
with a diversified portfolio is the impact of systematic risk on
portfolio return.
PORTFOLIO BETA
As explained, the beta or beta coefficient relates the volatility of a
single equity or equity portfolio to the volatility of the stock market
as a whole. Specifically, beta measures that part of the fluctuation
in returns driven by changes in the stock market. Volatility in this
context is a way of describing the changes in returns over a long-
time frame. The wider the range in market returns, the greater the
volatility and the greater the risk.
Any equity or equity portfolio that moves up or down to the same
degree as the stock market has a beta of 1.0. Any security or
portfolio that moves up or down more than the market has a beta
greater than 1.0, and a security that moves less than the market
has a beta of less than 1.0.
• If the S&P/TSX Composite Index rose 10%, an equity fund with
a beta of 1.0 could be expected to advance by 10%.
• If the Index fell by 5%, the equity fund with a beta of 1.0 would
fall by 5%.
• If an equity portfolio had a beta of 1.30, it would be expected to
rise 13% (1.3 times the index variation, or 1.3 × 10%) when the
Index rose 10%.
• An equity portfolio with a beta of 0.80 would be expected to
rise only 8% when the Index rose 10%.
M ost portfolio betas indicate a positive correlation between
equities and the stock market. Industries with volatile earnings,
typically cyclical industries, tend to have higher betas than the
market.
Defensive industries tend to have betas that are less than the
market, that is, less than 1. This implies that when the market is
falling in price, defensive stocks would normally fall relatively less
and cyclical stocks relatively more.
Simplistically, it could be stated that in a rising market it is better to
have high beta stocks and in a falling market it is better to have
defensive, low beta stocks. However, this is an over-generalization
and presumes that history repeats itself.
PORTFOLIO ALPHA
Quite often, equity portfolios outperform the market and move more
than would be expected from their beta. The additional movement
is due to the advisor’s or fund manager’s skill in picking those
securities that will outperform. This is known as alpha – the excess
return earned on the portfolio.
RISK AND RETURN
How does the mix of securities in a portfolio affect both the

risk and return of the portfolio? Complete the online learning
HOW ARE PORTFOLIOS MANAGED?

The initial construction of an investment portfolio is the first step.
The manager then must decide what changes should be made to
the portfolio. This means deciding what individual securities to sell
and buy and what sector weightings to use and the asset
allocation, based on changes in the economy. Portfolio managers
engage in this activity day-to-day using knowledge of the financial
marketplace and personal management style.
Some managers do not believe it is possible to “beat the market.”
They tend to hold well-diversified portfolios and avoid the
temptation of trying to pick individual stocks that might turn out to
be winners. Other managers believe the marketplace is full of
buying opportunities, with many undervalued stocks just waiting to
be discovered. Undervalued stocks offer the possibility of excess
returns: returns above those needed to compensate for risk.
The difference between these two management styles is really a
question of whether the portfolio manager believes that the
financial marketplace is efficient. If markets are efficient, then the
prices of stocks and other securities listed in the newspaper reflect
all the information that exists about them. If you buy those
securities, the best return you can hope for is compensation for
risk. If markets are less than efficient, however, then some prices
listed will not completely reflect all information. You might have
some favourable information that the market has not yet received
or digested. If so, you could buy a security at its current price, wait
for the market to catch on and bid up its price, and then sell the
security at the new price to make an excess return.
To beat the market like this, you would need some type of
advantage that other investors do not have. For example, you
could be unusually skillful in identifying undervalued securities.
Alternatively, you could have a friend in high places who provides
you with inside information of material significance that has not yet
been made public. However, this constitutes illegal insider trading
and this will expose you to legal action.
Nevertheless, if markets were completely efficient there would be
no justification for active portfolio management, which involves
seeking out information to find securities that are under- or over-
valued. Active managers try to outperform the market benchmarks
by changing the portfolio asset allocation, often using a strategy
called market timing.
In a market timing strategy, the manager tries to time the shift from
one class of security to another depending on anticipated changes
in the economy, the business cycle, industries, and companies. It is
the basic strategy of some balanced mutual funds. In theory,
market timing is easy. In practice, however, timers often change
their asset allocation either too early or too late.
If the manager believes markets are completely efficient, they
would simply invest in a stock market (or bond market) index. This
is the approach taken using passive portfolio management
where the portfolio manager does not try to earn excess returns.
Passive managers simply buy and hold an underlying stock or bond
index.
INVESTMENT OBJECTIVES
For professionally managed portfolios such as pension funds and
mutual funds, portfolio investment objectives are often stated in
terms of the types of return that the portfolio should generate. One
portfolio, for example, might have a goal of earning current income
only. Another might have the goal of earning some mixture of
capital gains, interest income and dividend income. Investors must
take greater risks to earn capital gains than dividend income, and
more risk to earn dividend income than interest income. As a result,
stating the types of return that the portfolio should earn is really a
statement about the risk level of the portfolio.
Portfolio investment objectives must eventually be translated into a
specific selection of individual securities, but this is not the most
important decision made by the portfolio manager. The single most
important decision, one that accounts for most of the success or
failure of a portfolio, is the asset allocation decision, which is the
selection of the classes of securities to be held and in what
proportion to hold them.
EXAMPLE
The manager of the XYZ Growth Fund has decided that an

asset mix of 5% cash, 10% high yield bonds, and 85% equities
is the optimal mix that will generate superior returns for the
portfolio.
The next most important decision is the selection of the specific

industries from which stocks will be selected: the portfolio’s sector
weighting. For example, the S&P/TSX Composite Index includes
11 industry sectors including energy, financials, technology, health
care, materials, utilities, and Telecommunications among others.
Selecting asset classes, asset allocations and sector weightings is
one way of developing an investment portfolio at an appropriate
level of risk. Another approach is developing a base policy asset
mix that the manager will follow over time to meet portfolio goals.
This approach is referred to as selecting the strategic asset
allocation.
STRATEGIC ASSET ALLOCATION

When a portfolio manager develops a strategy to maximize
portfolio returns, he or she does so with a particular asset mix or
allocation in mind. For example, 60% equities and 40% bonds,
or 10% cash, 40% bonds, and 50% equities, and so on.
This base policy mix is called the strategic asset allocation. This
is the long-term mix that will be adhered to by monitoring and, when
necessary, rebalancing. To find this base policy mix, the portfolio
manager will analyze a variety of asset mixes to determine the
optimal portfolio. The manager then reviews the range of outcomes
and chooses one to determine the long-term policy or strategic
asset allocation.
Strategic asset allocation is the basis of most in-house “model
portfolios” suggested by investment managers. Once the manager
determines the optimal weighting of the combination of all the funds
it offers for sale, you need only determine the client’s ability to bear
investment risk. Combine these two efforts and you have the best
possible asset allocation to recommend for the client. The strategic
asset allocation for a client ultimately will be determined through the
models and systems in place at your financial institution.
A client may reject the strategic asset allocation in favour of an
asset allocation he or she has determined. If the “know your client”
data and the client’s request show an acceptable fit, then you can
process the request, while at the same time indicating to the client
that your financial institution does not recommend the requested
asset allocation. If the fit is not right, however, then you may not
process the request.
WHAT ARE THE METHODS OF ANALYSIS?

Security analysis is the evaluation of the risk and return
characteristics of securities. Almost all investors, individual and
professional, do some type of analysis before making a security
purchase or sale. For individual investors, time often limits the
depth of analysis and the process tends to be informal. For
professional investors, their careers depend upon their ability to do
good security analysis.
Two basic types of security analysis are fundamental analysis and
technical analysis. Both are in widespread use in the investment
community, each approach offers very different views of how the
financial system operates.
FUNDAMENTAL ANALYSIS
Fundamental analysis involves assessing the short-, medium-
and long-range prospects of different industries and companies. It
involves studying capital market conditions and the outlook for the
national economy and for the economies of countries with which
Canada trades to shed light on securities’ prices.
In fact, fundamental analysis means studying everything, other than
the trading on the securities markets, which can have an impact on
a security’s value: macroeconomic factors, industry conditions,
individual company financial conditions, and qualitative factors such
as management performance.
By far the most important single factor affecting the price of a
corporate security is the actual or expected profitability of the
issuer. Are its profits sufficient to service its debt, to pay current
dividends, or to pay larger dividends? Fundamental analysis pays
attention to a company’s:
• Debt-equity ratio, profit margins, dividend payout, earnings per
share,
• Interest and asset coverage ratios,
• Sales penetration, market share, product or marketing
innovation, and the quality of its management.
TECHNICAL ANALYSIS
Technical analysis is the study of historical stock prices and stock
market behaviour to identify recurring patterns in the data. Because
the process requires large amounts of information, it is often
ignored by fundamental analysts, who find the process too
cumbersome and time consuming, or believe that “history does not
repeat itself.”
Technical analysts study price movements, trading volumes, and
data on the number of rising and falling stock issues over time
looking for recurring patterns that will allow them to predict future
stock price movements. Technical analysts believe that by studying
the “price action” of the market, they will have better insights into
the emotions and psychology of investors. They contend that
because most investors fail to learn from their mistakes, identifiable
patterns exist.
In times of uncertainty, other factors such as mass investor
psychology and the influence of program trading (sophisticated
computerized trading strategies) also affect market prices. This can
make the technical analyst’s job much more difficult. M ass investor
psychology may cause investors to act irrationally. Greed can force
prices to rise to a level far higher than warranted by anticipated
earnings. Conversely, uncertainty can also cause investors to
overreact to news and sell quickly, causing prices to drop suddenly.
SUMMARY
1. Describe the basic concepts of return and risk and explain how
they are used to evaluate the risk profile of mutual fund
investments.
◦ Given a choice between two investments with the same
amount of risk, a rational investor would always take the
security with the higher return. Given two investments with
the same expected return, the investor would always
choose the security with the lower risk.
◦ Given that all investors do not have the same risk profile,
different securities and different funds have evolved to
service each market niche.
2. Define inflation and purchasing power and the role taxation
plays when comparing the risk and return of securities.
◦ Inflation is a generalized, sustained trend of rising prices.
When prices are rising, money begins to lose its value—that
is, more and more money is needed to buy the same
amount of goods and services.
◦ Purchasing power is the ability to buy goods and services.
◦ The difference between just keeping up with inflation and
generating positive real returns represents an increase in
the investor’s wealth.
◦ The tax rate to be paid on investment income depends on
the type of income generated. The three types are interest
income, dividend income, and capital gains.
3. Calculate the return on a security.
◦ You can calculate the return (R) on a security held for one
year as:
◦ The geometric mean return calculates the average annual

compound return over several time periods and is calculated
as follows:
◦ The return on a portfolio is calculated as the weighted

average return on the securities held in the portfolio. The
formula is as follows:
Expected Return = R1(W1) + R2(W2) +…+ Rn(Wn)
4. Calculate the risk of a security.
◦ Variance measures the extent to which the spread of
possible returns on a security differs from the expected
return (the mean). The more likely it is that the return will not
be the same as the expected return, the riskier the security.
◦ Standard deviation is the measure of risk commonly applied
both to portfolios and to individual securities within a
portfolio. It is the square root of the variance and is
expressed as a percentage.
◦ Beta measures the degree to which individual equity
securities or a portfolio of equities tend to move up and
down with the market.
◦ Duration is a measure of the sensitivity of a bond’s price to
changes in interest rates. It is defined as the approximate
percentage change in the price or value of a bond for a 1%
change in interest rates.
5. Define portfolio analysis and explain the role of diversification,
describe the concept of correlation, and describe the tool used
to measure risk in a portfolio.
◦ Diversification refers to the spreading of investment risk by
buying different types of securities in different companies in
different kinds of businesses and or locations.
◦ The selection of securities within a portfolio must be done
carefully in order to maximize returns while reducing risk.
◦ Correlation looks at how securities relate to each other
when they are added to a portfolio and how the resulting
combination affects the portfolio’s total risk and return.
6. Describe the concept of efficient markets and how strategic
asset allocation is used to determine an optimal portfolio mix.
◦ If markets are efficient, then the prices of stocks and other
securities listed in the newspaper reflect all the information
that exists about them.
◦ The single most important decision, one that accounts for
most of the success or failure of a portfolio, is the asset
allocation decision, which is the selection of the classes of
securities to be held and in what proportion to hold them.
◦ This base policy mix is called the strategic asset allocation.
This is the long-term mix that will be adhered to by
monitoring and, when necessary, rebalancing.
7. Describe how fundamental analysis and technical analysis are
used in the selection of securities.
◦ Security analysis is the evaluation of the risk and return
characteristics of securities.
◦ Fundamental analysis involves assessing the short-,
medium- and long-term prospects of different industries and
companies. It involves studying capital market conditions
and the outlook for the national economy.
◦ Technical analysis is the study of historical stock prices and
stock market behaviour to identify recurring patterns in the
data.
REVIEW QUESTIONS

Understanding
9
Financial Statements
CONTENT AREAS
What are the Financial Statements?
What is the Statement of Financial Position?
What is the Statement of Comprehensive Income?
What is the Statement of Changes in Equity?
What is Financial Statement Analysis?
Appendix A: XYZ Inc. Financial Statements
LEARNING OBJECTIVES
1 | Describe the format and the items of the Statement of

Financial Position and explain how the items are
classified.
2 | Describe the structure of the Statement of

Comprehensive Income.
3 | Describe the purpose of the Statement of Changes in
Equity and describe its link with the Statement of
Financial Position and Statement of Comprehensive
Income.
4 | Describe the different types of liquidity ratios, risk

analysis ratios, operating performance ratios and value
ratios, and evaluate company performance using these
ratios.
5 | Explain how to analyze a company’s financial

statements using trend analysis and external
comparisons.
KEY TERMS

amortization
assets
audit
auditor’s report
cash flow from operations/total debt ratio
current assets
current liabilities
current ratio
debt/equity ratio
depreciation
earnings per common share (EPS)
equity
financial statement analysis
fixed assets
gross profit
gross profit margin ratio
interest coverage ratio
inventory turnover ratio
liabilities
liquidity ratio
long-term liabilities
market ratios
net profit margin
operating performance ratios
price-earnings ratio (p/e)
profit
quick ratio
ratio analysis
retained earnings
return on common equity (ROE) ratio
risk analysis ratios
statement of changes in equity
statement of comprehensive income
statement of financial position
trend ratios
value ratios
working capital
working capital ratio
yield
INTRODUCTION
So far in this course, you have been introduced to the types of
securities included in mutual funds and the methods used by
portfolio managers to construct portfolios of securities. This chapter
presents one type of fundamental analysis: the company analysis
performed by mutual fund portfolio managers when selecting
securities for inclusion in the mutual funds they manage.
One of the jobs of a mutual fund portfolio manager is to assess the
“true” value of the securities offered to the public by corporations. If
that “true” value differs from the current market price, this is an
indication of a buying or selling opportunity.
To assess the value of a stock, fund managers need information
about the companies they want to invest in, particularly information
about earnings (or profits) these companies are likely to generate
in the future. Earnings information is the cornerstone of choosing
stocks because the price one is willing to pay today for a share of
a company depends directly on estimates of how profitable the
company will be in the future.
If investors suddenly come to the conclusion that the future
earnings of a company will be higher than was previously thought,
that suggests the true value of the shares is higher than the price
they may be trading for in the market today. Investors will likely buy
these underpriced shares, bidding the price up until it reflects the
new earnings forecast. In other words, the value of a share is
primarily influenced by the company’s expected future earnings.
Understanding the link between future earnings and share price is
not that difficult, but trying to figure out what current information is
relevant to determine what those future earnings might be can be a
difficult task. Certainly, information about the company’s products,
competition, the skill of its managers, and the training and
dedication of its workers is all relevant, and better analyses result
when a close examination of all relevant factors is made. However,
the financial statements produced by management, and verified (or
audited) by accounting firms, provide good summaries of how well
the company has done in the recent past.
While a complete treatment of financial statement analysis is far
beyond the scope of this course, it will serve you well to be familiar
with at least some basic concepts. Understanding some aspects of
the security selection process will give you insight into the difficulty
mutual fund portfolio managers have in always making good
choices.
WHAT ARE THE FINANCIAL STATEMENTS?
Before we can discuss the tools of financial statement analysis, we
start with the basics of financial statements. Throughout our
discussion, we will refer to the set of financial statements
of XYZ Corporation, a fictional company, included in Appendix A of
this chapter. These financial statements are highly simplified in
order to allow you to focus on a few key elements. Real financial
statements are far more complex and are not presented here.
Financial statements of publicly traded companies in Canada are
produced according to International Financial Reporting Standards
(IFRS). IFRS is a globally accepted high-quality accounting
standard already used by public companies in over 100 countries
around the world. IFRS is principle-based, with a focus on providing
detailed disclosure.
In principle-based accounting, guidelines are more general because
the goal is to have the completed financial statements achieve a
set of good reporting objectives. An example of a good reporting
objective is sufficient disclosure of data so that an investor can
make an objective analysis.
IFRS requires an extensive and detailed disclosure by the
company to explain why particular accounting treatments are
utilized.
There are four essential financial statements produced by
corporations:
• the Statement of Financial Position
• the Statement of Comprehensive Income
• the Statement of Changes in Equity
• the Statement of Cash flow
While all four of these financial statements are important indicators
of the performance of the company, we will look at only some of
the key elements of the first three of these.
WHAT IS THE STATEMENT OF FINANCIAL
POSITION?
The statement of financial position shows a company’s financial
position at a specific date. In annual reports, that date is the last
day of the company’s fiscal year. While many companies have a
fiscal year end that corresponds with the calendar year end, i.e.,
December 31, this is not always the case.
EXAMPLE
Banks and trust companies traditionally end their fiscal year on

October 31. In this instance, October 2022 would be the last
month of the bank’s “fiscal 2022” while November 2022 would
represent the first month of “fiscal 2023.”
The statement of financial position shows what the company owns

and what is owing to it. These items are called assets. This
statement also shows the equity of the company which represents
the shareholders’ interest in the company and what the company
owes (called liabilities). Equity represents the excess of the
company’s assets over its liabilities. Accordingly, the company’s
total assets are equal to the sum of equity plus the company’s
liabilities.
A statement of financial position is prepared and presented in more
or less the same way for all Canadian publicly traded companies.
Assets, liabilities and shareholders’ equity are related by the
following equation:
Assets = Equity + Liabilities
For XYZ Inc., total assets ($520,000) equal shareholders’ equity
($240,000) plus liabilities ($280,000).
ASSETS
Assets are classified as either current or fixed, with the dividing
point usually being one year. Current assets are assets that are
expected to be converted to cash within one year, although this
conversion might be indirect.
For example, consider trade receivables. Trade receivables
represent the amounts owed to the company by clients who have
bought goods but haven’t paid for them yet. For the vast majority of
businesses, the average invoice is paid well within one year.
Therefore, trade receivables are considered current assets
because they will normally be paid and converted to cash within
one year.
While most companies will report many different kinds of current
assets, there are only three current asset accounts for XYZ: cash,
representing the total amount in all of the company’s deposit
accounts; inventories, representing the finished and unfinished
products which have not yet been sold; and trade receivables.
From the Statement of Financial Position, current assets for XYZ
total $120,000.
Current Assets
Cash $20,000
Inventories 60,000
Trade Receivables 40,000
Total Current Assets $120,000
Fixed assets are those assets that are expected to last longer
than one year. These are long-term assets used in the day-to-day
operations of a company to produce the goods or services the
company sells. They are not intended to be sold. Examples are
automobiles, trucks, factories, computers and other office
equipment.
Since these assets last several accounting periods (years), it is
only reasonable to adjust the values of those assets to reflect the
fact that a certain amount is used up each period. With the
exception of land, assets wear out over time or otherwise lose
their usefulness. This used-up amount is known as depreciation
or amortization.
On the XYZ Statement of Financial Position, fixed assets are
shown as “net” plant and equipment. The term “net” means that
depreciation has been removed from the original value of the fixed
assets. Total fixed assets for XYZ is $400,000.
Fixed Assets
Net Plant and Equipment 400,000
Note that total assets for XYZ is the sum of current and fixed
assets, or $520,000.
LIABILITIES
As with assets, liabilities are classified as either current or long-
term, with the same one-year dividing line. There are three current
liabilities for XYZ.
The first, trade payables are the mirror image of the trade
receivables seen on the asset section of the Statement of
Financial Position. Trade payables represent the goods the
company has bought for which payment has not yet been made.
Notes payable represent loans that must be paid off by the
company within one year. The last current liability account for XYZ
is accrued charges. This account represents wages earned by
employees but not yet paid, or taxes payable to the federal or
provincial governments.
From the Statement of Financial Position, current liabilities for XYZ
total $80,000.
Current Liabilities
Trade Payables $20,000
Notes Payable 40,000
Accrued Charges 20,000
Total Current Liabilities $80,000
Long-term liabilities are liabilities not likely to be paid off within

one year; such is the case for long-term debt. This debt could be in
the form of bonds issued by the corporation or a term loan made by
a lender. The notes to the financial statements would be consulted
to determine the precise composition of the debt. With long-term
liabilities of $200,000 added to the current liabilities, XYZ’s total
liabilities are $280,000.
SHAREHOLDERS’ EQUITY
Shareholders’ equity refers to the amount contributed to the
financing of the company by shareholders over time by one of two
means.
• First, shareholders might have contributed by buying shares
from the company when they were first issued in the primary
market; that is the amount indicated in the common
shares account.
• Second, all of the company’s annual profits that have not been
distributed to shareholders (generally in the forms of dividends)
but reinvested in the company continue to accumulate in
shareholders’ equity over time: these are known as retained
earnings. This decision to reinvest some of the profit comes
from the company’s board of directors.
From the Statement of Financial Position, total shareholders’ equity
for XYZ is $240,000.
Common Shares (100,000 outstanding shares) $40,00

0
Retained Earnings 200,00

0
Total Shareholders’ Equity $240,0

00
Therefore, the total of liabilities and shareholders’ equity is

$520,000, exactly equal to the total asset figure indicated above.
WHAT IS THE STATEMENT OF

COMPREHENSIVE INCOME?
Unlike the Statement of Financial Position, which shows what a
company owns and owes at a single point in time, the statement
of comprehensive income presents revenues and expenses
over a specific period. In the case of XYZ, the period is one-year.
Publicly traded companies provide shareholders with quarterly and
annual financial statements. In that case, the Statement of
Comprehensive Income will be over a three-month or a one-year
period.
All Statement of Comprehensive Incomes show the revenue
generated for the period and then reduce that amount by charging
off expenses of one kind or another. For XYZ, sales are reduced
by the expenses that were incurred in order to generate the goods
sold (Cost of Sales). These expenses include the cost of
inventories used to produce the goods as well as the labour that
went into their production. The revenue, net of the cost of sales
(the cost of producing those goods), is known as gross profit.
From the Statement of Comprehensive Income, the gross profit for
XYZ is $400,000.
Revenue $1,000,000
Less: Cost of Sales 600,000
Gross Profit $400,000
Then, calculate all expenses.
Expenses
General and Administrative $200,000
Selling Expense 50,000
Depreciation 25,000
Interest Expense 20,000
Taxes 50,000
Total Expenses 345,000
From gross profit, subtract all expenses which leave profit.

The profit for XYZ is $55,000.
Gross Profit $400,000
Less: Total Expenses 345,000
Profit $55,000
WHAT IS THE STATEMENT OF CHANGES IN
EQUITY?
The profit or loss in a company’s most recent year is determined in
the Statement of Comprehensive Income and then transferred to
the statement of changes in equity. Retained earnings are
profits earned over the years that have not been paid out to
shareholders as dividends. These retained profits accrue to the
shareholders, but the directors have decided for the present time
to reinvest them in the business.
The Statement of Changes in Equity is the link between the
Statement of Comprehensive Income and the Statement of
Financial Position as it makes the bridge between the yearly
earnings that appear in the Statement of Comprehensive Income
and the retained earnings that appear in the Statement of Financial
Position.
This statement starts with the opening balance (January 1, 20XX)
of the retained earnings account. This is the same amount as the
retained earnings from the December 31, previous year’s
Statement of Financial Position. Since XYZ has earned $55,000
from this year’s activities after all goods, workers, managers,
creditors and taxes have been paid, it only stands to reason that
this additional amount belongs to the shareholders. Thus, retained
earnings should increase by $55,000.
Notice, however, that the board of directors paid a dividend on its
common shares. Of the $55,000 earned, $30,000 has been paid out
in cash in the form of common share dividends (100,000 shares
outstanding × $0.30 per share).
Retained Earnings at beginning of period $175,00

0
Plus: Profit for the period 55,000

Less: Dividends paid on common shares 30,000
Retained Earnings at end of period $200,00

0
Therefore, retained earnings have grown by a total of $25,000.

Since the year began with a retained earnings account balance of
$175,000, the account balance at the end of this year should be
$200,000 — and that is exactly what is shown on the Statement of
Financial Position as at the end of the year. If the company
experiences a loss instead of a profit, retained earnings are
reduced by the amount of the loss.
THE AUDITOR’S REPORT

Canadian corporate law requires that every limited company
appoint an auditor to represent shareholders and report to them
annually on the company’s financial statements, expressing an
opinion in writing as to their fairness. The only exception is for
privately held corporations where all shareholders have agreed that
an audit is not necessary. The auditor is appointed at the
company’s annual meeting by a resolution of the shareholders and
may be dismissed by them.
In Canada the auditor’s report conventionally has four sections:
• The introductory section identifies the financial statements
covered by the auditor’s report.
• The second section outlines the financial statement
responsibilities of management.
• The third section outlines the auditor’s responsibilities and
states how the audit was conducted. The purpose of the third
section is for the auditor to inform the reader that the audit was
planned and conducted in accordance with international auditing
standards and that the auditor has made judgments in applying
these standards. It explains to the reader the nature and extent
of an audit.
• The fourth section gives the auditor’s opinion on the financial
statements of the company being audited. This paragraph
provides a statement on the fairness of the company’s financial
statements presented in accordance with International Financial
Reporting Standards.
FINANCIAL STATEMENTS REVIEW
How well do you understand the key purpose of the

various financial statements? Complete the online learning
WHAT IS FINANCIAL STATEMENT ANALYSIS?

M utual fund managers rely extensively on the financial statements
of companies they want to invest in. Their job is to find companies
that will outperform their peers within an industry. In order to
achieve this, fund managers must have an extensive knowledge of
the industry, but they also must be able to analyze and interpret
financial statements. Ratio analysis is one type of investment tool
to perform this analysis.
RATIO ANALYSIS
The method most commonly used to evaluate financial statements
is called ratio analysis, which shows the relationship between two
quantities. For instance, a 2:1 ratio means that the first quantity is
twice the amount of the second quantity.
EXAMPLE
A company with $100,000 in current assets and $50,000 in
current liabilities is said to have a 2:1 ratio, or $2 of current
assets for $1 of current liabilities. This ratio is the working capital
ratio, which we discuss below.
In the context of financial analysis, ratios may be used to analyze a

company’s liquidity, debt, return and stock value. The four main
types of ratios commonly used in financial analysis are:
• Liquidity ratios are used to judge the company’s ability to
meet its short-term commitments. An example is the working
capital ratio, which shows the relationship between current
assets and current liabilities.
• Risk analysis ratios show how well the company can deal
with its debt obligations. For example, the debt/equity ratio
shows the relationship between the company’s borrowing and
the capital invested in it by shareholders.
• Operating performance ratios illustrate how well management
is making use of the company’s resources. The return on
common equity, for example, correlates the company’s profit
with the money shareholders have invested to produce it.
These ratios include profitability and efficiency measures.
• Value ratios show the investor what the company’s shares are
worth, or the return on owning them. An example is the price-
earnings ratio, which links the market price of a common share
to earnings per common share, and thus allows investors to
rate the shares of companies within the same industry.
Ratios must be used in context. One ratio alone does not tell an
investor very much. Ratios are not proof of present or future
profitability; they are only clues. An analyst who spots an
unsatisfactory ratio may suspect unfavourable conditions.
Conversely, analysts may conclude that a company is financially
strong after compiling a series of ratios.
The significance of any ratio is not the same for all companies. A
ratio that compares company inventory does not have the same
meaning for a company that builds planes, for example, as it does
for a bakery shop. To be meaningful, company ratios must be
compared with similar companies or within a similar industry.
LIQUIDITY RATIOS
Liquidity ratios help analysts to evaluate the ability of a company to
turn current assets into cash to meet its short-term obligations. If a
company is to remain solvent, it must be able to meet its current
liabilities, and therefore it must have an adequate amount of
working capital.
WORKING CAPITAL RATIO OR CURRENT RATIO

The ability of a company to meet its obligations, expand its volume
of business, and take advantage of financial opportunities as they
arise is, to a large extent, determined by its working capital or
current ratio position. Frequent causes of business failure are the
lack of sufficient working capital and the inability to liquidate current
assets readily.
For XYZ:
XYZ’s current ratio is 1.5:1 which means there is $1.50 of current

assets for each dollar of current liabilities.
As discussed earlier, current assets are cash and other company
possessions that can be readily turned into cash within one year.
Current liabilities are liabilities of the company that must be paid
within the year.
The interpretation of this ratio depends on the type of business,
the composition of current assets, inventory turnover rate and
credit terms. A current ratio of 2:1 is generally considered good but
not exceptional because it means the company has $2 cash and
equivalents to pay for each $1 of its debt. However, the
composition of current assets is also an important factor to assess
the quality of the ratio.
EXAMPLE
Company A reports current assets of 50% cash, 25% trade

receivables, and 25% inventory. Company B reports 10% cash,
10% trade receivables, and 80% inventory. Both companies
have a current ratio of 2:1, but which company is in a better
position in terms of liquidity? Company A is in a better liquidity
position than Company B. Company A could pay its current
debts more easily and quickly.
Also, if a current ratio of 2:1 is good, is a 20:1 current ratio ten

times as good? No. If a company’s current ratio exceeds 5:1 and it
consistently maintains such a high level, the company may have an
unnecessary accumulation of funds that could indicate sales
problems (too much inventory) or financial mismanagement.
QUICK RATIO (THE ACID TEST)

The second of the two most common corporate liquidity ratios, the
quick ratio, is a more stringent test than the current ratio. In this
calculation, inventories, which are generally not considered liquid
assets, are subtracted from current assets. The quick ratio shows
how well current liabilities are covered by cash and by items with a
quick cash value.
Current assets include inventories that, at times, may be difficult to
convert into cash. As well, because of changing market conditions,
inventories may be carried on the Statement of Financial Position
at inflated values.
XYZ’s quick ratio is 0.75:1:
The quick ratio offers a more conservative test of a company’s

ability to meet its current obligations. For XYZ, the ratio is 0.75 to 1,
which means there are $0.75 of current assets, exclusive of
inventories, to meet each $1 of current liabilities.
There is no absolute standard for this ratio, but if it is 1:1 or better,
it suggests a good liquid position. However, companies with a quick
ratio of less than 1:1 may be equally good if they have a high rate
of inventory turnover because inventory that is turned over quickly
is the equivalent of cash.
FINANCIAL LEVERAGE (RISK ANALYSIS

RATIOS)
The capital structure of any company is made up of two elements:
equity and debt. The analysis of a company’s capital structure
enables analysts to judge how well the company can meet its
financial obligations. Excessive borrowing increases the company’s
costs because it must service its debt by paying interest on
outstanding bank loans, notes payable, bonds or debentures.
If a company cannot generate enough cash to pay the interest on
its outstanding debt, then its creditors could force it into bankruptcy.
If the company must sell off its assets to meet its obligations, then
investors who have purchased bonds, debentures or stock in the
company could lose some or all of their investment. Risk analysis
ratios are mainly used to assess the weighting of debt in a
company, the company’s ability to regularly pay interest due on its
debt, and if the company will be able to fully reimburse debtholders
in the event of bankruptcy.
DEBT/EQUITY RATIO
The debt/equity ratio pinpoints the relationship of debt to equity. If
the ratio is too high, it may indicate that a company has borrowed
excessively. Financial risk increases as the debt/equity ratio goes
higher. If the debt burden is too large, it reduces the margin of
safety protecting the debtholder’s capital, increases the company’s
fixed charges, reduces earnings available for dividends, and, in
times of recession or high interest rates, could cause a financial
crisis.
XYZ’s debt/equity ratio is 1:1:
You can interpret this result as $1.00 of debt for each dollar of
equity. Creditors would normally not lend money to companies that
show a debt/equity ratio that exceeds 0.50:1. XYZ seems to be
largely financed by debt, which may indicate that debt is excessive.
CASH FLOW FROM OPERATIONS/TOTAL DEBT RATIO

The cash flow from operations/total debt ratio gauges a
company’s ability to repay the funds it has borrowed. Bank
advances are short-term and must normally be repaid or rolled over
within a year. Corporate debt issues commonly have sinking funds
requiring annual cash outlays. A company’s annual cash flow
should therefore be adequate to meet these commitments.
Before calculating this ratio, it is important to define cash flow from
operations and consider its significance.
Cash flow from operations = a company’s profit + all deductions not
requiring a cash outlay (such as depreciation) – all additions not
received in cash (such as share of profit of associates).
XYZ’s cash flow from operations/total debt ratio is 0.33:1 (net
earnings + depreciation)/$240,000.
Cash flow from operations frequently provides a broader picture of

a company’s earning power than profit alone. Why? Some
accounts are considered expenses and are deducted from
earnings to get to profit, but do not incur any cash outflows. For
example, depreciation is an expense that reduces profit, but no
actual cash amount has been paid out for that account.
Consequently, cash flow from operations is considered by some
analysts a better indicator of the ability to repay debts and other
liabilities like dividends. It is particularly useful in comparing
companies within the same industry. It can reveal whether a
company, even one that shows little or no profit after depreciation,
can meet its debts.
A relatively high ratio of cash flow to debt is considered positive.
Conversely, a low ratio is negative. Analysts use minimum
standards to assess debt repayment capacity and provide another
perspective on debt evaluation.
Analysts usually calculate the cash flow from operations to total
debt outstanding ratio for each of the last five fiscal years. An
improving trend is desirable. A declining trend may indicate
weakening financial strength, unless the individual ratios for each
year are well above the minimum standards.
INTEREST COVERAGE RATIO

The interest coverage ratio reveals the ability of a company to
pay the interest charges on its debt and indicates how well these
charges are covered, based upon earnings available to pay them.
Interest coverage indicates a margin of safety, since a company’s
failure to meet its interest charges could result in bankruptcy.
All interest charges, including bank loans, and short-term and long-
term debt must be taken into account to correctly assess interest
coverage. Default on any one debt may impair the issuer’s ability to
meet its obligations to the others, and lead to default on other
debts. Interest coverage is generally considered to be the most
important quantitative test of risk when considering a debt security.
A level of earnings well in excess of interest requirements is
deemed necessary as a form of protection for possible adverse
conditions in future years. Overall, the greater the coverage, the
greater the margin of safety.
To assess the adequacy of the coverage, it is common to set
criteria. For example, an analyst may decide that an industrial
company’s annual interest requirements in each of the last five
years should be covered at least three times by earnings available
for interest payment in each year. At this level, the analyst would
consider its debt securities to be of acceptable investment quality.
A company may fail to meet these coverage standards without
ever experiencing difficulties in fulfilling its debt obligations.
However, the securities of such a company are considered a much
higher risk because they lack an acceptable margin of safety. Thus,
the interest coverage standards are only an indication of the
likelihood that a company will be able to meet its interest
obligations.
It is also important to study the year-to-year trend in the interest
coverage calculation. Ideally, a company should not only meet the
industry standards for coverage in each of the last five or more
years but increase its coverage. A stable trend, which means that
the company is meeting the minimum standards, but not improving
the ratio over the period, is also considered acceptable. However,
a deteriorating trend suggests that further analysis is required to
determine whether the company’s financial position has seriously
weakened.
The formula for interest coverage is:
XYZ’s interest coverage ratio is 6.25 times.
The calculation shows that XYZ’s interest charges for the year
were covered 6.25 times by profit available to pay them. Stated in
another way, XYZ had $6.25 of profit out of which to pay
every $1.00 of interest.
OPERATING PERFORMANCE RATIOS

The analysis of a company’s profitability and efficiency tells the
investor how well management is making use of the company’s
resources. In other words, these ratios analyze management
performance.
GROSS PROFIT MARGIN RATIO

The gross profit margin ratio, as well as the net profit margin
ratio, is useful both for calculating internal trend lines and for making
comparisons with other companies, especially in industries such as
food products and cosmetics, where turnover is high and
competition is stiff. The gross margin is an indication of the
efficiency of management in turning over the company’s goods at a
profit. It shows the company’s rate of profit after allowing for the
Cost of Sales.
XYZ’s gross profit margin ratio is 40%.

NET PROFIT MARGIN
Net profit margin is an important indicator of how efficiently the
company is managed after taking both expenses and taxes into
account. Because this ratio is the result of the company’s
operations for the period, it effectively sums up management’s
ability to run the business in a single figure.
NET (OR AFTER-TAX) RETURN ON COMMON EQUITY

(ROE) RATIO
The return on common equity (ROE) represents the amount of
profit returned as a percentage of shareholders’
equity. ROE measures a company’s profitability by revealing how
much profit the company generates with the money shareholders
have invested. The trend in the ROE indicates management’s
effectiveness in maintaining or increasing profitability in relation to
the company’s common equity capital. A declining trend suggests
that operating efficiency is waning, although further quantitative
analysis is needed to pinpoint the causes. For shareholders, a
declining ratio shows that their investment is being employed less
productively.
This ratio is very important for common shareholders, since it
reflects the profitability of their capital in the business.
XYZ’s return on common equity ratio is 22.9%.
INVENTORY TURNOVER RATIO

The inventory turnover ratio measures the number of times a
company’s inventory is turned over in a year. It may also be
expressed as a number of days required to achieve turnover. A
high turnover ratio is considered good. A company with a high
turnover requires a smaller investment in inventory than one
producing the same sales with a low turnover.
XYZ’s inventory turnover ratio is 10 times.
Over the course of a 365-day year, XYZ turned over its inventory
365/10 or once every 36.5 days. To be meaningful, the inventory
turnover ratio should be calculated using the cost of sales. If this
information is not shown separately, the revenue figure may have
to be used.
This ratio indicates management’s efficiency in turning over the
company’s inventory and can be used to compare one company
with others in the same field. It also provides an indication of the
adequacy of a company’s inventory for the volume of business
being handled.
If a company has an inventory turnover rate that is higher than its
industry, it generally indicates a better balance between inventory
and sales volume. The company is unlikely to be caught with too
much inventory if the price of raw materials drops or the market
demand for its products falls. There should also be less wastage
because materials and products are not standing unused for long
periods and deteriorating in quality and/or marketability. On the
other hand, if inventory turnover is too high in relation to industry
norms, the company may have problems with shortages of
inventory, resulting in lost sales.
If a company has a low rate of inventory turnover, it may be
because:
• the inventory contains an unusually large portion of unsaleable
goods
• the company is holding excess inventory
• the value of the inventory has been overstated
Since a large part of a company’s working capital is sometimes tied
up in inventory, the way in which the inventory position is managed,
directly affects earnings and the rate of return earned from the
employment of the company’s capital in the business.
VALUE RATIOS
Ratios in this group – sometimes called market ratios – measure
the way the stock market rates a company by comparing the
market price of its shares to information in its financial statements.
Price alone does not tell analysts much about a company unless
there is a common way to relate the price to dividends and
earnings. Value ratios do this.
EARNINGS PER COMMON SHARE (EPS) RATIO

In common stock analysis, great emphasis is placed on earnings
per common share (EPS). This ratio shows the earnings available
to each common share and is an important element in judging an
appropriate market price for buying or selling common stock. A
rising trend in EPS has favourable implications for the price of a
stock.
In practice, a common stock’s market price reflects the anticipated
trend in EPS for the next 12 to 24 months, rather than the current
EPS. Thus it is common practice to estimate EPS for the next year
or two. Accurate estimates for longer periods are difficult because
of the many variables involved.
XYZ’s earnings per common share ratio is $0.55
Because of the importance of EPS, analysts pay close attention to

possible dilution of the stock’s value caused by the conversion of
outstanding convertible securities, the exercise of warrants, shares
issued under employee stock options, and other changes.
Fully diluted earnings per share can be calculated on common
stock outstanding plus common stock equivalents such as
convertible preferred stock, convertible debentures, stock options
(under employee stock-option plans) and warrants. This figure
shows the dilution in earnings per share that would occur if all
equivalent securities were converted into common shares.
Earnings from operations after all prior claims have been met
belong to the common shareholders. The shareholders therefore
will want to know how much has been earned on their shares. If
profit is high, directors may declare and pay out a good portion as
dividends. Even in growth companies, directors may decide to
make at least a token payment because they realize that most
shareholders like to feel some of the profits are flowing into their
pockets. On the other hand, if profits are low or the company has
suffered a loss, they may not pay dividends on the common
shares.
DIVIDEND YIELD
Common and preferred shares may pay dividends. The yield on
common and preferred stocks is the annual dividend rate
expressed as a percentage of the current market price of the stock.
It represents the investor’s return on the investment.
PRICE-EARNINGS RATIO OR P/E MULTIPLE RATIO

The price-earnings ratio or P/E ratio is probably the most widely
employed of all financial ratios because it combines all the other
ratios into one figure. P/E ratio compares the company’s current
share price to its earnings per share.
Assuming that the current market price of XYZ common stock is $5

and that its earnings per common share is $0.55, the P/E ratio is
$5/$0.55 or 9.1.
The main reason for calculating earnings per common share – apart
from indicating dividend protection – is to make a comparison with
the share’s market price. The P/E ratio expresses this comparison
in one convenient figure, showing that a share is selling at so many
times its actual or anticipated annual earnings. At a price of $5, XYZ
common shares are selling at 9.1 times the company’s earnings.
P/E ratios enable the shares of one company to be compared with
those of another.
EXAMPLE
Company A – Earnings per share: $2; Price: $20

Company B – Earnings per share: $1; Price: $10
Though earnings per share of Company A ($2) are twice those

of Company B ($1), the shares of each company represent
equivalent value because Company A’s shares, at $20 each,
cost twice as much as Company B’s shares. In other words,
both companies are selling at 10 times earnings.
The elements that determine the quality of an issue – and

therefore are represented in the P/E ratio – include:
• tangible factors contained in financial data, which can be
expressed in ratios relating to liquidity, earnings trends,
profitability, dividend payout, and financial strength (Statement
of Financial Position ratios).
• intangible factors, such as quality of management, nature and
prospects for the industry in which the issuing company
operates, its competitive position, and its individual prospects.
All these factors are taken into account when investors and
speculators collectively decide what price a share is worth.
To compare the P/E ratio for one company’s common shares with
that of other companies, the companies should usually be in the
same industry. P/E ratios for various industries are available from
different sources. In practice, however, most investment analysts
and companies make their own projections of a company’s
earnings for the next 12-month period and calculate P/E ratios on
these projected figures in relation to the stock’s current market
price. Because of the many variables involved in forecasting
earnings, the use of estimates in calculations should be
approached with great caution.
The P/E ratio helps analysts to determine a reasonable value for a
common stock at any time in a market cycle. By calculating a
company’s P/E ratio over a number of years, the analyst will find
considerable fluctuation, with high and low points. If the highs and
lows of a particular stock’s P/E ratio remain constant over several
stock market cycles, they indicate selling and buying points for the
stock. A study of the P/E ratios of competitor companies and that
of the relevant market subgroup index also helps to provide a
perspective.
The P/E ratio comparison assists in the selection process.
EXAMPLE
Two companies of equal stature in the same industry and both

have similar prospects, but different P/E ratios. The company
with the lower P/E ratio is usually the better buy. As a rule,
P/E ratios increase in a rising stock market or with rising
earnings. The reverse is true in a declining market or when
earnings decline.
Since the P/E ratio is an indicator of investor confidence, its highs

and lows may vary from market cycle to market cycle. M uch
depends on changes in investor enthusiasm for a company or an
industry over several years.
Some investors consider the P/E ratio as a timing device for stock
transactions, but it should not be relied on exclusively and should
be used only in conjunction with other criteria. The P/E ratio
approach to stock selection assumes that an investor should buy a
stock if its P/E ratio is close to the low of its historical range and
sell when it is near its highest point.
Case Study | The Value of Advice: Using Market Ratios to Add

Value for Investors (for information purposes only)
Jerry is meeting with his client, Anne, to discuss investing new

money into her existing non-registered investment portfolio. As a
balanced growth investor with a long-term investment time horizon,
Anne is hoping that Jerry can recommend a mutual fund that is
focused on stable growth and, for tax planning purposes, one that
produces minimal but tax-effective income.
After reaffirming Anne’s goals and investment profile, Jerry
recommends to Anne a blue-chip equity fund, one that uses a
value investing approach. Jerry explains that using a value
investing approach can help reduce taxable short-term capitals
gains distributions, as the fund manager takes a long term, buy-
and-hold approach to investing, reducing short-term investment
turnover. Holding blue chip equities often means that these
companies pay dividends, and the fund Jerry recommends to Anne
does have a dividend yield of around 3%. However, with capital
appreciation, few capital gains distributions, and dividend income
eligible for tax credits, the fund meets Anne’s investment goals
nicely.
Anne, a knowledgeable investor, is interested in how a value style
fund manager analyses companies to identify opportunities. Jerry
explains that these fund managers will often use value or market
ratios to look for stocks that, based on their analysis, the market is
undervaluing relative to their industry peers. They often do this by:
• Determining the company’s earnings per share ratio and
whether it is rising or falling: If a company’s earnings are
consistently rising, then it is likely that it is well-managed and
well positioned in its industry to continue to produce solid
earnings growth.
• Calculating the dividend yield to determine if the company’s
stock is over- or underpriced: Yields that are too high can
suggest that the current price of a stock is too low relative to
what the company pays out to investors – this can indicate that
investors are under valuing the stock’s price given the dividend
cash flow per share.
• Examining the price/earnings (P/E) ratio to determine whether
investors are over- or undervaluing the company’s stock: A
high P/E ratio often indicates that investors are paying too
much for a company’s future earnings relative to other
companies’ stocks, while a low P/E ratio relative to its industry
peers can suggest that a company is out of favour with
investors — representing a possible opportunity for a fund
manager to buy it cheaply and wait for other investors to
realize the same thing.
FINANCIAL RATIOS
How well do you know the purpose of the different financial

ratios? Complete the online learning activity to assess your
knowledge.
TREND ANALYSIS
Ratios calculated from a company’s financial statements for only
one year have limited value. They become meaningful when
compared with other ratios either internally (with a series of similar
ratios of the same company over a period) or externally (with
comparable ratios of similar companies or with industry averages).
Analysts identify trends by selecting a base date or period, treating
the figure or ratio for that period as 100, and then dividing it into the
comparable ratios for subsequent periods.
Table 9.1 shows this calculation for a typical pulp and paper
company:
Table 9.1 | Pulp and Paper Company A – Earnings Per Share
Year Year 1 Year 2 Year 3 Year 4 Year 5
EPS $1.18 $1.32 $1.73 $1.76 $1.99

1.18 1.32 1.73 1.76 1.99
1.18 1.18 1.18 1.18 1.18
Trend 100 112 147 149 169
The above example uses Year 1 as the base year. The earnings
per share for that year, $1.18, is treated as equivalent to 100. The
trend ratios for subsequent years are calculated by dividing 1.18
into the earnings per share ratio for each subsequent year.
A similar trend line over the same period for Pulp and Paper
Company B is shown in Table 9.2.
Table 9.2 | Pulp and Paper Company B – Earnings Per Share
Year Year 1 Year 2 Year 3 Year 4 Year 5

EPS $0.71 $0.80 $0.90 $0.84 $0.78
.71 .80 .90 .84 .78
.71 .71 .71 .71 .71
Trend 100 113 127 118 110
Trend ratio calculations are useful because they clearly show

changes. Company A shows a steady earnings per share growth
during the period, while Company B shows a decline in earnings for
the recent years. While it is not always the case, these trends can
help analysts to forecast future earnings.
EXTERNAL COMPARISONS
Ratios are most useful when comparing financial results of
companies in the same or similar industries (such as comparing a
distiller with a brewer). Differences shown by the trend lines not
only help to put the earnings per share of each company in
historical perspective, but also show how each company has fared
in relation to others. Different industries may have different industry
standards for the same ratio. In fact, a range is often employed
rather than a specific target number.
In external comparisons, not only should the companies be similar
in operation, but also the basis used to calculate each ratio
compared should be the same. For example, there is no point
comparing the inventory turnover ratios of two companies if one
calculation uses “Cost of Sales” and the other uses “Revenue.”
This comparison would be inaccurate since the basis of calculation
is different.
Determining which items on a financial statement should be
included in a ratio can be difficult. An investor may not be able to
make a valid comparison between comparing ABC Ltd. and
DEF Ltd. if the research on each came from two different analysts.
Different assumptions can result in one analyst including an item
while an equally competent analyst may choose not to include it.
For example, one analyst may include a bond maturing in five years
as short-term debt while another analyst may consider that same
security to be a long-term debt.
Because there is flexibility in calculating the ratios, two analysts
could have differing opinions on the quality of an investment,
depending on the assumptions that each made. In addition to
comparisons between companies in the same industry, industry
ratios can be used to compare the performance of individual
companies. Industry ratios represent the average for that particular
ratio of all the companies analyzed in that specific industry.
Evaluating a company should be made within the content of overall
industry performance. For example, a company being analyzed may
have a ratio that gives it a relative standing above all others in the
industry, but due to a recession, all companies within the industry
may be below historical industry operating norms. To be thorough,
an analyst must compare the company to both the current average
of the industry, as well as the historical industry standard.
SUMMARY
1. Describe the format and the items of the Statement of
Financial Position and explain how the items are classified.
◦ One section of the Statement of Financial Position shows
what the company owns and what is owing to it. These
items are called assets.
◦ Assets are classified as current or fixed assets.
◦ The other sections of the Statement of Financial Position
show:
what the company owes (current and long-term liabilities)
1. and
2. the shareholders’ equity or net worth of the company

which represents the shareholders’ interest in the
company.
2. Describe the structure of the Statement of Comprehensive
Income.
◦ The Statement of Comprehensive Income presents
revenues and expenses over a specific period.
◦ Earnings (or profits) are calculated as sales minus all
expenses, interests and taxes.
3. Describe the purpose of the Statement of Changes in Equity
and describe its link with the Statement of Financial Position
and Statement of Comprehensive Income.
◦ The Statement of Changes in Equity represents the sum of
all retained earnings since the inception of the company.
◦ The Statement of Changes in Equity is the link between the
Statement of Comprehensive Income and the Statement of
Financial Position as it makes the bridge between the
earnings that appear in the Statement of Comprehensive
Income and the retained earnings that appear in the
Statement of Financial Position.
◦ Opening balance is the closing balance of the previous
year’s retained earnings. Profits are added and dividends
are deducted to arrive at the closing balance of retained
earnings. This closing balance is then transferred to the
Statement of Financial Position as retained earnings.
4. Describe the different types of liquidity ratios, risk analysis
ratios, operating performance ratios and value ratios, and
evaluate company performance using these ratios.
◦ Liquidity ratios are used to evaluate a company’s ability to
turn assets into cash to meet its short-term commitments.
Ratios in this category look at the relationship between
assets and liabilities, specifically, how well current liabilities
are covered by the cash flow generated by the company’s
operating activities.
◦ Risk analysis ratios show how well a company can meet its
debt obligations. Because financial risk can increase with
higher levels of debt, these ratios help to show whether a
company has sufficient earnings to repay the funds it has
borrowed and its ability to make regular interest payments
on its outstanding debt.
◦ Operating performance ratios illustrate how well
management is making use of company resources. These
ratios focus on measuring the profitability and efficiency of
operations. They look specifically at the company’s ability to
manage its resources by taking into account sales and the
costs and expenses incurred in producing earnings.
◦ Value ratios show the investor what the company’s shares
are worth, or the return on owning them, by comparing the
market price of the shares to information in the company’s
financial statements. For example, these ratios look at the
earnings available to common shareholders, the dividend
yield or return on company shares, and the ultimate
valuation of a company through the price-earnings ratio.
5. Explain how to analyze a company’s financial statements using
trend analysis and external comparisons.
◦ Financial ratios become meaningful when compared with
other ratios over a period. A series of similar ratios for the
same company can be compared; or the company’s ratios
can be compared to those of similar companies or industry
averages.
◦ Ratios are most useful when comparing financial results of
companies in the same or similar industries. Trend lines help
to put the ratios of each company in historical perspective
and identify how each company has fared in relation to
others.
REVIEW QUESTIONS

APPENDIX A: XYZ INC. FINANCIAL

STATEMENTS
ASSETS
Current Assets
Cash $20,00
0
Inventories 60,000
Trade Receivables 40,000

Total Current Assets 120,00
0
Fixed Assets
Net Plant and Equipment 400,00
0
Total Assets $520,0
00
LIABILITIES
Current Liabilities
Trade payables $20,00

0
Notes Payable 40,000

Accrued Charges 20,000
Total Current Liabilities 80,000
Long-term Liabilities
Long-term Debt 200,00

0
Total Liabilities $280,0

00
Common Shares (100,000 outstanding shares) $40,00
0
Retained Earnings 200,00
0
Total Shareholder’s Equity 240,00
0
Total Liabilities and Shareholders’ Equity $520,0
00
XYZ Inc.
Statement of Comprehensive Income
for the Year Ending December 31, 20XX
Sales $1,000,000
Cost of Sales (600,000)
Gross profit 400,000
Expenses
General and Administrative ($200,000)
Selling Expense (50,000)
Depreciation (25,000)
Interest Expense (20,000)
Taxes (50,000)
Total Expenses (345,000)
Profit $55,000
Earnings Per Common Share $0.55
Statement of Changes in Equity
as at December 31, 20XX
Retained Earnings at beginning of period $175,000
Plus: Profit for the period 55,000
Less: Dividends paid on common shares (30,000)
Retained Earnings at end of period $200,00
0
SECTION 4
UNDERSTANDING MUTUAL
FUNDS AND MANAGED
PRODUCTS

SECTION 4 | UNDERSTANDING
MUTUAL FUNDS AND
MANAGED PRODUCTS
Section 4 is all about mutual funds and managed products. We
begin in Chapter 10 with a discussion of the modern mutual fund.
We describe how mutual funds are organized to distribute
securities to the public, and the rules you must follow in dealings
with clients. The structure of mutual funds is also a focus in this
chapter.
Chapters 11 and 12 discuss the different types of mutual funds
offered in the marketplace. We begin with low risk mutual fund
products in Chapter 11 and move on to riskier mutual funds in
Chapter 12. The point that we emphasize throughout is that the
risk and return characteristics of a mutual fund depend directly on
the composition of its investment portfolio.
M utual funds are not the only type of managed product available to
investors. In Chapter 13, we provide a comprehensive overview of
the many types of alternative managed products available in the
marketplace. Although mutual fund sales representatives are not
licensed to sell these products, it is always good to know what
other products are available for investors and to be able to answer
client questions about these products.
The Modern Mutual Fund 10
CONTENT AREAS
What is a Mutual Fund?
How are Mutual Funds Organized?
How are Mutual Funds Regulated?
LEARNING OBJECTIVES
1 | Define a mutual fund, describe the advantages and

disadvantages of investing in mutual funds,
and differentiate between the two principal types of
mutual fund structures.
2 | Describe the organizational features and functions of a

mutual fund and compare and contrast the roles played
by the directors and trustees, fund manager, portfolio
managers, distributors, and custodian.
3 | Describe how mutual funds are regulated and describe

the role of the simplified prospectus and the fund facts
document.
KEY TERMS
Annual Information Form (AIF)
board of directors
custodian
declaration of trust
fund facts
fund manager
independent review committee
investment fund
mutual fund
National Instrument 81-101
net asset value per share (NAVPS)
net asset value per unit (NAVPU)
open-end trust
portfolio manager
pre-authorized contribution plan (PAC)
registrar
Self-Regulatory Organization (SRO)
simplified prospectus
System for Electronic Document Analysis And Retrieval

(SEDAR)
transfer agent
trust deed
trustee
INTRODUCTION
The Canadian mutual fund industry has experienced tremendous
growth over the past decade, both in choice of products available
to investors and in the dollar value of assets under management.
Accordingly, the industry offers advisors and investors numerous
opportunities and challenges. Are mutual funds ideal for all
investors? As we have discussed previously in this course, there
is no one perfect security that suits all investors; however, mutual
funds have become important investment products for many
investors.
Although they may seem simple and nearly universally available,
mutual funds are in fact a complex investment vehicle. Available in
a variety of different forms and through a variety of different
distribution channels, they may be one of the most visible vehicles
for many investors, from the smallest retail client to the largest
institutional investor. The funds themselves are subject to a range
of unique provisions and regulations; thus, it is important to ensure
a full understanding of this particular investment vehicle.
Do you fully understand what funds can, and cannot, do for a
portfolio? Can you provide an educated explanation about the
different charges and fees that apply and what the implications are?
Can you identify what needs to be done to stay within the
regulations? In this first chapter on mutual funds, we explore the
structure and regulation of the mutual fund industry.
WHAT IS A MUTUAL FUND?

A mutual fund is an 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.
Individuals who contribute money become share or unitholders in
own. Professional money managers manage the assets of the fund
by investing the proceeds according to the fund’s policies and
M utual fund shares/units are redeemable on demand at the fund’s
current price or net asset value per share (NAVPS) or net asset
value per unit (NAVPU), which depends on the market value of
the fund’s portfolio of securities at that time.
A fund’s prime investment goals are stated in the fund’s prospectus
and generally cover the degree of safety or risk that is acceptable,
whether income or capital gain is the prime objective, and the main
types of securities in the fund’s investment portfolio.
Individuals who sell mutual funds, whether they are investment
advisors or mutual fund sales representatives, must have a good
understanding of the type and amount of risk associated with each
type of fund. As is true with other financial services, the mutual fund
representative must carefully assess each client profile to ensure
that the type of mutual fund that is recommended properly reflects
the client’s risk profile and investment goals. The mutual fund
representative also recognizes that a client’s investment goals and
objectives are never static and that the review process is ongoing,
not transactional. Finally, he or she recognizes that proper
diversification means that a client’s portfolio will contain an asset
mix allocated among: cash or near-cash investments, equity
investments and fixed-income investments.
NOTE TO STUDENTS
We use mutual fund representative to refer to those individuals

who have met the regulatory requirements to advise on and sell
mutual funds. Please be advised that the use of dealing
representative is also used within the industry. For consistency,
this course will use mutual fund representative.
ADVANTAGES OF MUTUAL FUNDS

M utual funds offer many advantages for those who buy them.
Besides offering varying degrees of safety, income and growth,
their chief advantages are:
LOW-COST PROFESSIONAL MANAGEMENT

The fund manager, an investment specialist, manages the fund’s
investment portfolio on a continuing basis. Both small and wealthy
investors purchase mutual funds because they do not have the
time, knowledge or expertise to monitor their portfolio of securities.
This is an inexpensive way for the small investor to access
professional management of their investments.
This is perhaps one of the main advantages that mutual funds offer.
The fund manager’s job is to analyze the financial markets for the
purpose of selecting those securities that best match a fund’s
investment objectives. The fund manager also plays the important
role of continuously monitoring fund performance as a way of fine-
tuning the fund’s asset mix as market conditions change.
DIVERSIFICATION
A typical large fund might have a portfolio consisting of 60 to 100 or
more different securities in 15 to 20 industries. For the individual
investor, acquiring such a portfolio of stocks is likely not feasible.
Because individual accounts are pooled, sponsors of managed
products enjoy economies of scale that can be shared with mutual
fund share or unit holders. As well as having access to a wider
range of securities, managed funds can trade more economically
than the individual investor. Thus, fund ownership provides a low-
cost way for small investors to acquire a diversified portfolio.
VARIETY OF TYPES OF FUNDS AND

TRANSFERABILITY
The availability of a wide range of mutual funds enables investors
to meet a wide range of objectives (i.e., from fixed-income funds
through to aggressive equity funds). M any 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.
Transfers are also usually permitted between different purchase
plans under the same fund.
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). One of the main advantages of mutual funds is the low cost
to invest. With as little as $100, an investor can begin to purchase
units in a fund through a PAC. Again, with as little as $100 a month,
they can continue to contribute. At redemption, there are also
several plans from which to choose.
LIQUIDITY
M utual fund shareholders have a continuing right to redeem shares
for cash at net asset value. National Instrument 81-102 requires
that payments be made within two business days after the date of
calculation of the net asset value used in establishing the
redemption price.
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. In contrast, other types of securities may not be readily
traded during the probate period even though market conditions
may be changing drastically.
The term ‘estate’ refers to all the assets owned by an individual

at the time of death. Estate planning refers to planning for the
administration and disposing of property of one’s estate upon
death. Probate is the process of validating an individual’s will
prior to distribution of estate assets.
LOAN COLLATERAL AND MARGIN ELIGIBILITY

Fund shares or units are usually accepted as security for a bank
loan. They are also acceptable for margin purposes, thus giving
aggressive fund buyers both the benefits and risks of leverage in
their financial planning.
VARIOUS SPECIAL OPTIONS

M utual funds consist of not only an underlying portfolio of
securities, but also a package of customer services. M ost mutual
funds offer the opportunity to compound an investment through the
reinvestment of dividends.
Sponsors of mutual funds file a variety of reports annually to meet
their regulatory disclosure requirements. These reports include the
annual information form (AIF), audited annual and interim financial
statements and an annual report, among others. The reports must
be provided to unitholders or any person on request. They are
easily retrieved through SEDAR (the System for Electronic
Document Analysis and Retrieval) at www.sedar.com.
Increasingly, these reports contain useful educational features such
as manager commentaries.
Other benefits associated with managed products include record-
keeping features that save clients and their advisors time in
complying with income tax reporting and other accounting
requirements.
DISADVANTAGES OF MUTUAL FUNDS
COSTS
For most people, a weakness in investing in a mutual fund is the
perceived steepness of their sales and management 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.
Competition in the market has subsequently reduced both load and
management fees, and investors are now offered a wider choice of
investment options.
UNSUITABLE AS A SHORT-TERM INVESTMENT OR

EMERGENCY RESERVE
M ost funds emphasize long-term investment and thus are
unsuitable for investors seeking short-term performance. Since
sales charges are often deducted from a plan holder’s
contributions, purchasing funds on a short-term basis is
unattractive. The investor would have to recoup at least the sales
charges on each trading transaction. This disadvantage does not
apply to money market funds, which are designed with liquidity in
mind.
With the exception of money market funds, fund holdings are
generally not recommended as an emergency cash reserve,
particularly during declining or cyclically low markets when a loss of
capital could result from emergency redemption or sale.
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). Volatility in the market is extremely difficult to
predict or time, and is not controllable by the fund manager.
TAX COMPLICATIONS
Buying and selling by the fund manager creates a series of taxable
events that may not suit an individual unitholder’s investment time
horizon. For example, although the manager might consider it in the
best interests of the fund to take a profit on a security holding, an
individual unit holder might have been better off if the manager had
held on to the position and deferred the capital gains liability.
THE STRUCTURE OF MUTUAL FUNDS

An investment fund is an incorporated company or trust that is
established for the purpose of managing the fund’s investments for
persons who invest in the company or trust. By selling shares or
units to investors, the fund gathers money and it is invested in
accordance to the fund’s investment policies and objectives by the
fund’s portfolio manager(s). The fund earns income principally from
dividends and interest it receives on the securities it holds and
from the capital gains it may make by selling securities held in its
portfolio. An investment fund can also have capital losses.
A mutual fund may be structured as either a trust or a corporation.
MUTUAL FUND TRUSTS

The most common structure for mutual funds in Canada is the
open-end trust. The trust structure allows a fund itself to avoid
taxation. Any interest, dividends and capital gains income, net of
the fund’s fees, expenses and capital losses, if passed to its
unitholders each calendar year, will allow the trust to avoid being
taxed on its income. As a matter of course all mutual fund trusts
take advantage of this ability to avoid income taxes. Any income
that has flowed through to the unitholder is taxed in the hands of
the unitholder. The rate of income tax depends on the type of
income that the fund generated (i.e. interest, dividends, capital
gains) and the type of account (e.g., RRSP) the client holds the
mutual fund in.
The declaration of trust, trust deed (or similar document)
establishing the mutual fund trust sets out:
• the fund’s principal investment objectives
• its investment policy
• any restrictions on the fund’s investments
• who the fund’s trustee, manager and custodian will be (or
simply names the trustee and gives the trustee the power to
appoint a manager and a custodian)
• how many classes or series of units the fund will or may have.
Different classes and series having different characteristics are
established to make them more attractive to different types of
purchasers (i.e., general public, pension funds, institutional
investors)
Rights and privileges attached to mutual fund units are specified in
the trust deed. Always included is the holder’s right to redeem the
units at a price that is the same as, or very close to, the fund’s net
asset value per unit (NAVPU) next determined after the fund
receives a redemption request in proper form. A fund’s unitholders
typically are not given voting rights under the terms of the trust
deed. Voting rights, if any, set out in the trust deed and those set
out in NI 81-102 are described in the fund’s simplified prospectus.
NI 81-102 generally requires the trustee or manager of a mutual
fund trust (or an incorporated mutual fund) to convene a meeting of
unitholders to consider and approve certain specific matters. These
matters include a change in the fund’s fundamental investment
objectives, a change in the mutual fund manager, a proposed new
fee or expense or a proposed increase in a fee or expense to be
charged to the fund or unitholders or a decrease in the frequency of
calculating net asset value.
MUTUAL FUND CORPORATIONS

M utual funds may also be set up as federal or provincial
corporations. Provided they meet certain conditions set out in the
Income Tax Act, mutual fund corporations are eligible for a special
tax treatment if the corporation’s holdings consist mainly of a
diversified portfolio of securities. The income that the mutual fund
corporation earns must be derived primarily from interest and
dividends received from these securities and any capital gains
realized from the sale of these securities. Investors in mutual fund
corporations receive shares in the fund instead of the units that are
received by investors in mutual fund trusts. M utual funds
corporations lack the flow through status of mutual fund trusts.
However, mutual fund corporations can achieve a similar result by
declaring dividends during the course of the year that are
equivalent to the corporation’s net income after fees and
expenses. These dividends are then taxed in the hands of the
fund’s shareholders.
MUTUAL FUNDS FUNDAMENTALS
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trust and a mutual fund corporation? Complete the online
HOW ARE MUTUAL FUNDS ORGANIZED?

While there are significant structural differences between mutual
fund corporations and mutual fund trusts, they both share common
organizational features. Governance is the responsibility of the
board of directors or the Trustee, day to day management is the
responsibility of the fund manager, who can perform a number of
key functions on behalf of a fund itself, but most often hires others
to attend to many of these functions, including portfolio
management, distribution of units/shares, registration and transfer
agency services, accounting and trade processing. Each mutual
fund is required to have an Independent Review Committee (IRC).
A single IRC can act for a number of separate funds.
DIRECTORS AND TRUSTEES

The board of directors of a mutual fund corporation, and the
trustee(s) of a mutual fund trust, have the ultimate responsibility
for the fund’s activities, including ensuring that the fund’s
investments are in keeping with the fund’s investment objectives.
To assist in this task, the board of directors or trustee(s) may rely
on others to provide certain services to the fund, including a fund
manager, a portfolio manager(s), a principal distributor, a custodian,
and a registrar and transfer agent for the fund’s units/shares. While
the fund issues and redeems its own securities, it may enter into
contracts (with fund managers, distributors and custodians) that
spell out the services each will provide and the fees and other
charges to which each is entitled. Typically a fund manager is given
overall responsibility and it may hire others to provide portfolio
management, back office administration, distribution, custody, and
registrar and transfer agency services. A fund manager may not act
as a fund’s custodian.
THE FUND MANAGER

The fund manager provides day-to-day supervision of the fund’s
investment portfolio. While a fund manager may provide portfolio
management to a fund it manages, most often it hires a company
that specializes in providing such services, often an affiliated
company. In trading the fund’s securities, the fund manager must, or
ensure that the portfolio manager of the fund, observes a number
of guidelines, prohibitions and restrictions as specified in the fund’s
trust deed (or incorporation documents) and simplified prospectus,
as well as constraints imposed by applicable laws, most importantly
National Instrument 81-102. Often a fund manager will hire one or
more portfolio managers to manage the fund’s investment
portfolio under the fund manager’s supervision. The fund manager
is responsible for the portfolio manager’s actions. Fund managers
and portfolio managers generally maintain a portion of fund assets
in cash and short-term liquid debt instruments to be able to pay
unitholders or shareholders who redeem their units or shares
respectively, pay distributions (or dividends in the case of mutual
fund corporations)1 and purchase securities for the fund’s portfolio
as opportunities arise. A fund manager’s ability to properly judge
the amount of cash needed, and still have fund assets as fully and
productively invested as possible, has a direct bearing on the
success of the fund.
Other responsibilities of a fund manager, which it can attend to itself
or outsource, include calculation of the fund’s net asset value,
preparation of the fund’s fund facts document, simplified
prospectus, annual information form and other required reports,
income tax reporting, shareholder or unitholder record-keeping and
reporting, and providing instructions to the custodian2 for the
release of the fund’s cash or securities to settle the fund’s
purchases and sales of securities. The fund manager can retain
third parties to provide these services, but is ultimately responsible
for the actions of such third parties. The fund manager receives a
management fee for managing the fund which it uses to pay for
services that others provide to the fund. This fee typically is
calculated and accrues daily and is paid monthly in arrears. It is
calculated as a percentage of the net asset value of the fund being
managed.
Starting in late 2010, mutual fund managers were required to be
registered with provincial and territorial securities administrators,
and must meet a number of requirements, including capital and
insurance requirements.
INDEPENDENT REVIEW COMMITTEE

Each mutual fund is required under National Instrument 81-107 to
have an independent review committee (or IRC) which is
required to either approve or consider conflicts of interest that are
identified by the manager of the fund. With regard to certain
matters, such as inter-fund trading or the purchase of securities
underwritten by an affiliate of the manager, the independent review
committee’s approval must be obtained prior to such activities
taking place. Where a conflict of interest arises, the IRC will only
approve actions if certain requirements are met, including and most
importantly the action achieves a fair and reasonable result for the
fund. With regard to other conflicts of interest that are identified by
the manager, the approval of the IRC is not required, but the IRC
issues a report each year to unitholders where it is obliged to
describe each instance where its recommendation with regard to a
conflict of interest has not been followed by the manager of the
fund.
MUTUAL FUND DISTRIBUTION

M utual funds are distributed through a number of channels by
dealing representatives employed by investment dealers, mutual
fund dealers and, to a lesser extent, exempt market dealers.
M utual funds can be distributed through sales forces employed by
organizations that control both management and distribution of
mutual funds (e.g., IGM Financial Inc., which includes Investors
Group, M ackenzie Investments and Investment Planning Counsel)
and by dealing representatives employed by dealers who are
affiliated with financial institutions. Employees of trust companies,
banks or credit unions who are employed both by the financial
institution to provide banking and related services, can also be
registered as dealing representatives for an affiliated, but separate,
mutual fund dealer.
When selling or providing advice or information about mutual funds,
these employees are acting solely on behalf of the affiliated mutual
fund dealer. They are required to comply with all the laws and
regulations that apply to dealing representatives. For example, they
must explain the objectives and relevant features of various funds
using language that clients can understand, including
unsophisticated clients, They handle client inquiries about a fund’s
features, and receive and transmit orders for fund unit/share
redemptions and purchases. As dealing representatives these
employees must meet the “Know Your Client” rule and suitability
standards in providing such services.
THE CUSTODIAN
When a mutual fund is established, a separate organization, most
often a trust company, is appointed as the fund’s custodian. The
custodian receives and holds the fund’s money obtained from all
sources—investors buying the fund’s units or shares, income
earned by the fund’s investment portfolio, proceeds from the sale
of the fund’s investments, holds all the fund’s assets and
distributes the fund’s money to pay the fund’s expenses, including
management fees, purchases of securities for the fund’s
investment portfolio, payments for redeemed units and shares and
distributions or dividends to unitholders or shareholders
respectively.
Sometimes the custodian also serves as the fund’s registrar and
transfer agent, maintaining records of who owns the fund’s
units/shares. This duty is complicated by the fact that the number
of outstanding units/shares is continually changing through
purchases and redemptions. Fractional share purchases and the
reinvestment of distributions/dividends further complicate the
custodian’s task.
To better keep track of account activity, almost all mutual funds use
a book-based system for settling account transactions. With this
system, purchases and redemptions of fund units and shares are
recorded in a client’s account maintained by the registrar and
transfer agent. There are no paper certificates representing the
shares or units. Instead of issuing certificates, the fund manager or
the dealer periodically issues statements that set out the client’s
holdings in each fund at the end of the applicable period that
reconcile to the registrar and transfer agent’s records.
HOW ARE MUTUAL FUNDS REGULATED?

The Canadian securities industry is a regulated industry. Each
province and territory has its own securities act and its own
regulator who is responsible for regulating the underwriting and
distribution of securities designed to protect investors and the
industry. Securities regulations related to mutual funds are based
upon three broad principles: personal trust, disclosure and
regulation.
The success of these principles in promoting positive market
activities relies largely on ethical conduct by industry registrants.
The code of ethics establishes norms for duty and care that
incorporate not only compliance with the “letter of the law,” but also
respect for the “spirit of the law.” These norms are based upon
ethical principles of trust, integrity, justice, fairness and honesty.
The code distills industry rules and regulations into five primary
values:
• M utual fund representatives must use proper care and exercise
professional judgement.
• M utual fund representatives should conduct themselves with
trustworthiness and integrity, and act in an honest and fair
manner in all dealings with the public, clients, employers
and employees.
• M utual fund representatives should conduct, and should
encourage others to conduct, business in a professional
manner that will reflect positively on the individual registrant,
the firm and the profession, and should strive to maintain and
improve their professional knowledge and that of others in the
profession.
• M utual fund representatives must act in accordance with the
securities act of the province or provinces in which registration
is held, and must observe the requirements of all Self-
Regulatory Organizations (SROs) of which the firm is a
member.
• M utual fund representatives must hold client information in the
strictest confidence.
SELF-REGULATORY ORGANIZATIONS
(SROS)
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. Furthermore, all securities industry
participants are subject to the securities law in their particular
provinces and in any other province where the relevant securities
administrators may claim jurisdiction.
Please note that reference to province or provincial

encompasses Canada’s 10 provinces and three territories.
The Mutual Fund Dealers Association (M FDA) is the mutual

fund industry’s SRO for the distribution side of the mutual fund
industry. It does not regulate the funds themselves. That
responsibility remains with the provincial securities commissions,
but the M FDA does regulate how the funds are sold. The M FDA is
not responsible for regulating the activities of mutual fund dealers
who are already members of another SRO. For example, IIROC
members selling mutual fund products will continue to be regulated
by IIROC.
In Québec, the mutual fund industry is under the responsibility of
the Autorité des marchés financiers and the Chambre de la
sécurité financière. The Autorité is responsible for overseeing the
operation of fund companies within the province, while the
Chambre is responsible for setting and monitoring continuing
education requirements and for enforcing a code of ethics. A co-
operative agreement currently in place between the M FDA and the
Québec regulatory organizations will help to avoid regulatory
duplication and to ensure that investor protection is maintained.
NATIONAL INSTRUMENTS 81-101 AND 81-102

Canadian funds fall under the jurisdiction of the securities act of
each province. Securities administrators control the activities of
these funds, and their managers and distributors, by means of a
number of National and Provincial Policy Statements dealing
specifically with mutual funds, and by provincial securities
legislation applicable to all issuers and participants in securities
markets. National Instrument 81-101 (NI 81-101) deals with
mutual fund prospectus disclosure. National Instrument 81-102
(NI 81-102) and a companion policy contain requirements and
guidelines for the distribution and advertising of mutual funds.
GENERAL MUTUAL FUND DISCLOSURE

REQUIREMENTS
M ost mutual funds are qualified for sale in all provinces and are
therefore registered for sale in each jurisdiction. With certain
exceptions, the funds must annually file client disclosure
documents (i.e., Fund Facts, simplified prospectus and Annual
Information Form) all of which must be acceptable to the provincial
securities administrator. M ost funds, particularly the smaller ones,
file their respective client disclosure documents in provinces where
sales prospects appear favourable. Selling a fund’s securities to
residents of provinces in which the fund has not been qualified is
prohibited. It is important, therefore, that mutual fund
representatives deal only in those funds registered in their own
jurisdiction.
M utual funds predominantly use the client disclosure documents
system to qualify the distribution of mutual fund securities to the
public. The actual requirements of this system are set out in NI 81-
101.
The documents included as part of the disclosure requirements
consist of:
• Fund Facts
• Simplified Prospectus
• The Annual Information Form (AIF)
• 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.
NI 81-101 requires only the delivery of the fund facts document to
an investor in connection with the purchase of a mutual fund,
unless the investor also requests delivery of the simplified
prospectus, the annual information form and/or the financial
statements.
THE FUND FACTS DOCUMENT

The Fund Facts document is designed to give investors key
information about a mutual fund. It must be written in plain language
and must consist of no more than two double-sided pages. It must
be presented in an easily understood format that follows a
universal standard so that investors can compare mutual fund data
consistently. The purpose of the Fund Facts document is to
provide timely information that may affect the investors’ decision.
Pre-purchase delivery of the Fund Facts document to investors is
mandatory for each class or series of mutual funds. It may be
delivered in person, by email, or through other means, according to
how the dealer typically interacts with its investors.
The following disclosure of investor rights related to withdrawal and
misrepresentation must appear in the Fund Facts document:
• Investors have the right to withdraw from the purchase within
48 hours after confirmation of the purchase is received.
• Depending on the province, they maintain their right of
damages or to rescind the purchase if the Fund Facts
document, simplified prospectus, AIF, or financial statements
contain a misrepresentation.
• Each province specifies a time limit within which investors must
act to claim the right to damages or rescission.
• Investors can request a copy of the simplified prospectus at no
charge.
DISCLOSURE COMPONENTS OF FUND FACTS

The fund facts document is divided into two major headings, each
with its own section of related items.
The sections covered under the first heading provide information
about the fund:
Table 10.1 | Information About The Fund
Fund Facts Purpose

Section
Introduction Provides the document date, name of the fund,

the fund manager and if the mutual fund has more
than one class or series of securities, the name of
the class or series.
Quick Facts Provides key background points including the date

the fund was created, the total value of all units of
the fund, the M anagement Expense Ratio (M ER),
the identity of the portfolio manager, the expected
frequency and date of distributions, the minimum
investment needed for both the initial and repeat
purchases.
Investment Provides the fundamental nature of the mutual
of the Fund fund under the heading “What Does the Fund
Invest In?” as well as a list of top 10 investments
and the percentage of net asset value for each
investment, the investment mix, a breakdown of
the fund’s investment exposure.
Risks Provides a reminder that the fund is subject to a
certain degree of risk, the extent of that risk
demonstrated by the risk rating assigned to the
fund (there are 5 risk ratings: Low, Low to
M edium, M edium, M edium to High and High).
Investors are also reminded that the fund does
not guarantee a return and the investor may not
get back the amount of money invested.
Past Appears under the heading “How Has the Fund
Performance Performed?” and provides three illustrative tools:
I. The Fund’s performance over the past 10
years (or since the date of its inception if
under 10 years), illustrated by a chart, on
a year by year basis. Returns are “after
expenses” have been deducted.
II. A table showing both the best and worst
returns for the Fund in a 3-month period
over the past 10 years (or since the date
of its inception if under 10 years).
III. An average return calculation based on
an investment of $1,000 into the Fund
10 years ago (or since the date of its
inception if under 10 years) and its worth
today, together with the percentage
annual compound return during this
period.
Suitability Falls under the heading of “Who is this Fund for?”

and provides a description of the investor
characteristics for whom the Fund may or may not
be appropriate and the portfolios for which the
Fund is and is not suited.
Impact of The tax consequences of the Fund are highlighted
Income in this area under the heading of “A word about
Taxes on taxes.”
Investor
Returns
The sections of the fund facts document covered under the second
heading provide information about costs, rights and other
information:
Table 10.2 | Cost, Rights and Other Information
Fund Facts Purpose

Section
Cost of This area is divided into 3 subsections:
Buying, I. Sales Charges – disclosure of fees that
Owning may be charged to the investor in a variety
and of ways depending on the type; front load,
Selling the low load, deferred sales charges or no
Fund load.
II. Fund Expenses – although an investor
does not pay for these expenses directly,
they may reduce the Fund’s returns. Such
expenses may include M anagement
Expense Ratio (M ER) and the Trading
Expense Ratio (TER). The TER
represents the amount of trading
commissions incurred to manage the
portfolio compared to the total assets of
the fund. Both ratios are expressed as a
percentage value and translated to a dollar
figure relative to every $1,000 invested.
Trailing commissions are also highlighted in
this area.
III. Other Fees – these may include short-term
trading fees, switch fees and/or change
fees.
Statement This area would fall under the heading of “What if I
of Rights change my mind?” It advises the investor that they
may have certain rights and options within a defined
time period available to them. These rights include
cancelling a purchase within 48 hours after receiving
confirmation of the purchase.
More If the investor wishes to obtain more information,
Information such as the simplified prospectus and other
about the disclosure documents, the appropriate contact
Fund information would be provided in this area.
FUND FACTS DOCUMENT
Follow the steps to load a Fund Facts document and

familiarize yourself with each section. Complete the online
THE SIMPLIFIED PROSPECTUS

Despite the introduction of the fund facts document, the simplified
prospectus of a mutual fund is still required to be filed and made
available to an investor upon their request.
A mutual fund prospectus is normally shorter and simpler than a
typical prospectus for a new issue of common shares. Under the
simplified prospectus system, the issuer must abide by the same
laws and deadlines that apply under the full prospectus system. As
well, the buyer is entitled to the same rights and privileges.
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. The simplified
prospectus is written in plain language and set up in a specific
format so that it is easier for the investor to find the information.
The mailing or delivery of the simplified prospectus must be made
to the purchaser upon their request. For further purchases of the
same fund, it is not necessary to provide the simplified prospectus
(or fund facts document) again unless it has been amended or
renewed.
The simplified prospectus consists of two sections:
• Part A provides introductory information about the mutual fund,
general information about mutual funds and information
applicable to the mutual funds managed by the mutual fund
organization.
• Part B contains specific information about the mutual fund.
The simplified prospectus may be used to qualify more than one
mutual fund, as long as Part A of each prospectus is substantially
similar and the funds belong to the same mutual fund family,
administered by the same entities and operated in the same
manner.
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
• M ethod used to set the price of the securities being sold or
redeemed, and disclosure of any sales charges
• M ethod of distribution
• 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
• Notice of any legal proceedings material to the issuer
• Identity of the auditors, transfer agent and registrar
• Statement of the purchaser’s statutory rights
• Summary of the fees, charges and expenses payable by the
security holder
The prospectus must be amended concurrently with the fund facts
document when material changes occur, and investors must
receive a copy of the amendment.
Certain types of mutual funds may not use the simplified
prospectus system under National Instrument 81-101. M utual funds
that invest in real property, for example, cannot use the simplified
prospectus system.
As part of the simplified prospectus system, a fund must provide its
investors with financial statements on request. Annual audited
financial statements must be made available to the securities
commission(s) where the fund is registered on or before the
deadline set by the commission(s). These statements must be
made available to new investors.
Unaudited financial statements as at the end of six months after
the fund year-end must also be submitted to the securities
commissions, usually within sixty days after the reporting date.
These statements must also be given to new investors.
THE ANNUAL INFORMATION FORM
Delivery of the annual information form (AIF) is available to
investors on request. M uch 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
Case Study | Never Put All Your Eggs in One Basket: Daniella
Diversifies (for information purposes only)
Daniella has been investing since her early teens, using savings
from her part-time job to buy T-bills. After graduating from university
and getting her first full-time job, Daniella began to save larger
amounts of her income, and began buying Government of Canada
bonds through her online brokerage account. Daniella’s bond
portfolio returns were satisfactory, generating steady if low returns
as interest rates continued at their near-historic lows.
Recently, Daniella has learned more about investing and has read
that over the long term, equity investments tend to outperform
bond investments. Furthermore, the tax rate on dividend and
capital gains generated by equities is much lower than that of
interest income. She decides she wants to invest some of her
savings into equities, but wants to start small and build her comfort
level and knowledge over time.
She meets with Rebecca, her bank’s mutual fund representative, to
discuss her options and to get some advice. Daniella explains her
situation and her wish to invest in equities to earn better returns
over time. Rebecca confirms for Daniella that historically equities
have outperformed bonds over the long term. She also explains to
Daniella that investing in equities will help diversify her portfolio,
enhancing returns while reducing the risk of overconcentration in
one asset class. Equities can also provide diverse exposure to
blue-chip companies like banks that produce bond-like returns
through their dividend payments, while also gaining exposure to
companies that are more growth-orientated, like in the technology
sector.
Rebecca then explains the importance of achieving diversification
in regards to the stocks of various companies across a range of
sectors and industries, again to avoid over-concentration risk. She
explains that by doing so, Daniella will, as the old saying goes,
avoid putting all of her eggs in one basket. So, in the event that
one company’s stock underperforms or its value falls dramatically,
Daniella will have a variety of other holdings to offset that bad
performance.
However, to achieve an appropriate level of diversification requires
the purchase of at least 25 to 30 stocks. Given the cost and the
investment amount required,, it is unrealistic at this stage for
Daniella to do this. Nor would she have the time and knowledge to
manage all of those holdings. So, Rebecca recommends to
Daniella that she can achieve instant diversification through a risk-
appropriate mutual fund. A mutual fund will provide Daniella with the
flexibility she needs to invest a smaller amount and to increase her
equity exposure over time in a cost-effective manner. While she
continues to build her knowledge about equities, she can
immediately benefit from the knowledge and capabilities of the
fund’s portfolio managers while achieving the benefits of
diversification instantly.
Rebecca shows Daniella the fund facts document of a fund that
she feels would be appropriate in meeting Daniella’s needs,
pointing out how the mandate of the fund is clearly defined, the
fund’s top holdings are listed and that all costs and fees are easily
understood and transparent for investors. Daniella agrees with
Rebecca’s recommended course of action and they then begin the
process of establishing Daniella’s investment plan.
SUMMARY
1. Define a mutual fund, describe the advantages and
disadvantages of investing in mutual funds, and differentiate
between the two principal types of mutual fund structures.
◦ A mutual fund is an investment vehicle operated by a fund
manager that pools contributions from investors and invests
them in a variety of securities, which may include stocks,
bonds and money market instruments, depending on the
investment policies and objectives of the mutual fund.
◦ A modern mutual fund can be established as either a trust or
a corporation. M utual fund trusts issue units, while mutual
fund corporations issue shares.
◦ The trust structure enables the fund itself to avoid taxation.
Any interest, dividends or capital gains income, net of the
fund’s fees and expenses can be passed on directly to the
unitholders without the trust being subject to any income
taxes.
◦ A mutual fund corporation’s holdings must consist mainly of a
diversified portfolio of securities. The income that a mutual
fund corporation earns must be derived primarily from the
interest and dividends received on the securities it owns and
net capital gains realized from the sale of these securities.
2. Describe the organizational features and functions of a mutual
fund and compare and contrast the roles played by the
directors and trustees, fund manager, distributors, and
custodian.
◦ The board of directors of a mutual fund corporation, and the
trustees of a mutual fund trust, have ultimate responsibility
for the fund’s activities, including ensuring that the
investments are in keeping with the fund’s investment
objectives.
◦ The fund manager provides day-to-day supervision of the
fund’s investment portfolio.
◦ The fund manager typically hires a portfolio manager or
managers to manage the fund’s investment portfolio, and
hires a custodian to hold the fund’s assets and a registrar
and transfer agent to keep track of units or shares
outstanding and who owns the units or shares. The fund
manager is responsible for the distribution of units and can
use a variety of distribution channels consisting of mutual
fund dealers and investment dealers, both those affiliated
and unaffiliated with the fund manager.
◦ M utual funds are distributed in many ways, including dealing
representatives who are employees or agents of investment
dealers and mutual fund dealers.
◦ The custodian receives and holds the fund’s money
obtained from all sources—investors buying the fund’s units
or shares, income earned by the fund’s investment portfolio,
proceeds from the sale of the fund’s investments and
distributes the fund’s money to pay the fund’s expenses.
3. Describe how mutual funds are regulated and describe the role
of the simplified prospectus and the fund facts document.
◦ M utual funds are subject to provincial and territorial laws and
regulations.
NI 81-102 addresses key aspects of the creation, operation
◦ and distribution of mutual fund securities.
◦ National Instrument 81-101 sets out the requirements as to

the form and content of a mutual fund’s disclosure
documents, including the fund facts document, which is the
single most important document for investors.
◦ The fund facts document states the fundamental investment
objectives of the fund, the risk factors, and the fees and
charges that investors will have to pay directly and fees and
expenses paid by the fund.
◦ The form and content of the fund facts document must
comply with the requirements of National Instrument 81-101;
the fund facts document must be given to the investor.
REVIEW QUESTIONS

1 Unitholders and shareholders generally re-inv est distributions and div idends in the
funds.
2 The portfolio manager ty pically is granted this authority by the fund manager.
Conservative Mutual Fund Products 11
CONTENT AREAS
What are Money Market Mutual Funds?
What are Mortgage Mutual Funds?
What are Bond and Other Fixed-Income Funds?
LEARNING OBJECTIVES
1 | Compare and contrast the investments objectives and features of

money market funds, mortgage funds, bond funds and other fixed-
income funds.
2 | Differentiate the two methods of calculating yield of money market

funds.
3 | List and describe the investment objectives, comparative returns and

the volatility of the different types of fixed-income mutual funds.
4 | Describe the impact of interest rate risk on fixed-income securities

and the concept of duration as it applies to conservative mutual
funds.
KEY TERMS
Key terms are defined in the Glossary and appear in bold text in the
chapter.
amortization period
amortized cost
basis points
bond funds
capital gains
closed mortgage
conventional mortgage
corporate bonds
current yield
default risk
duration
effective yield
fixed-income funds
interest rate risk
market review
money market fund
mortgage
mortgage funds
non-conventional mortgage
open mortgage
preferred dividend funds
seven-day yield
short-term bond funds
term
term to maturity
time-weighted maturity
volatility
INTRODUCTION
At this point in your studies, you will begin to learn about the products mutual
fund sales representatives are licensed to sell. This is the “know your product”
side of providing excellent client service. When assisting clients with their
investment decisions, product knowledge is every bit as important as knowing
the client. Lack of a thorough understanding of both the client and product areas
risks an improper fit between clients and mutual funds. The next two chapters
examine the various types of mutual funds available in the marketplace. This
examination begins with conservative mutual fund products, consisting of money
market mutual funds, mortgage mutual funds, bond funds and other fixed-income
mutual funds. These are products sitting at the lower end of the risk hierarchy.
The following sections examine the investment objectives of the specific class of
fund and compare the performance of the fund class to other fund classes and
benchmarks. For example, how does the return on money market funds compare
to the fund next highest in risk? As well, how do money market funds compare to
the returns on T-bills?
The chapter then goes on to explain what to look for in the mutual fund tables.
Finally, the chapter presents a sample mutual fund, citing its investment
objectives and examining the composition of its portfolio as contained in its
annual report.
WHAT ARE MONEY MARKET MUTUAL FUNDS?

According to the Canadian Investment Funds Standards Committee (CIFSC),
money market funds must invest at least 95% of their total net assets in money
market securities. M oney market securities are short term, highly liquid fixed
income investments of varying maturities of 364 days or less that are readily
convertible into cash.
Their returns reflect changes in short-term interest rates, moving up as interest
rates rise, and down as they fall. There are, however, two important differences
that distinguish money market fund investments from their traditional banking
counterparts.
• M oney market investments are not insured by the Canada Deposit
Insurance Corporation (CDIC) or any other insurer.
• M oney market funds may fluctuate in value with changes in short-term
interest rates.
The risk of default on these portfolios is very low, since they are backed by the
governments issuing them. This does not mean that their value cannot change,
however. Recall that the value of any fixed-income security, like a bond, will
fluctuate as market interest rates change. The change in value will be inversely
related to the direction of interest rates and directly related in larger magnitudes
as maturities increase in length. The value of money market securities should still
fluctuate with changing interest rates, but the fluctuation should be relatively
small, because their maturity is very short.
MONEY MARKET FUNDS: INVESTMENT OBJECTIVES

The investment objective of a money market fund is to earn stable returns by
investing in short-term money market securities. These securities include
Government of Canada T-bills, T-bills of other provinces, very-short-term
government securities other than T-bills, and high-quality corporate securities
such as commercial paper and bankers’ acceptances. As required by National
Instrument 81-102, the term to maturity of these securities is less than one year,
and the average term to maturity of a money market fund must be 90 days or
less.
The value of short-term debt securities is not very sensitive to changes in
interest rates. A risk associated with long term investing in money market funds
is that these funds sometimes have a return that does not keep pace with
inflation, thus eroding the purchasing power of the investment. However, money
market securities, and money market funds, are expected to have a low amount
of volatility (risk). In addition, money market securities generally have a low
amount of default risk. Certainly, the securities issued or guaranteed by the
government have virtually no default risk. Corporate money market securities
have some default risk, but mutual funds will invest only in those that have high
credit ratings.
Safety of principal and liquidity are of prime importance for money market funds.
Given the low risk characteristics and the built-in liquidity of money market
securities, this objective is relatively easy to achieve. The objectives of safety of
principal and high liquidity are similar to the investment objectives of traditional
banking and trust company products, such as term deposits and guaranteed
investment certificates (GICs). There is, however, an important difference
between money market funds and traditional deposits. M oney market funds are
not covered by deposit insurance. Clients must be informed of this fact prior to
the purchase of any mutual fund, and this is especially important because of the
similarity between money market funds and deposits.
THE RETURNS ON MONEY MARKET FUNDS

Given the low risk profile and objectives of capital preservation and liquidity of
money market funds, you would expect that their return performance would show
considerable stability. This performance profile is confirmed in the graph in
Figure 11.1. This graph compares the annual returns of a money market fund to
the annual returns of mortgage funds during a hypothetical period of 15 years.
Figure 11.1 | Simple Annual Return Funds
Source: Bloomberg
Notice that the return pattern on mortgage mutual funds is both higher and more
volatile than money market funds. Using the same data that were used to
construct Figure 11.1, this means that the compound average annual return over
the example of a 15-year period on mortgage funds (4.42%) is higher than the
compound average annual return in the same period for money market funds
(3.21%). The trade-off of creating the higher return on the average mortgage
fund, therefore, is more volatility from year to year.
If you compare what you earn on the average money market fund to what you
might earn on an average T-bill, you will find that the average money market fund
return is lower. Perhaps the simplest reason for the difference is the management
fees charged on money market fund. Although management fees are lower for
this type of mutual fund, they still reduce the net return earned by your clients. If
you assume an annual management fee of 1%, then the total return earned by
the average money market mutual fund was equivalent to that earned on T-bills
over the 15-year period.
All returns earned on money market funds are considered interest earnings and
are taxed as interest income. Since money market funds invest only in money
market securities that pay income, no other type of income can be earned. In
general, money market funds distribute the earned interest income on a monthly
basis.
READING PERFORMANCE TABLES: MONEY MARKET

FUNDS
Until the advent of the Internet, mutual fund data in the financial press were
constrained by the newspaper columns in which they were printed. As the
Internet grew and mutual fund data became more widely disseminated, the
amount and detail of data also expanded. M utual fund data are now readily
available in great depth on the websites of newspapers
(e.g., www.globeandmail.com), web search and links sites (e.g.,
www.fundlibrary.com) and third-party providers such as Morningstar
(www.morningstar.ca).
A mutual fund investor turning to any of these sources typically finds a basic
array of information on funds of interest, which could include:
• performance data, usually from one month to inception
• comparison to the returns of an appropriate index over the same time periods
• sector or asset allocation breakdown
• top 10 holdings and portfolio weights
• a record of distributions
• a profile of the fund manager
• price history and charts
• background information, including management fees, sales fees, RRSP
eligibility and minimum investment amounts
Performance data for money market funds are reported slightly differently
compared to other types of mutual funds. While other funds report changes in net
asset value per unit, most money market funds assume that the net asset value
per unit is usually constant at $10 and instead report the yield currently being
earned.
When money market funds report performance, they use two yield calculations:
the current yield and the effective yield. The current yield for a money market
fund is calculated as the most recent seven-day yield on the fund, adjusted to an
annual rate. The seven-day yield is calculated as follows:
EXAMPLE
Consider a fund with $10 million of net assets that has earned the following
amounts over the last seven days.
Day Earnings (net of expenses) Cumulative NAV
1 $1,500 $10,001,500
2 $1,600 $10,003,100
3 $1,750 $10,004,850
4 $1,400 $10,006,250
5 $1,499 $10,007,749
6 $1,340 $10,009,089
7 $1,400 $10,010,489
The seven-day yield is calculated by dividing the ending net asset value
($10,010,489) by the fund’s initial net asset value ($10 million) and then
subtracting 1. The current yield is the seven-day yield multiplied by 365/7.
The effective yield is computed using the seven-day yield (0.0010489 in the
example) and the following effective yield formula.
Substituting the 0.0010489 for the seven-day yield in this formula gives an
effective yield of 5.62%.
Note: to calculate 1.0010489 to the power of 365/7, you would need to use
the “Y to the X” exponent button on your calculator. The Y variable on your
calculator would be 1.0010489 and the X variable would be 52.1429 (since
365/7 = 52.1429). 1.0010489 to the power of 52.1429 = 1.0562.
National Instrument 81-102 gives money market funds the choice of reporting
current yield or current and effective yield. However, money market funds usually
provide two yield calculations. Both yields are required to avoid confusion in
interpretation. Previously, some funds reported only their current yield, while
others reported only their effective yield. Since the effective yield is always
higher than the current yield for the same fund, funds reporting only current yield
appeared to be generating lower returns, which was not necessarily the case.
Confusion is eliminated by providing both yields.
To interpret the yields, you must examine the assumptions made in each yield
calculation. First, note that the current yield calculation looks only at the return
over the most recent seven-day period and ignores what your client might do
with the money if it were paid out. This calculation assumes, therefore, that
compounding of returns will not take place.
The effective yield calculation, in contrast, makes the assumption that the yield
generated over the last seven days will remain constant for one year into the
future, and that the returns earned weekly are re-invested in the fund. Thus,
weekly compounding of returns at the current rate is assumed in the effective
yield calculation.
Which of these two calculations is best depends on your point of view. If you are
looking for a short-term return, comparable to term deposits and GICs, and do
not expect to re-invest the income, then the current yield (which does not
assume compounding) is perhaps better. If, however, you are looking for a
somewhat longer-term investment, then the effective yield is better, as it
assumes the compounding of returns, which is more consistent with longer term
investments. M oney market fund standard performance data are the effective
and/or current yields, computed using data not more than 45 days old.
SAMPLE MONEY MARKET FUND

This examination of a sample money market fund uses hypothetical information
to illustrate how this type of mutual fund might operate and the types of
investments the fund might contain.
As with most mutual funds, the sample prospectus is designed to avoid repetition
by dealing simultaneously with all of the mutual funds distributed by the same
distributor. For the money market fund, the investment objective could be:
“…to conserve capital while maintaining liquidity and achieving a regular
income. For that purpose, the Fund’s assets are primarily invested in
commercial paper and bankers’ acceptances issued and guaranteed by major
Canadian corporations and all financial institutions, including Canadian
chartered banks, trust companies, and savings and credit unions. The Fund
may also invest in Treasury bills issued by the Government of Canada or a
province of Canada, short-term debt securities of municipal and school
corporations, or in guaranteed funds of Canadian financial institutions. The
average weighted duration until maturity of the Fund’s portfolio does not
exceed 180 days. The Fund plans to maintain the value of its units at
approximately $10.”
How are these investment objectives expressed in the portfolio that the fund
manager has constructed? First, look at the breakdown of the portfolio
investments at the end of December 20X1, presented in pie-chart form in
Figure 11.2. Of the whole portfolio, approximately 22% is invested in federal and
provincial T-bills, 11% is in bonds maturing within 6 months, and 67% in notes
(commercial paper and bankers’ acceptances) and cash.
Figure 11.2 | Sample Money Market Fund at Dec. 20X1 (by unamortized
cost)
Turning to the Statement of Investment Portfolio (Figure 11.3), note that there are
a total of 25 different securities in the portfolio. Of the 25, three are federal T-bills
of varying remaining maturities, ranging from three months (April 1, 20X2) to about
six months (June 10, 20X2). There are four provincial T-bills and notes of banks
and provinces.
Figure 11.3 | Sample Statement of Investment Portfolio: Sample Money

Market Fund
Investment Portfolio as at December 31, 20X1
Par Value Cost
Money market securities (87.81%)

Bank of M ontreal, notes
20X2-02-24 $3,000,000 $2,909,820
Caisse centrale Desjardins, notes
20X2-02-24 3,800,000 3,760,062
20X2-10-02 2,600,000 2,571,712

Canadian Imperial Bank of Commerce, notes
20X2-03-29 1,900,000 1,872,070
Diversified Trust, notes
20X2-01-21 2,000,000 1,983,260

Laurentian Bank, notes
20X2-02-26 4,300,000 4,260,741
National Bank of Canada, notes
20X2-01-25 1,500,000 1,463,175

Prime Trust, notes
20X2-01-22 1,700,000 1,692,554
Province of Nova Scotia, notes
20X2-06-07 7,200,000 7,028,956

20X2-06-21 3,000,000 2,929,530
Province of Quebec, notes
20X2-01-06 150,000 148,065
20X2-03-30 4,000,000 3,918,680

20X2-03-31 2,850,000 2,784,123
Reliant Trust, notes
20X2-02-04 4,000,000 3,947,040
Toronto-Dominion Bank, notes

20X2-02-26 3,000,000 2,963,850
Treasury Bills – Canada
20X2-04-01 1,000,000 981,160

20X2-05-27 1,000,000 981,180
20X2-06-10 1,840,000 1,799,686
Treasury Bills – Quebec
20X2-01-22 3,000,000 2,962,110

20X2-01-29 5,645,000 5,504,742
20X2-09-10 280,000 270,449
Treasury Bills – Newfoundland
20X2-01-14 2,000,000 1,973,820

Total money market securities 58,706,785
Quebec Public Corporations (3.16%)
Hydro-Québec
Euro, 11.000%, 20X2-02-09 2,100,000 2,111,015

Educational Institutions (1.07%)
Commission scolaire des Portages-de-l’Outaouais
10.500%, 20X2-06-21 700,000 716,103
Institutional, Commercial and Industrial (7.48%)

G.M .A.C.
5.550%, 20X2-04-09 5,000,000 5,002,741
Total bonds 7,829,859
Total investments (99.52%) 66,536,644

Cash and net balance payable (0.48%) 318,619
Net assets (100%) $66,855,263
The total portfolio value is stated at cost but is expected to be a good

approximation of market value given the stable nature of the securities. The
value is about $67 million. Note that the largest single investment is $7.2 million
in a Province of Nova Scotia note maturing June 7, 20X2.
The financial statements also include a market review (not presented here). In
the market review, the fund manager explains what has happened to rates, and
therefore the performance, of the fund over the recent past, and why. The fund
manager also provides a forecast or outlook for the fund over the next few
months. The outlook portion of the market review reflects the fund manager’s at
the time of the statements. Those views are likely to change as time goes on,
and the fund manager can turn out to be wrong.
MONEY MARKET RETURNS
Can you calculate the different kind of money market yields? Complete
the online learning activity to assess your knowledge.
WHAT ARE MORTGAGE MUTUAL FUNDS?

These funds generally invest in high-quality residential mortgages (usually
National Housing Act – NHA – insured). Small parts of their portfolio can be
invested in cash and bonds and mortgage backed securities. Mortgage funds
are in the “fixed-income” category, along with bond funds and preferred dividend
funds. All three of these types of funds earn income in the form of interest (for
mortgage and bond funds) and dividends (for preferred dividend funds). Unlike
money market funds, which also earn interest income, these fixed-income funds
can also generate capital gains.
M ortgage mutual funds are considered to carry higher risk than money market
funds but less risk than bond funds. In addition to the fact that mortgage fund
returns have been more volatile than money market funds over the last 10 years,
the assets that mortgage funds hold have higher default risk. This is because
mortgage funds are backed by the creditworthiness of individuals rather the
creditworthiness of a government, as in the case of T-bills.
INTRODUCTION TO MORTGAGES
A mortgage is a loan secured against real property. It has two main
characteristics: an amortization period, during which the entire principal amount
of the mortgage will be paid off, and a term, during which a particular rate of
interest on the mortgage stays in effect. Amortization periods range up to
25 years (sometimes longer). Terms can be as long as 10 years and as short as
six months. Variable interest rate mortgages are also available.
M ortgages are characterized as either open or closed. An open mortgage can
be repaid at any time by the mortgagor (the borrower) without paying an interest
penalty. A closed mortgage can also be repaid prior to the end of the term, but a
substantial interest penalty may apply. Because of this penalty, the borrower
does not break the term until its end, when the mortgage term reopens for
renegotiation. Open mortgages typically have a higher interest cost than closed
mortgages because of the repayment feature.
Residential mortgages are conventional mortgages if they do not exceed 80%
of the appraised value of the property. M ortgage lenders do not generally require
insurance on conventional mortgages, because they have good security in case
of default. Non-conventional mortgages require insurance. Insurance raises the
cost of the mortgage by as much as 300 basis points (A basis point is 1/100 of
a percent). If you negotiate a mortgage at 5%, for example, and are required to
pay 75 basis points more for insurance, the mortgage will cost 5.75% (5% +
0.75%).
Under certain conditions, residential borrowers can have their mortgages insured
under the National Housing Act. The Act provides government guarantees in case
of default. M ortgage borrowers make “blended” monthly mortgage payments that
include principal repayment and interest.
A confusing aspect of mortgage mutual funds involves understanding why a
mortgage fund’s net asset value should move up or down with changing
mortgage interest rates. Recall that fixed-income securities move in the opposite
direction to market interest rates. Consider that a mortgage rate, once negotiated
between the borrower and lender, is fixed until the end of the term, at which point
the rate is renegotiated. Now imagine that you are the fund manager for a
mortgage mutual fund and have just bought a $100,000 mortgage at par from a
financial institution. Buying the mortgage at par means that the mortgage interest
rate and the current rate on mortgages are the same. Assume that the rate is 5%
and that your mortgage fund computes net asset value per share (NAVPS) on a
daily basis.
What would happen to the NAVPS if mortgage rates suddenly increase to 6%?
Of course, only the interest rates on newly negotiated mortgages would
increase. The rate on the $100,000 mortgage you bought previously is fixed at
5% until the end of its term. Is that mortgage still worth par value?
To answer this question, think about whether you would be able to sell that
mortgage to someone at par. Clearly, if someone had $100,000 to invest today,
he or she would be able to buy a mortgage offering an interest rate of 6%. The
investor would not pay you $100,000 for a 5% rate. If you wished to sell the
mortgage, then you would have to lower your price until the price paid—given the
5% fixed payments to be made—results in a return to the buyer of 6%, the “going
rate” on mortgages. In other words, the market value of your $100,000 par value
mortgage must fall.
Computing a fund’s net asset value per unit means determining the value of the
portfolio as if you were going to sell it all today. In the case of a rise in mortgage
rates, the price at which you could sell the portfolio today will be lower, so the net
asset value will decline. The opposite is true for a fall in mortgage rates. Falling
mortgage rates will result in an increase in the value of the mortgage portfolio.
When the investment objectives of a mortgage mutual fund suggest the
possibility of capital gains, it is referring to times when mortgage interest rates fall.
M ortgages do not trade on exchanges or on the OTC market. To be fair to new
purchasers of a mortgage fund’s units, the fund’s current market value must be
determined prior to completing the purchase, and this can be done only by
computing the fund’s value as if all of the mortgages were to be sold.
MORTGAGE FUNDS: INVESTMENT OBJECTIVES

The investment objective of mortgage funds is to earn current income through
investment in a diversified portfolio of mortgages while at the same time
preserving capital. In some cases, the investment objective also includes a
desire to earn capital gains, but the emphasis is always on the side of preserving
capital.
M ortgage funds are not identical in risk and do not have identical portfolios. The
types of mortgages that a mortgage fund can hold vary greatly from mortgage
fund to mortgage fund. As a result, the funds’ risk levels can vary greatly as well.
Some funds specify exactly what kind of mortgages they can invest in. For
example, the investment strategy of a typical mortgage fund limits mortgages in
the following way:
• First mortgages on Canadian residential and commercial properties that are
National Housing Act (NHA) insured. This is sometimes referred to as a
mortgage “guaranteed by the government.”
• Debt instruments issued or guaranteed by the Government of Canada, any
Canadian provincial government or agencies of any of these governments.
• Debt instruments issued by Canadian municipalities and companies.
Some mortgage funds restrict investment to residential first mortgages. Other
funds invest in commercial and industrial mortgages. Commercial and industrial
mortgages have different characteristics from residential mortgages. First, they
tend to have high principal amounts, so each mortgage held in the fund is larger.
Second, they tend to have longer terms. While residential mortgages have terms
from one to three years on average, commercial and industrial mortgages have
terms of three to five years.
All mortgage characteristics are important in understanding the risk level of
mortgage funds. Two kinds of risks in mortgage funds are default risk and
volatility.
Default risk is low for virtually all mortgage funds, because the portfolios are
highly diversified. For funds holding residential mortgages, many individual
mortgages are required to form a large portfolio. A typical mortgage fund may hold
10,000 to 15,000 individual mortgages.
M ortgage funds, therefore, have low default risk. M ost default risk has been
removed by holding many mortgages. In addition, most of the mortgages held by
funds investing in residential mortgages are either NHA-insured or privately
insured against default. Finally, in the case of many mortgage funds, any
mortgage found to be in default is bought by the fund’s distributor or the
distributor’s parent company.
The volatility of mortgage funds is directly related to the average term of its
mortgage portfolio. As with bonds, the longer the average term to maturity, the
higher the fund’s sensitivity to changes in mortgage interest rates.
Interest rate sensitivity is expected to be lower for mortgage funds than for bond
funds for two reasons.
• First, mortgage rates change much less frequently than interest rates on
bonds. The decision to change mortgage rates rests with the banks and
other mortgage lenders, while the interest rates (or yields) on bonds change
when investors bid up or bid down the prices of bonds that trade in the
market. This bidding takes place daily.
• Second, mortgages by nature have less interest rate risk than bonds. The
reason, in part, is that interest on mortgages is paid monthly, while interest on
bonds is paid semi-annually. Another reason is that the average mortgage
has a shorter term than the average bond.
From the perspective of both default risk and interest rate risk, mortgage funds
are more risky than money market funds but should be less risky than bond
funds.
M any mortgage funds contain additional fixed-income securities. Depending on
market conditions, fund managers might decide to hold short-term debt
instruments, such as T-bills, in the portfolio, and some mortgage funds hold
bonds as well. Some funds might even hold mortgage-backed securities, a type
of bond based on the interest and principal to be repaid on a pool of mortgages.
What a mortgage fund is permitted to hold as investments is stated in the
investment objectives. If you are ever in doubt, just check the portfolio holdings
contained in the annual report.
THE RETURNS ON MORTGAGE MUTUAL FUNDS
As you can see from Figure 11.4, mortgage mutual funds are less volatile than
bond funds but more volatile than money market funds. Since mortgage fund
returns are less volatile (less risky) than bond funds, you should expect
mortgage funds to earn a lower return. Over the hypothetical period of 15 years,
it does appear that mortgage fund returns (4.42%) have been lower than returns
on bond funds (5.31%) on average.
Figure 11.4 | Simple Annual Returns: Mortgage Funds
Source: Bloomberg
The data in Figure 11.4 is consistent with everything you would expect about the
relative risk and return characteristics of money market funds, mortgage funds
and bond funds. The money market fund achieved a 3.21% annualized return, the
mortgage fund achieved a 4.42% annualized return and the bond fund achieved a
5.31% annualized return over the same 15-year period. This is a good example
of the relationship between the return and the volatility of returns. However, this
does not mean that higher risk securities will always provide higher returns.
The returns on mortgage mutual funds are made up of two components: interest
and capital gains. The interest component is distributed to unitholders at least
quarterly and often monthly. Capital gains are distributed annually at the end of
the year.
A TYPICAL MORTGAGE MUTUAL FUND

Following is a mock-up of a typical mortgage mutual fund, including its statement
of investment objectives and portfolio holdings (Table 11.1). How is the mutual
fund manager attempting to put the objectives into practice?
Table 11.1 | Summary of Investment Portfolio (at December 31, 20X1)
Number of Principal Amortized % of

NHA Mortgages Value Cost Current Value Net Assets
Total M ortgages $1,182,709,510 $1,180,622,413 $1,206,991,713 89.5
13,946
Holdings Average Cost Current Value % of Net Assets
Total Short-Term Notes $119,520,24 $120,419,57 9.0

5 1
Total Portfolio $1,300,142,6 $1,327,411,2 98.5

58 84
Cash and Other Net Assets $20,684,353 $20,684,353 1.5

Total Net Assets $1,320,827,0 $1,348,095,6 100.00
11 37
The accompanying notes are an integral part of these financial statements.
Statement of Investment Objective, Risk Factors, and Suitability
Investment • To provide a high level of income and some capital growth,

Objective while preserving capital by investing primarily in first
mortgages.
Risks • M ortgage funds tend to be more stable than bond funds.

• There is very little risk that the mortgages in the fund will
default, because they are insured by an agency of the federal
government.
Suitability • Appropriate for investors looking for regular income who are
uncomfortable with a lot of risk.
Based on the stated objective of holding NHA-insured mortgages, you would

expect to see such mortgages occupying a major portion of the portfolio. A look
at the Statement of Portfolio Holdings confirms this: NHA-insured mortgages
account for 89.5% of the portfolio. Short-term notes (money market securities)
make up the next highest percentage at 9%. The rest of the portfolio consists of
cash and other assets (1.5%). This is a large mortgage fund with a market value
of $1.2 billion. Note that the portfolio is diversified over 13,946 mortgages.
The mortgage fund includes a column called amortized cost. This cost reflects
the fact that the mortgages may have been added to the portfolio when the
market rate for them was different from their fixed rate. Recall that, as with bonds,
changes in mortgage rates have an opposite impact on the value of a mortgage.
If the market rate is different from the rate on a specific mortgage, then it will have
a value different from its par value.
WHAT ARE BOND AND OTHER FIXED-INCOME

FUNDS?
Bond funds invest in all types of bonds. They are considered more risky than
mortgage funds and less risky than balanced funds (which contain a selection of
stocks). However, it is also true that individual bond funds can actually be riskier
than individual balanced funds, or even individual equity funds. The point is that
the risk characteristics of a fund depend entirely on the composition of its
investment portfolio. Some equity funds may be very conservatively managed,
while some bond funds may be very aggressively managed.
The investment objective of fixed-income funds is to earn current income while
preserving capital. Some fixed-income funds also try to earn capital gains. The
principal fixed-income mutual funds are mortgage funds and bond funds. Other
fixed-income mutual funds are the preferred dividend fund, investing primarily in
preferred shares, and the short-term bond fund. The short-term bond fund is a
cross between a money market fund and a bond fund and has characteristics of
both.
This section examines the investment objectives of bond funds, compares the
performance of bond funds to other types of investments and funds, reviews the
performance reporting of bond funds in financial publications or online and then
studies a hypothetical fund in some detail. Also included is a look at other fixed-
income funds, specifically the characteristics of preferred dividend and short-term
bond funds.
INTEREST RATE RISK AND THE CONCEPT OF

DURATION
Interest rate risk is the fundamental risk factor for fixed-income securities such
as bonds, mortgages and preferred shares. Recall that as interest rates move up,
the value of a fixed-income security falls, and as interest rates fall, the value of a
fixed-income security moves up.
Also recall that as the term to maturity on fixed-income securities becomes
longer, the more sensitive they become to changes in interest rates. For
example, a 20-year bond will be much more sensitive to interest rate changes
than a three-year bond. In addition, if a bond has a lower coupon rate, its value
will tend to be more sensitive to interest rate changes than a bond with a higher
coupon rate. For example, a bond with a 3% coupon will be more sensitive to
interest rate changes than a bond with a 7% coupon. To make matters more
complicated, there are additional factors that influence a bond’s sensitivity to
interest rate changes.
As mutual fund sales representatives, we would like to have a simple number or
index that can tell us which of two bonds will be more sensitive to a change in
interest rates without having to examine the bonds’ features directly. We would
also like to be able to look at two bond portfolios and use the same simple
number or index to say which of the two portfolios is more sensitive to interest
rate changes. Fortunately, such a number exists; it is called duration. You have
seen in Chapter 8 that as a bond’s duration increases, its interest rate sensitivity
increases as well. The same is true of a bond portfolio.
Duration is expressed in years. It is sometimes referred to as a bond’s time-
weighted maturity. This is an important measure for fund managers because
they can use it to decide how much interest rate risk a fund should bear, based
on its investment objectives and the manager’s outlook for changes in interest
rates:
• If fund managers believe that interest rates are ready to fall, then they will
increase the duration of the bond portfolio by replacing short-term, high
coupon bonds with longer term, lower coupon bonds in the portfolio (that is,
make it more sensitive to the fall in rates so that the portfolio will increase in
value).
• If fund managers believe rates will rise, then they will shorten the duration of
the portfolio (by replacing long-term, low coupon bonds with shorter term,
higher coupon bonds in the portfolio) to make it less sensitive to interest rate
changes. By shortening the portfolio’s duration, they will protect the portfolio
from a decline in value to a certain extent as rates rise.
Duration is not the same as term to maturity, but they are related. For all bonds
except zero coupon bonds, the duration is always less than the term to maturity.
Recall that zero coupon bonds are sold at discount to face value, do not pay
interest, and mature at face value, so for zero coupon bonds the duration is equal
to the term to maturity.
M ost mutual funds report the durations of their fixed-income funds. Duration is a
useful measure for mortgage funds, bond funds, preferred dividend funds and
balanced funds. A mutual fund company’s fund facts document and simplified
prospectus, regarding the investment strategy of its bond fund, may read:
The fund’s policy is to maintain a minimum duration of six years.
The mutual fund company may also indicate that the duration of its income fund
will be between three and 10 years. From these data, you know that a fixed-
income fund with a duration of 3 years is less interest-rate sensitive than a fixed
income fund with a duration of 10 years. Other factors such as default risk and
market risk (for balanced funds) must be included when you consider total risk,
but duration provides a clear answer to the question of relative interest-rate risk
and volatility.
BOND MUTUAL FUNDS: INVESTMENT OBJECTIVES

Bond mutual funds are designed to provide current income and capital
preservation with some potential for capital gains. Conservative bond funds will
put more emphasis on the current income and capital preservation side, while
more aggressive funds seek out higher capital gains.
To provide current income, a fund manager primarily invests in higher-coupon
government securities and corporate bonds. Higher-coupon securities provide
higher current cash flow, and government securities have essentially no default
risk. Corporate bonds, especially those with lower credit ratings, offer better
yields than government bonds to compensate for their higher risk. To provide
capital gains potential, the manager invests in bonds with a longer duration when
interest rates are expected to fall.
Until the late 1970s, bonds were considered very stable types of investments,
suitable for risk-averse investors. Since that time, with the increased volatility of
interest rates, they have sometimes proven as risky as equities and at times
even more volatile than equities. M utual fund sales representatives need to be
aware that some clients might still believe that bond funds are stable
investments. Clients should be informed that this is not really the case today
given fluctuating interest rates. Also, different bond funds can take quite different
positions regarding risk. If your bond fund has done much better than other bond
funds, then its duration has almost certainly been higher. Investing in fixed-
income securities does not mean that a fund has the same objective or risks as
other bond funds.
THE RETURNS ON BOND FUNDS

Figure 11.5 presents the simple annual returns for bond funds over a hypothetical
15-year period, comparing bond fund returns to the returns on equity mutual
funds.
Figure 11.5 | Simple Annual Returns: Canadian Bond Funds
Source: Bloomberg
Similar to money market funds, bond fund returns are lower than the returns on
the investments (long-term bonds) that constitute the funds. This lower return
might be the result of bond fund management fees. The management expense
ratios for bond funds are around 2%. Also, the figure shows that in comparison to
equity funds, bond funds have been less volatile.
The average returns over the 15-year period provide a useful lesson about risk.
Based on the volatility of returns, you would expect equity funds to perform
better than bond funds. Equity funds earned 6.17% on average, while bond funds
earned 5.31%. Even with the dramatic volatility equity funds return experienced in
years 13 and 14, equity funds performed better than bond funds over the 15-year
period.
A TYPICAL CANADIAN BOND FUND

From the fund facts document, simplified prospectus or annual report, the
investment objective of a typical bond fund may read as follows:
Objectives To provide high income with some capital growth.
Invest in high quality Canadian government and corporate debt
securities with terms to maturity of more than one year.
This statement of objectives is similar to that of other bond funds. Note that this
fund states that securities will likely have a term to maturity of more than one
year. This fund would be very conservative if the average term to maturity were
close to one year, which is a very short duration.
Given the maturity breakdown of the sample portfolio, the fund reports a duration
of 5.3. Other than cash and money market (comprising 6.4%), 49.8% of holdings
have maturities of less than 5 years, 29.7% have maturities of 5-10 years, and
16.9% have maturities of more than 10 years.
Figure 11.6 | Typical Bond Fund Sectors
The sector breakdown of a typical bond fund, shown in Figure 11.6, might read as
follows:
• 59% is invested in Government of Canada bonds
• 10% is invested in provincial bonds
• 24% is in corporate bonds
• 4% is in money market securities
• 3% is in cash
SHORT-TERM BOND FUNDS: INVESTMENT

OBJECTIVES
A short-term bond fund is part money market fund and part bond fund. You would
expect its investment objectives to reflect this combination. A short-term bond
fund’s objectives are to preserve capital and generate better current income than
is likely from a money market fund. Although there is some capital gain potential,
you would not expect this to be a key objective given the short duration of this
type of fixed-income fund.
In the past, short-term bond funds often were regarded as “aggressive” money
market funds. This is not unreasonable, since short-term bond funds typically
have a large percentage of their investments in money market securities.
However, the Canadian Securities Administrators have been increasingly
concerned about the possibility of misleading consumers. They do not want
consumers to see the name “money market” and immediately believe that the
fund must be very low risk. For this reason, the only funds allowed to be called
money market funds are those meeting certain criteria having to do with the
maturity of the assets held in the portfolio. M oney market funds cannot have a
maturity longer than 364 days.
Funds consisting of short-term domestic and foreign government bonds can have
different objectives, risk levels, and investment strategies.
Table 11.2 | Examples of Short-Term Government Bond Funds
XYZ Short-Term Bonds ABC Short-Term Bonds

Objective M aximize income while Provide a high current income while
simultaneously preserving maintaining reasonable unit price
capital and liquidity by stability. The net assets of this
investing primarily in short- Fund are invested only in term
term bonds. deposits, treasury bills and other
money market instruments. It may
also be invested in debt securities
having a term to maturity of five
years or less, issued by Canadian
federal, provincial or municipal
governments or a public body or
agency established by them, the
World Bank, and the U.S.
government.
Investment Invests mainly in short- The Fund does not invest more
Strategy term bonds of the than 20% of its assets in debt
Canadian or provincial securities of the World Bank and
governments and their the U.S. government together,
agencies. The Fund may provided, however, that the portion
invest up to 20% of its of assets invested in debt
portfolio in short-term U.S. securities of the World Bank does
government bonds. The not exceed 10%.
weighted average term to
maturity of the Fund’s
portfolio is limited to a
maximum of five years.
The Fund’s portfolio is
actively traded to realize
capital gains when
available.
Risks The unit price, or net The principal risks of this Fund are
asset value of the Fund, referred to in the prospectus
varies with movements in introduction and later under “Risks
interest rates. Since the Relating to Interest Rate
Fund can invest in bonds Fluctuations” in order for all risks to
issued in U.S. dollars, the be disclosed and explained to the
unit price may also be investor. The short-term investment
affected by changes in objectives restrict the portfolio to
U.S. currency exchange maturities of less than five years. If
rates against the most of the securities had terms
Canadian dollar. close to five years, you would think
of this fund as a “medium-term”
bond fund, but it is likely that few of
the securities would have a five-
year maturity.
Distributions The Fund’s income is The Fund’s income is distributed

distributed quarterly. monthly.
PREFERRED DIVIDEND FUNDS: INVESTMENT

OBJECTIVES
Preferred dividend funds have the goal of earning current dividend income while
at the same time preserving capital. As with other fixed-income funds, there is a
limited potential for capital gains.
The decision to call one fund a preferred dividend fund and another an equity
fund has more to do with the stability of the dividend income the fund expects to
earn than with the precise composition of its investment portfolio. If the
investment objective is high current dividend income, then you know that the
most stable form of dividends is from preferred shares. Therefore, you would
expect preferred shares to play a major role in the portfolio. Common shares of
some firms also pay very regular dividends, however. In other words, a preferred
dividend fund need not hold only preferred shares in its portfolio. It may even
hold mostly common shares and still be called a preferred dividend fund.
However, when most of the shares held are common shares, the fund is referred
to simply as a “Dividend Fund”.
There are two reasons for wanting to earn dividend income as opposed to the
interest income expected from bond funds.
• First, dividends are paid by securities having a higher risk profile than bonds
(especially government bonds), such as preferred shares and the common
shares of “mature” companies. Given the higher risk, these securities are
expected to earn higher returns than debt securities.
• Second, dividend income from Canadian sources is taxed at a lower rate than
interest income, due to the dividend tax credit.
Preferred dividend funds are not as common as other types of fixed-income
funds. Two examples follow.
Table 11.3 | Examples of hypothetical Preferred Dividend Funds
Guarded Monthly The Canada Bank

Dividend Fund Dividend Fund
Investment To generate a high level of dividend To provide high

Objectives income and to preserve capital. dividend income
while emphasizing
the preservation of
the capital
investment of unit
holders. This Fund
will invest the
majority of its assets
in preferred shares of
Canadian issuers.
Principal High-quality preferred shares of The December 31,

Investments Canadian corporations. “High quality” 20XX Annual Report
preferred shares means that fund indicates that
managers likely restrict their selection to preferred shares
preferred shares rated either make up 66% of the
P1 or P2, the two highest-quality ratings portfolio. M oney
for preferred shares. market securities,
The investment objectives are reflected including T-bills and
in the make-up of the December 31, bankers’
20XX portfolio. 64.2% of the portfolio is acceptances,
invested in different P1 and P2 preferred account for another
shares; 11% of the preferred shares are 10%.
floating-rate rather than fixed-rate.
Principal The P1 and P2 preferred shares ratings The principal risks

Risks reduce significantly the default risk of the referred to in the
portfolio. The principal risk is the introductory
variability in value due to interest paragraph are
rates risk. completed by “Risks
Relating to Financial
M arkets
Fluctuations” and
“Risks Relating to
Interest Rate
Fluctuations.”
Distributions Pays dividends monthly from the Fund’s Income distributions

income, capital gains or from capital. The are made quarterly
Fund will generally distribute enough in and capital gains are
capital gains dividends so that it receives distributed once a
refunds of all tax it would otherwise pay. year.
The requirement of generating dividend
income from “Canadian corporations” is
there to make sure that the dividend tax
credit can be applied to dividend income.
Note that you must look at the objectives and portfolio of a fixed-income fund,
not just its name, to determine if it is actually a “preferred dividend fund” as
described in this section or some other type of fund.
Case Study | A Preference for Preferreds: Using Preferred Dividend Funds

to Generate Tax-Effective Income (for information purposes only)
John is meeting with Terry, his mutual fund advisor, to discuss options to invest
new funds he has from the sale of a vacation property. Retired, John lives off of
the income produced by his investment portfolio. He is a conservative investor
who values low volatility and income-focused investments over higher volatility
and capital growth-focused ones. Terry has structured John’s portfolio so that it
is made up of mostly of income-producing mutual funds, such as traditional bond
and mortgage funds. He has also made sure that John’s portfolio has a portion
of it in money market funds to meet short-term cash flow and any emergency
needs.
John’s investment income is fairly high, so for tax reduction purposes, he asks
Terry about conservative investment options that produce relatively low volatility
returns, preserve capital but that produce tax-effective returns.
Terry explains that preferred dividend funds would be an ideal fit for John’s
portfolio given his stated desire for a stable income-producing investment that
produces tax-effective income. Terry goes on to explain to John that preferred
shares generally produce higher levels of income than bonds because they are
perceived as slightly riskier. For instance, companies must pay bond holders the
interest payments owed on the bonds before paying dividends to preferred
shareholders. However, Terry explains that the fund he would recommend to
John only purchases top-rated, blue chip companies’ preferred shares with
excellent track records of paying their dividends.
While they rarely experience capital growth, the preferred shares in the fund do
produce a steady quarterly cash flow of dividends that will support John’s
retirement income needs, while also generally producing a low volatility
investment experience. Lastly, John will benefit from the dividend tax credit on
the fund’s dividend income, significantly reducing taxes on that investment
income versus the taxes on the interest income produced by bond and
mortgage bond funds.
MONEY MARKET TERMINOLOGY
How familiar are you with money market mutual fund terminology?
Complete the online learning activity to assess your knowledge.
SUMMARY
1. Compare and contrast the investments objectives and features of money
market funds, mortgage funds and bond and other fixed-income funds.
◦ The investment objective of a money market fund is to earn stable returns
by investing in short-term money market securities.
◦ The investment objective of mortgage funds is to earn current income
through investment in a diversified portfolio of mortgages while at the
same time preserving capital.
◦ Bond mutual funds are designed to provide current income and capital
preservation with some potential for capital gains.
◦ A short-term bond fund’s objectives are to preserve capital and generate
better current income than is likely from a money market fund.
◦ Preferred dividend funds have the goal of earning current dividend income
while at the same time preserving capital.
2. Differentiate the two methods of calculating yield of money market funds.
◦ Both the current yield and the effective yield use the seven-day yield. The
seven-day yield is calculated by dividing the ending net asset value by the
fund’s initial net asset value and then subtracting 1.
◦ The current yield for a money market fund is calculated as the most recent
seven-day yield on the fund, adjusted to an annual rate. The formula is:
◦ The effective yield is computed using the seven-day yield and the
following effective yield formula.
3. List and describe the investment objectives, comparative returns and the
volatility of the different types of fixed-income mutual funds.
◦ The volatility of returns of fixed-income mutual funds are, from lowest to
highest:
– money market funds
– mortgage funds
– bond funds
– preferred dividend funds
4. Describe the impact of interest rate risk on fixed-income securities and the
concept of duration as it applies to conservative mutual funds.
◦ Interest rate risk is the fundamental risk factor for fixed-income securities
such as bonds, mortgages and preferred shares. As interest rates move
up, the value of a fixed-income security falls.
◦ Duration is a measure of the sensitivity of a bond’s price (or the price of a
portfolio of bonds) to changes in interest rates. The higher the duration of
the bond (or the portfolio of bonds), the more it will react to a change in
interest rates.
REVIEW QUESTIONS
Now that you have completed this chapter, you should be ready to
answer the Chapter 11 Review Questions.
If you have any questions about this chapter, you may find answers in
the online Chapter 11 FAQs.
Riskier Mutual Fund
12
Products
CONTENT AREAS
What are Equity Mutual Funds?
What are Balanced Mutual Funds?
What are Global Mutual Funds?
What are Specialty Mutual Funds?
LEARNING OBJECTIVES
1 | Describe and compare and contrast the composition of

the different types of equity mutual funds.
2 | List and describe the investment objectives,

comparative returns and the volatility of the different
types of equity mutual funds.
3 | Describe the features and key types of specialty mutual

funds.
KEY TERMS
balanced mutual funds
currency forward contract
equity growth funds
equity index funds
equity mutual funds
foreign exchange risk
fund of funds
fund wraps
glide path
global equity funds
global mutual funds
international funds
market risk
natural resource funds
portfolio allocation service
precious metals funds

small cap funds
specialty mutual funds
standard equity funds
target-date funds
INTRODUCTION
This chapter covers riskier mutual fund products ranging from equity
and balanced mutual funds, which are toward the middle of the risk-
return spectrum, to global and specialty mutual funds, which are at
the higher end of the risk-return spectrum. M utual fund sales
representatives should not, however, rely on a fund’s name or
categorization to determine its suitability for clients; instead, you
must do your homework and take a close look at a mutual fund’s
fund facts document, prospectus and annual report. A balanced
fund may turn out to be a high-risk product if it is slanted
aggressively towards equities, while a specialty fund may be lower
risk because of its investment objective and portfolio composition.
WHAT ARE EQUITY MUTUAL FUNDS?

Equity mutual funds invest in the common and preferred shares of
publicly-traded companies. Equity mutual funds as a group have the
goal of earning capital gains, sometimes with a current dividend
income component. They are the riskiest of the three basic mutual
fund types—money market, fixed-income, and equity funds—and
are suitable primarily for clients with longer investment time
horizons.
It is difficult to discuss equity mutual funds as one mutual fund
category. The problem is that although all equity mutual funds share
the objective of investing in equities, the particular equities they
select give different funds very different risk and return
characteristics. This chapter examines Canadian equity mutual
funds in terms of three fairly distinct types: “standard” equity funds,
equity growth funds and equity index funds.
What are the investment objectives of these types of equity funds,
what are their return characteristics in comparison to the S&P/TSX
Composite Index, and what are some examples of equity funds?
STANDARD EQUITY FUNDS

There are no mutual funds that distributors refer to as “standard”
equity funds. The term is used here to distinguish this type of fund
from the two other types discussed. A standard equity fund
seeks to earn some combination of dividend income and capital
gains from investment in Canadian common stocks. This objective
appears to be similar to that of a preferred dividend fund. The
difference between the two is that an equity fund usually has a
much stronger capital gains focus. Note as well that equity funds
make no specific attempt to preserve capital; in other words, equity
funds are willing to put capital at substantially greater risk than
preferred dividend funds in the hope of earning higher returns.
To earn both dividend income and capital gains, portfolio fund
managers must seek out common shares that pay dividends
generally but also have some potential for capital appreciation. The
most conservative of these equity funds hold common shares of
large capitalization firms with strong dividend records. That is,
these firms almost always pay their quarterly dividend. The capital
appreciation potential for this type of shares is, however, limited.
EQUITY GROWTH FUNDS

The investment objective of an equity growth fund is capital
gains. Some dividend income may be earned, but probably not
much. Equity growth funds seek out smaller firms that do not have
the financial ability to pay dividends. They need all the funds they
can obtain in order to grow. If these firms are successful, their
share prices should increase to reflect the growing value of
the firm.
The key risk factor that equity growth funds present to you and
your clients is that smaller, growing firms have a greater potential
for failure than larger, well-established firms. In addition, these
growth firms often trade at very high price/earnings ratios (recall
that the P/E ratio is the price paid for a share relative to the profit
earned per share). This tends to make a growth firm’s share price
particularly volatile, causing equity growth funds to have a lot of
volatility.
As with standard equity funds, equity growth funds can be
conservative or aggressive for their class. An aggressive growth
fund invests exclusively in smaller, lesser-known firms. Sometimes
these types of funds are called small cap funds. “Small cap”
stands for small capitalization, which means that the market value
of the equity of the firm is relatively low, probably because the firm
itself is small. In this chapter, small cap funds are treated as
specialty mutual funds.
Recall that you can calculate the market value of a firm’s equity in
the following way:
M arket Capitalization = Number of shares outstanding ×
Current M arket Share Price
In contrast to aggressive growth funds, more conservative equity
growth funds seek out small, growth-oriented firms that have higher
market capitalizations than small cap funds.
EQUITY INDEX FUNDS

An equity index fund has the goal of replicating the movements of
a market index. In Canada, that particular index is often the
S&P/TSX Composite Index. Equity index funds intend to do this by
constructing an investment portfolio that has similar weightings to
the index it tries to replicate.
For example, if Company ABC represents 4% of the chosen index,
the equity index fund would include 4% of Company ABC shares.
And so on for most of the stocks represented in the index. Index
funds generally do not hold all of the stocks represented in the
index they try to replicate. Some very illiquid stocks, or those that
have a very small weighting in the index may not be included in the
index fund.
Equity index funds typically generate capital gains, and are also
likely to earn a certain amount of dividend income simply because
some of the stocks in the index will pay dividends. This is not
always the case, however. Some equity index funds do not own
equities at all. Instead, they hold risk free investments like T-bills
and purchase derivatives that closely replicate the index return.
EXAMPLE
An index fund can construct its portfolio by buying Canadian T-

bills and S&P/TSX 60 Index Futures. The return from that
combination of T-bills and futures will mimic the return on the
Index, but the returns will be made up of interest income from
the T-bills and the futures contracts, not from dividends and
capital gains on the stocks underlying the Index.
Equity index funds appeal to clients who believe strongly in market

efficiency and think that portfolio managers generally lack the skills
to beat the markets consistently. There is the added benefit of
lower management fees, due to the fact that equity index funds are
easier to construct and manage than other types of equity funds.
As a result, investing in an index fund is a lower-cost way for your
clients to pursue a passive investment strategy.
An alternative to index funds are exchange-traded funds (ETFs).
These are discussed in greater detail in Chapter 13. In Canada,
ETFs are traded on the Toronto Stock Exchange and are bought
and sold through appropriately licensed investment advisors or
discount brokers.
A WORD ABOUT DERIVATIVES

Within specified guidelines, mutual funds are permitted to use
derivative securities. Recall from Chapter 7 that derivatives are
financial instruments, such as futures and options that derive their
value from the value of underlying securities such as bonds, stocks
and indexes.
This means, for example, that equity mutual funds are allowed to
use futures contracts on stock market indexes to hedge the value
of their portfolios. Equity funds also are allowed to take speculative
positions on stock market indexes within certain limits defined
under National Instrument 81-102. Speculative positions may have
an underlying value of not more than 10% of the value of the
mutual fund’s portfolio.
The difference between a hedger and a speculator is that a hedger
uses derivatives as a kind of insurance policy against the decline of
the portfolio. A speculator is simply taking a bet on the future
movement of the market. M ost mutual funds do not permit their
managers to take speculative positions in derivatives, but they do
permit them to hedge the value of the portfolio by using them.
What a manager is permitted to do is specified in the fund’s
simplified prospectus.
RESPONSIBLE INVESTMENT
Responsible investment (RI) refers to the incorporation of
environmental, social and governance (ESG) factors into the
selection and management of investments. There is growing
evidence that incorporating ESG factors into investment decisions
can reduce risk and improve long-term financial returns. ESG
issues are also some of the most important drivers of change in
the world today.
In Canada, RI gained prominence during the 1970s and 1980s. At
that time, it was commonly known as ethical or socially responsible
investing. Since then, shareholder activism or corporate
engagement has subsequently become commonplace.
Today, there is no one-size-fits-all strategy or approach.
Responsible investors practice both values-driven approaches,
which incorporate the investors’ moral or ethical beliefs, and
valuation-driven approaches, which consider the materiality of ESG
issues. The former is a values-alignment approach, and the latter
considers the materiality of ESG issues. There are numerous
different strategies available to serve the diversity of responsible
investors, including ESG integration, shareholder engagement,
screening, thematic, and impact investing. On the more technical
side, there are even more sub-strategies, including carbon
efficiency, ESG momentum, tilting, smart beta, and others.
ESG ISSUES
ESG issues are some of the most important drivers of change in
the world today. They are also critical economic issues with
significant implications for businesses and investors.
Environmental, or “E”, issues generally include the conservation of
our natural resources, climate change, water and waste
management, and more. Social issues are those that relate to
people and society and they include human capital management,
diversity and inclusion, human rights, and Indigenous and
community relations. Governance issues relate to the controls,
standards, and processes for running a company and overseeing
its operations.
Examples of ESG issues include:
• Climate Change
• Water Scarcity
• Supply Chain
• Indigenous and Community Relations
• Executive Compensation
• Diversity and Inclusion
There are many sources of ESG information, including corporate
ESG ratings and rankings, corporate sustainability reports, in-house
research, ESG information disclosure in securities filings, and media
coverage.
DID YOU KNOW?
Equity funds are not the only RI choices available to

investors. Responsible investments are found in all major
asset classes and investment vehicles, including:
• Equities
• Fixed income (corporate bonds, green bonds,
sustainability bonds, community bonds, etc.)
• M oney market
• Alternative investments such as impact investments
• Real estate
• M utual funds
• Exchange-traded funds
• Guaranteed investment certificates
• Segregated funds
RETURNS ON EQUITY MUTUAL FUNDS

Figure 12.1 presents the hypothetical 15-year return performance of
equity mutual funds and equity growth mutual funds in comparison
to Toronto Stock Exchange returns and money market funds. The
growth funds are represented by returns from the small or mid cap
equity funds category.
Figure 12.1 | Simple Annual Returns: Equity Mutual Funds
Source: Bloomberg
The average return performance of both types of equity funds

parallels that of the S&P/TSX Index, and both are much more
volatile than the returns on money market funds. In addition, the
data indicate that the average return on the S&P/TSX Index
was 3.9% and the average return of equity funds was 6.2%. The
average return on money market funds over the same period
was 3.2%. The average performance of equity growth funds was
6.6%. Because of the global downturn in Year 13, where markets
around the world experienced losses ranging from 30% to 40% of
their value, the extreme volatility had a strong negative impact on
the reported 15-year returns by equity funds.
HYPOTHETICAL EXAMPLES OF EQUITY

FUNDS
The following examples compare three different types of equity
mutual funds—blue chip, growth, and index funds—in terms of their
investment objectives, portfolios, and investment strategies.
CRYSTAL CANADIAN BLUE-CHIP FUND

The investment objective of the Crystal Canadian Blue-Chip Fund
is:
“…to seek the greatest potential returns while accepting the
greater volatility. Crystal Canadian Blue-Chip Fund maintains a
diverse portfolio of equity securities of Canadian companies
listed on Canadian stock exchanges that are considered likely to
benefit from prevailing and anticipated economic conditions.”
This investment objective is entirely consistent with that of a
standard equity fund. Note that the Fund will only invest in
exchange-traded stocks, as opposed to OTC (over-the-counter)
stocks. This suggests a conservative approach, since stocks
traded OTC may be less liquid and their prices also may not reflect
the most current information.
The portfolio of this Fund is summarized below and presented in
Figure 12.2. Note that Canadian equities account for 96% of the
portfolio. Short-term notes account for the rest. For a typical
breakdown of equities within the various industries, see the
example of the growth company fund that follows this one.
Crystal Canadian Blue-Chip Fund Asset Allocation
Equities $323,061,694
Short term Notes $13,839,150
Total $336,900,844
Figure 12.2 | Crystal Canadian Blue-Chip Fund Portfolio
Canadian equity funds may also have two features that differ from
the Crystal Blue Chip Fund example. First, many are permitted to
hold foreign equities. Second, other portfolios may contain greater
amounts of short-term notes, T-bills and cash.
There are two reasons for holding cash or cash-equivalents.
• One reason relates to transactions. Fund managers like to
have some cash reserved to meet redemption demands of
unitholders and be able to buy attractively priced securities
should they become available.
• Another reason for holding cash is that managers may want to
take a defensive position in relation to the equity markets in
general. In other words, they are concerned about the
performance of equity markets over the short run and do not
want to put all the fund’s assets at risk in that market. When
they feel that market conditions have improved, fund managers
will likely decrease their cash holdings by buying equities.
CRYSTAL CANADIAN GROWTH COMPANY FUND

The fund objectives of the Crystal Canadian Growth Company
Fund are to achieve long-term capital growth.
Fund Primarily equity securities of Canadian companies

investments judged to have the potential for above-average
growth.
Fund focus The Fund tends to focus on small- and medium-

sized companies, but may also invest in larger
companies.
Special The share prices of smaller or less well-known

risks companies tend to fluctuate more than the share
prices of larger companies because of the greater
uncertainty of investing in less established
businesses. Smaller companies may have limited
product lines, markets, management expertise or
financial resources, making them more vulnerable
to setbacks.
According to the following information, also shown in Figure 12.3,

the foreign stock component is about 11% of the value of the
portfolio. The Canadian equity portion of the portfolio is made up of
stocks from many sectors. The single largest sector is “Industrial
Products” representing about 20% of the portfolio’s value.
Crystal Canadian Growth Company Fund Asset Allocation
Domestic Equities
Communication & M edia $281,302,000
Conglomerates $113,208,000
Consumer Products $123,555,000
Financial Services $67,700,000
Industrial Products $411,104,000
M erchandising $117,869,000
Oil and Gas $164,940,000
Paper and Forest Products $114,139,000
Real Estate $31,778,000
Transportation $122,979,000
Utilities $41,936,000
Sub-total $1,590,510,000 (77%)
Foreign Equities $228,875,000 (11%)
Total Equities $1,819,385,000 (88%)
Canadian Govt. T-Bills $245,089,000 (12%)
Total Investment Portfolio $2,064,474,000
Figure 12.3
CRYSTAL CANADIAN INDEX FUND
The investment objective of the Crystal Canadian Index Fund is:
“… to provide long-term growth of capital primarily by
purchasing Canadian equity securities to track the performance
of a Canadian equity market index.”
The Fund seeks to achieve its investment objective by tracking the
performance of a generally recognized index of Canadian equity
market performance (the “Recognized Canadian Index”), currently
the S&P/TSX Composite Index. The number of securities
comprising the Recognized Canadian Index in which the Fund
actually invests from time to time will depend on the size and value
of the Fund’s assets. The Fund will therefore be rebalanced with a
frequency and degree of precision that seeks to track the
Recognized Canadian Index as closely as possible, consistent
with minimizing trading costs.
This index fund is designed to mimic the S&P/TSX Composite
Index while at the same time keeping trading costs low. This is
entirely consistent with the objectives of Index funds.
The portfolio of this Fund would be consistent with its objectives.
Its holdings would consist of S&P/TSX Composite Index stocks
with possibly a small percentage of the stocks not belonging to the
Index. Portfolio managers for the Fund would construct a portfolio
with essentially the same stocks and weightings as the Index.
WHAT ARE BALANCED MUTUAL FUNDS?

Balanced mutual funds invest a percentage of their assets in
fixed-income securities and a percentage in equities. They are
often referred to as “hybrid” products, because they are part fixed-
income fund and part equity fund. Balanced mutual funds have the
objective of earning some amount of both current income and
capital gains while at the same time preserving capital.
Balanced funds ideally provide a “balanced” mix of safety, income
and capital appreciation. These objectives are sought through a
portfolio of fixed-income securities for stability and income, plus a
broadly diversified group of common stock holdings for
diversification, dividend income and growth potential. The balance
between defensive and aggressive security holdings is rarely 50-
50. Rather, managers of balanced funds adjust the percentage of
each part of the total portfolio according to current market
conditions and future expectations.
INVESTMENT OBJECTIVES OF BALANCED

MUTUAL FUNDS
As noted above, balanced mutual funds have the objective of
earning some amount of both current income and capital gains
while at the same time preserving capital. Thus, balanced mutual
funds have characteristics of both fixed-income funds (that earn
current income) and equity funds (that earn capital gains).
The distinguishing feature of balanced mutual funds is the way they
go about meeting their investment objectives. Portfolio managers
frequently attempt to shift the proportions of investments in fixed-
income and equity securities in keeping with changing market
conditions.
• When interest rates have peaked, managers want to be in
fixed-income securities.
• When the stock market is set for an increase, they want to be
in stocks.
• When both bond and stock markets are volatile, they will hold
large amounts of money market securities. In other words,
balanced mutual fund managers attempt to time the market to
get the best returns depending on market conditions.
A common misconception is that a balanced fund’s objective is to
hold a “balance” between stocks and bonds. This is not the case.
Nevertheless, balanced mutual funds typically hold both debt and
equity securities in the portfolio at all times. While fund managers
might shift the portfolio toward debt or equity, they do not as a rule
go to 100% in either direction, as that would be inconsistent with
their “middle-of-the-road” investment objectives.
While most balanced mutual funds attempt to time the market to
some extent, some do not. Instead, they hold fixed proportions of
debt and equity securities over the longer term.
RETURNS ON BALANCED MUTUAL FUNDS

Since balanced mutual funds are part bond fund and part equity
fund, you might expect them to perform mid-way between the
performances of the two funds. If the efforts at market timing
succeed, however, balanced mutual funds should earn returns on
bond funds in periods when bonds outperform equities, and returns
on equity funds when equities outperform bonds. Figure 12.4
compares the performance of equity funds, bond funds and
balanced mutual funds during a hypothetical 15-year period.
Figure 12.4 | Simple Annual Returns: Balanced Mutual Funds

Compared with Bond Funds and Equity Funds
Source: Bloomberg
Since balanced mutual funds are composed of both bonds and

equities, their returns generally fall somewhere between bond fund
returns and equity fund returns. As you can notice in figure 12.4,
balanced funds returns were more volatile than bond funds returns
and less volatile than equity funds returns over the 15-year period.
HYPOTHETICAL EXAMPLES OF BALANCED

FUNDS
The fundamental nature or features of the Crystal Balanced Fund is
stated in the fund facts document and prospectus as follows:
“This Fund invests primarily in Canadian equities, bonds and
short-term debt securities, but may also invest in foreign
securities. The objective of the Fund is to provide a combination
of capital growth and modest income at a competitive rate of
return for a balanced-oriented client. The percentage of the
Fund invested in each asset class is adjusted in response to
changes in the market outlook for each asset class.”
The Summary of Investments and Other Net Assets presented in
Figure 12.5 indicates that the portfolio of the Crystal Balanced Fund
consists of 37% Canadian equities, 17% foreign equities and 46%
bonds.
Figure 12.5 | Summary of Investments in a Balanced Fund
TARGET-DATE FUNDS
Target-date funds (also referred to as target-based funds or life-
cycle funds) have two characteristics that distinguish them from
other mutual funds: a maturity date and a glide path.
Investors who buy this product generally select maturity dates that
match a certain life goal or target date in the future (e.g., date of
retirement).
The glide path refers to changes in the fund’s asset allocation mix
over time which allows the fund to pursue a growth strategy by
holding more risky assets in the early years of the fund’s life and
then gradually reduce the risk of the fund as the target date
approaches. The adjustment is made automatically by the fund
manager without any action from fund holder. Target-date funds are
structured on the assumption that risk tolerance and risk capacity
declines as investors grow older.
These funds have their own category under the CIFSC
classification. Upon maturity, target-date funds are moved out of
the target-date group and included in the appropriate fixed income
or balanced fund category.
EXAMPLE
An investor who plans to retire in 2030 could buy a 2030 target-

date fund. The asset allocation may gradually move from 80%
equity and 20% fixed income in the early years to an asset
allocation of 20% equity and 80% fixed-income by the target
date.
The increase in popularity of target-date funds is driven by

demographics—baby boomers in Canada will retire in significant
numbers over the next 15 to 20 years.
Case Study | Targeting Education: Saving for Emma (for

Ryan is meeting with his clients, Carol and Kevin. The couple has
a two-year-old daughter, Emma. With the rising cost of education,
Carol and Kevin want to begin saving for Emma’s post-secondary
education as soon as possible. They anticipate she will begin her
post-secondary education around age 17.
Ryan establishes that Carol and Kevin’s risk profile is such that
they have a high risk tolerance and a relatively high risk capacity
and that their investment time horizon is long enough to allow
them the ability to take a reasonable amount of risk to achieve
their long-term goal of growth.
Given their investment profile, Ryan recommends a Target
Education Fund to meet the couple’s education funding needs for
Emma. With 15 years until Emma will begin drawing down the
portfolio to fund her education, Ryan recommends the Crystal
Target Education 2035 Fund (the fund).
Ryan explains to Carol and Kevin that the fund has a target
maturity date of 2035, meaning that the fund’s glide path works to
grow the fund in the early years and to gradually reduce risk as the
target date of 2035 approaches. The fund is more heavily-
weighted in equities in the early, growth-orientated years. Over
time, the fund manager will gradually reduce the equity portion of
the fund’s holdings and increase its bond weighting, reducing risk
as the target date approaches.
In its final few years, the majority of the fund’s holdings will be
short-term bonds and money market funds to ensure that its
volatility and risk are very low. In the last year before its maturity
date, it will hold 100% money market funds, securing the savings
of investors as their draw down period begins in 2035. For Carol
and Kevin, this means that they only need to focus on saving and
can leave the investment management to the fund manager,
comfortable in the knowledge that the fund will be managed
appropriately to achieve their goal of funding Emma’s education.
WHAT ARE GLOBAL MUTUAL FUNDS?

Global mutual funds, as the name suggests, hold assets from
many countries in their portfolios. Technically, a global mutual fund
can hold securities from any country, including Canada. The term
international fund is sometimes used to describe a fund that
invests anywhere except Canada. Some mutual funds specialize in
a particular country or region. For example, many distributors offer
“Asia” funds, “Europe” funds, “Japan” funds and “U.S.” funds.
Global funds can be bond funds, equity funds or virtually any of the
fund types discussed in this chapter. The most common type of
global mutual fund is, however, the global equity fund.
INVESTMENT OBJECTIVES OF GLOBAL

MUTUAL FUNDS
The investment objectives of global mutual funds depend first on
the class of security they are designed to hold in their portfolios.
For example, the primary objective of a global equity fund is to earn
capital gains over the long term. The objective of an international
bond fund, on the other hand, will be to earn interest income with
some capital gains over a somewhat shorter horizon.
Investment objectives of a global mutual fund do not explain why
investors may be attracted to a global mutual fund rather than a
domestic equivalent. Investors are attracted to global mutual funds
for two main reasons. The first is that at any one time, different
countries are at different stages of an economic cycle.
EXAMPLE
It may be the case that the Canadian equity market is in a slump

when the equity markets of other countries are performing well.
Clients then can benefit from the higher returns available in non-
Canadian markets. What this really means is that clients can
benefit from additional diversification. Also, the Canadian
securities market is relatively small, comprising only around 3%
of the world’s market capitalization. Investing exclusively in a
Canadian basket could leave a client unduly exposed to
geographic concentration risk.
Another reason global mutual funds are attractive is that they can
provide a hedge against a decline in the relative value of the
Canadian dollar.
EXAMPLE
If investors buy a Japan fund, and then the value of the

Canadian dollar falls relative to the yen, the Canadian dollar
value of that investment will increase whether the value of the
fund’s units in yen has remained unchanged.
A global mutual fund subjects the client to at least two types of

risk: market risk of the country (or countries) in which the fund
invests; and foreign exchange risk, because the value of the
Canadian dollar can rise or fall in relation to the currency of another
country.
Not all global mutual funds expose clients to foreign exchange risk,
however. Portfolio managers can undertake hedging transactions in
the foreign exchange market to remove or greatly reduce the
foreign exchange risk of their fund. They can do this by selling
foreign currency for future settlement, either through currency
futures contracts or another similar type of contract called a
currency forward contract.
EXAMPLE
Assume that a portfolio manager sells yen for delivery in six

months at today’s exchange rate. If the value of the yen rises
relative to the Canadian dollar, the fund will make a profit on the
contract. If the value of the yen falls, the fund will take a loss.
What the manager is doing through the currency forward market
is fixing the price at which the mutual fund company will convert
the yen it eventually receives into dollars.
A global mutual fund’s prospectus will indicate if the fund hedges

the foreign currency risk by using these currency derivatives. It is
important for mutual fund sales representatives to know whether
their global mutual funds hedge foreign exchange risk, because
some clients will want to bear that risk themselves, while others will
not.
In addition to market and foreign exchange risk, there are other risk
factors for global mutual funds. First, accounting practices differ from
country to country to a certain extent. While some countries follow
practices similar to those used in Canada, others do not. Portfolio
managers need reliable accounting data to assess the risks and
potential profitability of companies. If the accounting data are not
reliable or comparable, then investment results can suffer. Likewise,
the level of compliance and the regulatory environment differ widely
from country to country, especially in the emerging markets of Asia
and Eastern Europe.
The second additional risk factor for global mutual funds has to do
with the liquidity and efficiency of foreign stock markets. Canadian
markets are liquid for most stocks, and the prices at which stocks
trade generally reflect the information investors have about them.
This is the idea of market efficiency. Foreign stock markets (and
bond markets for that matter) might not offer as much liquidity as
Canadian markets, and stock prices might not reflect information as
rapidly. For established markets, such as the U.S., these problems
do not exist. For much smaller stock markets, however, such as
those in developing countries, inefficient stock markets can make it
difficult for portfolio managers to make changes to their portfolios.
RETURNS ON GLOBAL EQUITY FUNDS

Global equity funds are the most common type of global mutual
funds. This section compares the performance of global equity
funds to Canadian equity funds during a hypothetical 15-year
period. In Figure 12.6, the average performance of Canadian equity
funds is similar to the performance of the S&P/TSX Composite
Index.
Figure 12.6 | Simple Annual Returns: Global Equity Funds

Source: Bloomberg
Figure 12.6 illustrates that the average performance of global equity

funds can diverge significantly from Canadian equity funds. For
instance, in Year 1 Canadian equity funds posted returns of 26.4%,
while global equity funds lagged behind at 14.8%. In Year 3 the
tables were turned: Canadian equity funds fell by 2.7%, while global
equity funds rose by 17%. During this 15-year period, both
experienced two major downturns: one in Year 7, where the
Canadian equity fund fell by 13.2%, while the global equity fund lost
19.7%, and in Year 13, where the Canadian equity funds lost
between 34.6% and the global equity fund lost 31.4%. The average
annual performance of global equity funds has been lower over the
15-year period (2.84%) compared to Canadian equity funds
(6.17%).
Global equity funds earn two types of return: dividends and capital
gains. Capital gains are probably more significant. Dividends from
global funds do not come from Canadian corporations and therefore
are not eligible for the dividend tax credit. As a result, foreign-
source dividends are taxed at the same rate as interest income.
HYPOTHETICAL EXAMPLES OF GLOBAL

FUNDS
The following examples compare two different types of global
mutual funds—government bond funds and emerging market funds
—in terms of their investment objectives, portfolios, investment
strategies, and risks and returns.
CRYSTAL GLOBAL GOVERNMENT BOND FUND

The investment objective of the Crystal Global Government Bond
Fund is:
“…to seek, over the long term, as high a level of total return as
is consistent with investments in debt instruments issued or
guaranteed by governments and other governmental agencies.
The Fund seeks to achieve its investment objective by investing
in bonds, debentures and other evidences of indebtedness
issued or guaranteed by governments, semi-governmental
entities, governmental agencies, supranational entities (such as
International Bank for Reconstruction and Development), and
other governmental entities in a variety of countries and
denominated in the currencies of such countries. The Fund will
be managed so as to be prudently diversified at all times among
different regions, countries and securities. Under certain market
conditions, short-term securities may be held within the
portfolio.”
This is exactly the kind of investment objective to expect from a
global bond mutual fund invested in government securities.
Portions of the Investment Portfolio shown below and presented in
Figure 12.7 reveal that the diversification of the fund extends to
nine countries (including Canada).
Belgium $3,296,264 (2.8%)
Canada $14,195,190 (12.1%)
Finland $3,366,934 (2.9%)
France $10,229,732 (8.7%)
Germany $20,693,569 (17.6%)
Italy $8,484,775 (7.2%)
Netherlands $3,129,604 (2.7%)
United Kingdom $8,751,246 (7.4%)
USA $36,704,681 (31.2%)
Supranational $8,653,625 (7.4%)
Total $117,505,620
Figure 12.7 | Diversification in a Global Government Bond

Portfolio
It is not immediately apparent whether this Fund hedges the value
of the Canadian dollar. The following statement appears at the end
of the section on “Derivatives” in the prospectus:
“The Crystal Global Government Bond Fund will be permitted to
invest in forward currency and currency futures contracts for
the purpose of protecting itself from exchange rate fluctuations
to the extent determined by the portfolio advisor. Such forward
and futures contracts shall not exceed three years in duration
and shall be limited to the market value of the foreign securities
owned by the Fund and quoted in that currency. Adjustments
shall be made to such forward and futures contracts owned by
the Fund to ensure that these contracts are limited as above,
which adjustment shall be made at least weekly and more
frequently if necessary having regarded market conditions….”
As discussed earlier in this chapter, some global mutual funds
hedge foreign exchange risk. If clients invest in a global mutual fund
to diversify beyond Canadian dollars, they may not want to buy
units of a fund that hedges its exposure. Instead, they may want to
invest in a fund that does not reduce the foreign exchange
exposure through hedging.
CRYSTAL EMERGING MARKETS FUND
The investment objective of the Crystal Emerging M arkets Fund is:
“… to achieve long-term capital appreciation through
investment, primarily in equity securities. Under normal
conditions, at least 65% of the Fund’s total assets will be
invested in emerging country equity securities, which for this
purpose means common and preferred stock (including
convertible preferred stock), bonds, notes and debentures
convertible into common or preferred stock, stock purchase
warrants and rights, equity interests in trusts or partnerships
and American, global or other types of depository receipts. As
used herein, an “emerging country” is any country that the
World Bank has determined to have a low- or middle-income
economy.
The Fund seeks to achieve its investment objective by investing
primarily in (1) equity securities in companies whose principal
trading market is in an emerging country, (2) equity securities,
traded in any market, of companies that derive significant
annual revenue from either goods produced, sales made or
services rendered in emerging countries, or (3) equity securities
of companies organized under the laws of, and with a principal
office in, an emerging country. The Fund will be managed so as
to be prudently diversified at all times among different regions,
countries and securities. Under certain market conditions short
term securities may be held within the portfolio.”
This statement of investment objectives sets out clearly what the
portfolio manager may invest in. The Statement of Investment
Portfolio (not shown) indicates that the Fund has equity
investments in 26 countries and bond investments in two countries.
This Fund does not hedge the value of the Canadian dollar.
WHAT ARE SPECIALTY MUTUAL FUNDS?

Specialty mutual funds are funds that restrict the investment
objectives in some particular way. Of course, in a sense, all mutual
funds are specialized. However, specialty mutual funds tend to
concentrate investments in securities or industries to a far greater
degree than other funds. Examples of specialty mutual funds are
precious metals funds and natural resource funds. Each type of
specialty mutual fund can be thought of as comprising its own
mutual fund category.
RISK FACTORS OF SPECIALTY MUTUAL

FUNDS
Specialty mutual funds have risk factors consistent with the make-
up of their investment portfolios, just like the other types of funds.
For example, gold funds rise and fall with the value of gold and
securities based on the price of gold. However, many specialty
mutual funds have an additional risk factor that other funds
generally avoid: a lack of diversification.
Because of their specialization, specialty mutual funds tend to
construct portfolios that are not as well diversified by industry
sector as more standard types of funds. For example, a real estate
mutual fund is exposed to the risk of the real estate market alone,
and a resource mutual fund tends to invest only in firms in the
natural resource sector of the economy. In comparison to traditional
Canadian equity funds, for example, the lack of diversification in
specialty funds can be striking.
To what extent is this lack of diversification a problem for clients?
The answer to this question depends to a great extent on how the
particular specialty mutual fund fits in with the client’s current
portfolio. If a less-than-well-diversified specialty mutual fund is a
client’s only investment, there could be a problem.
Your clients get the most diversification benefit by holding
securities that have a low degree of correlation. That is, they get a
reduction in total risk from holding a portfolio of two uncorrelated
stocks, but no risk reduction if the stocks are perfectly (positively)
correlated.
The same logic works for portfolios as for individual securities.
EXAMPLE
Imagine you have a client with a portfolio consisting of an equity

fund and a bond fund. The client may be able to get more risk
reduction without sacrificing return by adding another mutual fund
that is not well correlated with the returns of the existing
portfolio. That additional mutual fund might be a specialty fund,
such as natural resource fund, or a real estate fund. In itself, the
specialty fund is poorly diversified, but put together with the
existing portfolio, the client can have still more diversification.
The key thing to remember is that no investment should be

considered in isolation from the client’s existing portfolio. It is not a
good investment strategy for clients to buy a specialty mutual fund
as their only investment, as they may be exposing themselves to
more risk than necessary to earn the same expected return.
HYPOTHETICAL EXAMPLES OF SPECIALTY

FUNDS
The following examples compare three different types of specialty
mutual funds—a resource fund, a precious metals fund, and a
special growth fund—in terms of their investment objectives,
investments, and risks.
CRYSTAL RESOURCE FUND

The investment objective of the Crystal Resource Fund is:
“…to provide capital growth by investing primarily in stocks of
Canadian natural resource companies. This Fund invests in the
stocks of companies primarily engaged in the precious metals,
base metals, oil and gas, and forest products sectors, which
have high growth potential. The Fund may invest in small cap
companies and purchase and sell commodities such as
precious and other metals and minerals.”
The prospectus has the following to say about risks:
“Because it invests in only a few sectors of the economy, the
value of the Fund may vary more than funds that invest in many
different industries. Its value is also affected by movements in
commodity prices and changes in global economic conditions.
Because it may invest in smaller companies, the value of the
Fund may vary more than funds that invest only in larger,
established corporations.”
As is the case with many specialty mutual funds, the goal is to earn
capital gains. It is notable that this specialty mutual fund invests in
the types of firms, industries and securities that other types of
specialty mutual funds invest in. The prospectus states, for
example, that this Fund may buy securities of small capitalization
firms. Specialty small cap mutual funds do exist, and there are also
mutual funds that specialize in only one commodity (e.g., gold). In a
sense, the Crystal Resource Fund is more diversified than some
other specialty mutual funds.
The $35,289,000 Investment Portfolio, presented in Figure 12.8,
indicates the following partial breakdown by investment area:
• oil and gas, $7,991,000 (22.6%);
• gold and precious metals, $14,169,000 (40.2%);
• paper and forest products, $2,104,000 (6.0%);
• industrial products, $1,430,000 (4.1%);
• metal and minerals, $6,904,000 (19.6%); and
• money market securities $2,691,000 (7.6%). These securities
are held for liquidity purposes: either to meet redemption
demand or to take advantage of perceived market
opportunities.
Figure 12.8 | Diversification in a Resource Fund
CRYSTAL PRECIOUS METALS FUND

According to the investment objectives of the Crystal Precious
M etals Fund:
“This Fund seeks to provide long-term capital growth by
investing primarily in precious metals (gold, silver and platinum)
in the form of bullion, coins, receipts and certificates, and in
common shares and other securities of Canadian and foreign
companies involved directly or indirectly in the exploration,
mining and production of these metals. The Fund will not
purchase silver and platinum in excess of 20 percent of its net
asset value. The Fund may from time to time have a large
portion of its assets in cash or cash equivalents in response to
changing market conditions.
Because the Fund invests in a specialized sector, it is
particularly sensitive to changes in that sector. The price of gold
and other precious metals can swing dramatically because of
international monetary policy, political events and speculation. In
addition, the price of gold may be affected by political conditions
in South Africa, which remains the world’s largest producer.
Changes in the sector will affect the value of the precious
metals held by the Fund, as well as the value of the companies
in which the Fund has invested. The price of precious metals is
quoted in U.S. dollars, so the unit value of the Fund will be
affected by changes in the value of the U.S. dollar relative to
the Canadian dollar.”
This Fund is more specialized than the resource fund described
above, since it invests only in the precious metals sector.
According to its Annual Report, 58% of the Fund’s assets, shown
in Figure 12.9, consist of the common shares of Canadian firms
engaged in gold and precious metals mining activities
($118,040,000). The Fund also holds gold and silver certificates
worth $43,661,000 (21%) and shares of foreign metal and mining
firms worth $35,399,000 (17%).
Figure 12.9 | Assets of a Precious Metals Fund
CRYSTAL SPECIAL GROWTH FUND

The simplified prospectus for the Crystal Special Growth Fund
describes the objectives, investment policy and additional risk
factors as follows:
Objective The objective of this Fund is to generate long-term
capital appreciation by directing investments into
areas of emerging trends and values.
Investment To achieve this objective, the Fund invests primarily

Strategy in smaller companies. The emphasis is on analyzing
and picking individual stocks rather than industry
sectors.
Risks The Fund invests in smaller companies, generally

lower than $500 million in market capitalization. The
securities of smaller companies are often less liquid,
less marketable and more volatile than those of
larger companies.
It is possible to think of this Fund as simply an equity mutual fund,

except that it specializes in small capitalization (or small cap) firms.
These are typically firms making and marketing new types of
products for which market demand may be difficult to determine. In
addition, many small-cap firms can be bought only on the OTC
market and may trade infrequently. This makes the market for
shares of these firms less efficient.
In the Investment Portfolio, shown below in summary form and
presented in Figure 12.10, Canadian equities account for 84.5% of
the special growth fund portfolio.
Canadian equities
Industrial products $44,321,217 (24.4%)
Consumer products $28,538,870 (15.7%)
Communications & media $25,576,540 (14.1%)
Oil and gas $21,316,424 (11.7%)

Gold and precious metals $9,468,408 (5.2%)
Other industries $24,382,502 (13.4%)
Total $153,603,961 (84.5%)
Foreign equities $16,556,495 (9.1%)
Note that cash and short-term investments make up the balance

(6.4%) of the portfolio.
Figure 12.10
FUND WRAPS
A fund wrap program provides a series of portfolios with multiple
mutual funds to reflect pre-selected asset allocation models. Each
model is designed to meet the needs of a group of investors
sharing a similar client profile. In contrast to a balanced mutual fund,
a fund wrap generally outsources the management and security
selection within each asset category to different managers.
Responsibility for the asset allocation decision falls to the wrap
sponsor. For convenience, all administrative, management and
trading costs are usually rolled into one wrap fee.
Fund wrap investors hold the unitized value of the fund of funds,
but they do not hold title to the underlying funds or to the funds’
underlying securities. Fund wraps are available with advisor
compensation either built in or excluded (fee-based approach),
increasing the flexibility and acceptability of these products.
From a trading point of view, there is no substantial difference
between fund wraps and traditional mutual funds. From the client’s
point of view, the purchase, redemption and reporting process is
the same as for mutual funds. From the mutual fund salesperson’s
point of view, the process also is largely the same, with differences
only in details of compensation.
From a regulatory point of view, fund wraps constitute a specific
investment structure. A fund of funds exists as a legal entity, in
addition to the legal existence of the underlying mutual funds. Thus,
specific regulatory provisions govern the development and
promotion of fund wraps. Regulations include, for example,
prohibitions against “double dipping” (charging fees twice for the
same services or components). Otherwise, trading fund wraps as
units is essentially the same as trading fund units.
Fund wraps can be funds of funds or portfolio allocation services.
With a fund of funds, the client owns units of a pool of mutual
funds, while in a portfolio allocation service, the client owns units
of several mutual funds in the proportions established through the
allocation service. Thus, in a portfolio allocation service, the
investor actually owns units of the constituent mutual funds rather
than units of a fund holding other funds.
RISKIER MUTUAL FUNDS
How do equity, balanced, and specialty funds compare?

knowledge.
SUMMARY
After reading this chapter, you will be able to:
1. Describe and compare and contrast the composition of
different equity mutual funds.
◦ Equity mutual funds invest in the common and preferred
shares of publicly-traded companies.
◦ Equity mutual funds as a group have the goal of earning
capital gains, sometimes with a current dividend income
component.
◦ Canadian equity mutual funds can be categorized into three
fairly distinct types: “standard” equity funds, equity growth
funds and equity index funds.
◦ ESG issues are some of the most important drivers of
change in the world today. ESG considerations include
climate change, water scarcity, Indigenous and community
relations, and diversity and inclusion.
2. List and describe the investment objectives, comparative
returns and the volatility of the different types of equity mutual
funds.
◦ Equity growth funds pursue capital gains. Some dividend
income may be earned, but probably not much.
◦ An equity index fund has the goal of generating capital gains.
It intends to do this by constructing an investment portfolio
designed to mimic a particular stock market index.
◦ Balanced mutual funds have the objective of earning current
income and capital gains while at the same time preserving
capital.
◦ A new type of balanced fund has emerged in recent years:
target-date funds. These funds have a maturity date and the
risk of the fund decreases as the maturity date approaches.
◦ The primary objective of a global equity fund is to earn
capital gains over the long term.
◦ The investment objectives of specialty mutual funds is to
concentrate investments in securities or industries to a far
greater degree than other funds to achieve better returns
than diversified investments.
◦ The average return performance of equity funds parallels
that of the TSX Index, and equity and growth funds are much
more volatile than the returns on money market funds.
◦ Since balanced mutual fund are composed of both bonds
and equities, their returns generally fall somewhere between
bond fund returns and equity fund returns.
3. Describe the features and key types of specialty mutual funds.
◦ Specialty mutual funds tend to concentrate investments in
specific securities or industries.
◦ Specialty mutual funds are generally not well diversified and
are exposed to the risk inherent to the industry or sector.
◦ A fund wrap program provides a series of portfolios with
multiple mutual funds to reflect pre-selected asset allocation
models.
◦ In contrast to a balanced mutual fund, a fund wrap generally
outsources the management and security selection within
each asset category to different managers.
◦ From a trading point of view, there is no substantial
difference between fund wraps and traditional mutual funds.
◦ Fund wraps can be funds of funds or portfolio allocation
services.
REVIEW QUESTIONS

Alternative Managed
13
Products
CONTENT AREAS
What are Principal-Protected Notes?
What are Hedge Funds?
What are Closed-End Funds?
What are Exchange-Traded Funds?
What are Segregated Funds?
LEARNING OBJECTIVES
1 | Identify and distinguish between the features,

advantages, and risks of the various alternative
managed products discussed.
2 | Identify and describe the costs associated with these

alternative managed products.
3 | List and compare the requirements to consider before

investing in each product.
KEY TERMS

accredited investor
alternative managed products
alternative mutual fund
annuitant
beneficiary
closed-end discretionary fund
closed-end fund
contract holder
death benefits
directional strategies
event-driven strategies
exchange-traded funds
first-order risk
guaranteed minimum withdrawal benefit plan
hedge funds
high-water mark
hurdle rate
incentive fees
interval fund
market sentiment
maturity guarantee
minimum investment
offering memorandum
performance averaging formulas
performance participation cap
portfolio funds
principal-protected note
probate
relative value strategies
reset option
second-order risk
segregated fund
tracking error
INTRODUCTION
Since the early 1990s, managed products have become popular
investment vehicles for many investors, particularly those who
consider direct investing in bonds or equities too complex or risky.
These products are often appropriate for investors who have a
limited amount of money to invest but want the benefits of
diversification and professional investment management.
M anaged products include more than just mutual funds—the one
constant in the investment industry is change. Continual innovation
in financial markets, products, and the wealth management industry
in general has resulted in an overwhelming number and variety of
alternative managed products, which makes the process of making
investment decisions all the more challenging. With more choice,
investors have more homework to do before investing, and mutual
fund representatives compete against new products they are not
licenced to sell.
Alternative managed products are professionally managed
portfolios of basic asset classes and/or commodities and include
segregated funds, hedge funds, alternative mutual funds,
exchange-traded funds, closed-end funds and principal-protected
notes (PPN).
What distinguishes alternative managed products from other
groups of investment products, such as mutual funds, is their use
of complex investment strategies, such as the use of derivatives,
leveraging and principal guarantees. The risk/return profiles of
alternative managed products when compared to conventional
asset classes are skewed by the use of these investment
strategies.
This chapter looks at the features, advantages, and costs of the
most common classes of alternative managed products.
WHAT ARE PRINCIPAL-PROTECTED NOTES?
A principal-protected note (PPN) is a debt instrument. Like other
debt instruments, a PPN has a maturity date upon which the issuer
agrees to repay investors their principal. In addition to the principal,
PPNs provide interest paid either at maturity or as regular
payments linked to the positive performance of the underlying PPN
asset. The underlying assets can be common stocks, indexes,
mutual funds, exchange-traded funds, commodities or hedge funds.
In Canada, PPNs are issued only by the six major banks (the Big
Six). The banks function in three main roles: guarantor,
manufacturer, and distributor.
• As the issuers of PPNs, the banks guarantee the return of
principal at maturity. The value of the guarantee is based wholly
on the perceived creditworthiness of the issuer. In the event of
default, PPN investors rank equally with all other investors in
the bank’s deposit notes.
• As manufacturers, they choose the underlying asset, the term
to maturity, and any special features tied to interest payments.
This role is almost always performed by a group that
specializes in equity derivatives, which is typically part of the
bank’s Capital M arkets division.
• Banks distribute PPNs primarily through their investment dealer
arm, although some banks use a third-party investment dealer
or mutual fund dealer.
COSTS OF PRINCIPAL-PROTECTED NOTES

M any costs are associated with PPNs. These products are not
mutual funds; as a result, they are not held to the transparency
standards of mutual funds or prospectus-based financial products.
In fact, the lack of transparency in these products prevents
investors from clearly understanding all of the costs involved. It is
particularly important, then, to determine their suitability before
investing in PPNs.
PPNs are not protected by the Canada Deposit Insurance
Corporation (CDIC)—they are considered uninsured deposit notes.
PPNs are not issued under a prospectus because they are not
considered securities. In most provinces, those who sell PPNs
require no special licensing.
There are implicit as well as explicit costs to consider when
purchasing a PPN. Explicit costs are described in the offering
documents and include the costs identified in Table 13.1.
Table 13.1 | Common Explicit Costs Attached to PPNs
Commissions PPNs have been designed in many ways to

resemble mutual funds with either a front-end or
back-end load. PPNs differ from mutual funds in
that investors bear the cost of the commission at
the time of purchase because the net asset value
(NAV) of the PPN declines directly as a result of
commissions paid.
Management Like mutual funds, many PPNs carry a

fees management fee for actively managing the PPN’s
assets. Some PPNs, however, are issued without
management fees. When a management fee is
charged it is charged to the assets of the PPN.
M anagement fees affect the PPN’s performance,
which in turn affects the final payoff received by
investors.
Early M any PPNs carry an early redemption fee or

redemption deferred sales charge. A typical early redemption
fees fee schedule runs from two to five years and
declines over time, as with a mutual fund. The
purpose of the early redemption fee is to ensure
that the PPN’s issuer receives the full fees it was
expecting.
Structuring Some PPNs include an explicit charge for

costs and structuring, and most PPNs charge a fee for
guarantee providing the capital guarantee.
fees
Implicit Costs include fees borne by investors that may or may not
be immediately visible and that may or may not be openly
disclosed in the documents. Table 13.2 identifies the more common
implicit costs.
Table 13.2 | Common Implicit Costs Attached to PPNs
Performance M any mutual fund-based and income-producing

Averaging PPNs use performance averaging formulas in
Formulas which the PPN’s final payoff is based not on the
value of the underlying asset at maturity, but on
some average performance of the underlying asset
over the life of the note. This average performance
typically is based on the note’s monthly average
NAV and may raise or lower the return
to investors.
Performance A PPN with a performance participation cap

Participation promises to pay the return earned by some
Caps particular asset up to a maximum amount.
Example: An index-linked GIC might pay 60% of
the return of the S&P/TSX 60 Index while
guaranteeing investment principal. If the
performance of the underlying asset exceeds the
cap, investors would incur an opportunity cost
because they could have earned a higher return
on the investment if the cap did not exist.
Price The final payoff is based on the underlying asset’s
Returns vs. price return rather than its total return. Total return
Total refers to the change in price plus any income such
Returns as dividends or interest. Using price return rather
than total return is a hidden cost because it
underestimates the actual performance of the
underlying asset.
ADVANTAGES AND RISKS OF PRINCIPAL-

PROTECTED NOTES
Individual investors with relatively small amounts to invest can use
PPNs to invest in markets they normally could not access. A PPN
could use as its underlying asset a basket of selected commodities
or a hedge fund. In this case, a PPN investor would not be subject
to large investment minimums, accreditation requirements or margin
calls that would normally be associated with direct commodity or
hedge fund investments.
In addition, a PPN can enhance the return available from cash or
cash-equivalents such as GICs or T-bills. Today, with relatively low
real interest rates (the nominal interest rate minus the expected
rate of inflation) on most traditional cash equivalents, a PPN can
produce a higher yield while still protecting the principal invested.
Finally, PPNs may also be appropriate for the extremely risk-
averse investor who has the ability but not the willingness to take
equity-like risk. As long as the investor is convinced that the
issuer’s guarantee is secure, investing in a PPN can provide the
investor with exposure to equities, commodities and more without
the risk of investing in them directly.
While a PPN is free from risk of principal loss, it is not considered
to be an entirely risk-free investment. Risks associated with PPNs
include liquidity risk, performance risk, credit risk, and currency risk,
described in Table 13.3.
Table 13.3 | Risks Associated with PPNs
Liquidity M ost PPNs offer liquidity. They usually can be

Risk resold to the issuer before maturity, at certain dates,
with associated costs and advance notice.
However, the issuer is under no obligation to buy
back the notes. Investors should buy PPNs with
the intention of holding them until maturity.
Performance The performance of a PPN may not exactly track

Risk the performance of the underlying asset. It can
either underperform or outperform it. The mismatch
in performance is likely in the early years of the
PPN issue. Investors are not just purchasing an
underlying asset’s returns with a principal protection
feature tacked on, because many factors are
involved in pricing a PPN, including interest rates,
fees, the actual performance of the underlying
asset, whether leverage has been used, and
various explicit and implicit fees.
Credit Risk The issuer may not be able to return the principal at
maturity. Although the likelihood is small, especially
because the issuers are large, well-known banks,
the risk is still there.
Currency Because many PPNs track the returns from a

Risk foreign underlying asset that may be denominated
in a foreign currency, investors may be exposed to
currency risk. A change in the value of the foreign
currency relative to the Canadian dollar will reduce
the returns when reconverted to Canadian dollars.
BEFORE INVESTING IN PRINCIPAL-
PROTECTED NOTES
PPNs are in some ways more difficult to evaluate than
conventional investments. PPN issuers are not obligated to
disclose as much information as they would if shares or a bond
were brought to market. Still, the following points should be
considered when evaluating a PPN:
• The creditworthiness of the issuer should be without question.
The issuer is the only party investors can turn to for payment
of principal and return.
• Investors should understand the calculation method used to
arrive at the final variable return.
• Investors should understand the risk factors behind the
underlying asset, whether it is a mutual fund, hedge fund or
common stock.
• The principal protection should be worth paying for. This is
especially important for longer term equity-based PPNs (over
five years), where the maturity horizon lowers the risk of loss.
The principal protection might be worth the cost for an
underlying basket of commodities but may not be worth the
cost for an underlying mutual fund that has never lost money
over the corresponding term of the PPN.
Case Study | Paul Balances Risk and Reward (for information

purposes only)
Sandra is a mutual fund representative who works for the mutual

fund arm of ABC Bank. She is meeting with her client Paul. Having
suffered heavy investment losses during the most recent financial
crisis, Paul moved most of his investment portfolio into GICs and
has been wary of re-investing since then. However, Paul has
since seen equity markets rebound sharply over the last few
years and knows that he requires growth in his portfolio to reach
his retirement goals. Given how low present GIC rates are, Paul
wants to discuss with Sandra investment opportunities that will
allow him to benefit from the performance of equity markets
without putting his principal at risk.
Sandra explains to Paul that mutual funds are not guaranteed as to
their principal or return and that with the exception of money
market funds, there is potential risk of negative returns in even the
most conservative funds. However, Sandra suggests that if Paul
wants to participate in the equity markets without placing his
principal at risk, there is the option of principal-protected notes.
Sandra explains to Paul that PPNs provide investors with a
principal guarantee on their original investment. The investor’s
return consists of a percentage of the market index’s return over a
pre-set timeframe.
Sandra suggests to Paul that the 3-year ABC Bank Canadian
Equity Growth PPN would be an ideal fit. The PPN’s three-year
term allows Paul to learn about how this solution can work to help
him reach his goals while not locking him into a longer term. ABC
Bank is a top Canadian chartered bank, so there is essentially
zero issuer credit risk. Paul’s principal is guaranteed. The return of
the PPN is linked to the S&P/TSX Composite Index’s return over
the three-year period, so Paul will participate in the upside of the
market’s performance while avoiding any downside.
However, Sandra explains that the cost of the guarantee is that
Paul will receive only 50% of the Index’s return at the conclusion
of the three-year term and that if the return is negative, he will
receive his principal back, but a nil return on his investment. Paul is
willing to accept this cost given his desire to find the right balance
between risk and reward that properly fits his needs.
WHAT ARE HEDGE FUNDS?

Hedge funds are lightly regulated pools of capital whose managers
have great flexibility in their investment strategies. Hedge fund
strategies are often referred to as alternative investment
strategies. Hedge fund managers are not constrained by the rules
that apply to mutual funds. The managers can take short positions,
use derivatives for leverage and speculation, perform arbitrage
transactions, and invest in almost any situation in any market
where they see an opportunity to achieve positive returns.
In addition to alternative strategies, the category of alternative
investments includes alternative assets and private equity. These
investments include, but are not limited to, real estate,
commodities, and investments in securities that are not publicly
listed (i.e., private equity).
Despite the hedge fund name, some funds do not hedge their
positions at all. It is best to think of a hedge fund as a type of fund
structure, rather than a particular investment strategy.
Another type of fund structure that utilizes alternative strategies is
the alternative mutual fund, otherwise known as liquid
alternatives or simply as liquid alts. This type of fund was recently
introduced into Canada, replacing what were known as commodity
pools. By regulation, alternative mutual funds are allowed greater
use of short sales, leverage, and derivatives compared to mutual
funds, but not to the same extent as hedge funds. Unlike hedge
funds, alternative mutual funds can be sold to retail investors.
Hedge funds, in contrast, have a more limited audience.
DID YOU KNOW?
Proficiency Standards to Sell Alternative Mutual Funds

IIROC Registered Representatives (RRs) are able to deal
in alternative mutual funds within their existing licensing
approval category, however as with all products the dealer
and the RR need to ensure that Know Your Product
requirements are met.
M utual fund sales representatives are not allowed to
distribute alternative mutual funds unless they possess one
of the following:
• Passing grade for the Canadian Securities Course;
• Passing grade for the Derivatives Fundamentals
Course;
• Successful completion of the Chartered Financial
Analyst Program; or
• Any applicable proficiency standard mandated by a self-
regulatory agency
This proficiency requirement was the one aspect of the
CSA regulation that governed commodity pools (NI 81-104)
that has been retained at least for the time being. The CSA
is evaluating proficiency requirements more generally and it
is possible the requirements to deal in alternative mutual
funds may change in the future along with other proficiency
alterations.
Because hedge fund managers have tremendous flexibility in the

types of strategies they can employ, the manager’s skill is more
important than for other alternative managed products. Additionally,
a hedge fund’s investment objectives and investor suitability vary
depending on the manager’s choice of strategy and the targeted
risk/return level.
Like mutual funds, alternative mutual funds and hedge funds:
• Are pooled investments that may have front-end or back-end
sales commissions.
• Charge management fees.
• Can be bought and sold through an investment dealer.
Despite these similarities, there are differences to consider,
summarized in Table 13.4.
Table 13.4 | Comparing Mutual Funds to Alternative Mutual
Funds and Hedge Funds
Main Product
Features and Alternative
Regulatory Conventional Mutual Hedge
Restrictions Mutual Funds Funds Funds
Investment M aximize relative M aximize M aximize

objective return absolute absolute
return, while return, while
providing providing
downside downside
protection in protection in
falling falling
markets markets
Permitted M aximum of 5% of M aximum of Permitted as

short sale of fund NAV 10% of per offering
a single issuer fund NAV memorandum
Permitted M aximum of 20% of M aximum of Permitted as

total short fund NAV 50% of per offering
sales for fund fund NAV memorandum
Diversification M aximum of 10% of M aximum of Limit set by

- NAV invested in 20% of NAV offering
concentration securities of invested in memorandum
(issuer level) any one issuer securities of
any one
issuer
Fund NAV Required to Same as Frequency

calculation calculate NAV conventional set by
frequency weekly, unless they mutual fund offering
use specified memorandum
derivatives or short (usually
sell – in which case monthly or
the NAV must be quarterly)
calculated daily
Charging Yes Yes As defined in

management offering
fees permitted memorandum
Charging Yes, but can only Yes, but Yes, but

performance charge performance performance performance
fees permitted fees tied to a fees fees normally
reference normally charged
benchmark or index charged based on the
based on total return of
the total the fund itself
return of the
fund itself
Product Usually daily Usually daily Usually

redemption monthly,
sometimes
quarterly
Permitted General public General Exempt,

investors public accredited,
institutional,
or minimum
initial
$150,000
investment
Fund holdings M onthly: Top ten M onthly: Disclosure

disclosure security holdings Top ten frequency
(transparency) security stipulated in
holdings offering
Quarterly: Quarterly: memorandum
Complete Complete (typically
fund holdings report fund holdings semi-annual
report or annual)
Investor rights Right to cancel Right to No right of

of withdrawal investment within cancel withdrawal
48 hours of receipt investment
of confirmation within 48
purchase hours of
receipt of
confirmation
purchase
INVESTING IN HEDGE FUNDS

Hedge funds are typically sold to investors without a prospectus.
Securities regulators permit the sale of securities without a
prospectus, but only under certain conditions and only to investors
who meet exempt investor qualifications. The exempt market is
composed of both institutional investors and individual investors.
Common prospectus exemptions allowed by securities regulators
include the accredited investor exemption, the minimum investment
exemption, and the offering memorandum exemption. Typically,
individual hedge fund investors must qualify as accredited
investors.
Accredited An accredited investor is described in National

investor Instrument 45-106 as follows:
exemption • An individual who, either alone or with a
spouse, beneficially owns financial assets
with an aggregate realizable value (before
taxes, but net of related liabilities) that
exceeds $1 million.
• An individual whose net income before taxes
exceeded $200,000 (or exceeded $300,000 if
combined with a spouse’s income) in each of
the two most recent years, and who has a
reasonable expectation of exceeding that
same income level in the current year.
• An individual who, alone or with a spouse,
has net assets (which would include real
estate, and which is again net of any related
liabilities) worth at least $5 million.
Persons relying on the accredited investor
exemption to distribute securities to such an
investor must obtain a completed and signed risk
acknowledgement form from that individual
accredited investor.
The accredited investor exemption includes other
categories of entities and individuals, as
described in National Instrument 45-106.
Minimum The minimum investment exemption is not

investment available to retail investors. This exemption
exemption allows the sale of securities to non-individual
investors who make a prescribed minimum
investment. National Instrument 45-106 sets this
minimum at $150,000 across all jurisdictions in
Canada.
Offering The offering memorandum exemption allows an

memorandum issuer to sell its securities based on an offering
exemption memorandum being made available to investors.
An offering memorandum is a document that
provides information on the business and affairs
of the issuer, including audited financial
statements. It also describes certain rights of the
investor, including a two-business-day right of
withdrawal and a right of action for damages (and
rescission) if the offering memorandum contains a
misrepresentation.
This exemption is subject to investment limits
(e.g., $10,000 for investors who do not meet
certain income and asset thresholds) and
requires that investors sign a risk
acknowledgement form.
Additional restrictions and requirements that apply
may vary between provinces, so it is best to
consult your jurisdiction to determine their nature.
The market for hedge funds can be grouped under the following
two categories:
• Funds targeted toward high-net-worth and institutional
investors
• Funds, and other hedge fund-related products, targeted toward
the less affluent individual investor (i.e., the retail market)
Hedge funds targeted toward high-net-worth and institutional
investors are usually structured as a limited partnership or trust,
and are issued by way of private placement.
As mentioned, in the broader retail market, alternative mutual funds
are now available as a way to gain access to alternative
investment strategies. Other retail vehicles through which
alternative strategies can be accessed are closed-end funds and
exchange-traded funds (described later in the chapter).
HEDGE FUND STRATEGIES

Hedge fund investment strategies span all asset classes, all
regions of the world and all levels of market capitalization. Hedge
funds nevertheless can be placed into three major categories
based on the strategies they use—relative value, event-driven and
directional. The three strategies are listed in order of increasing
expected return and risk:
• Relative value strategies attempt to profit by exploiting
inefficiencies or differences in the pricing of related stocks,
bonds or derivatives in different markets. Hedge funds using
these strategies usually have low or no exposure to the
underlying market direction. Their returns are due to the
manager’s skill in identifying mispriced securities.
• Event-driven strategies seek to profit from unique events
such as mergers, acquisitions, stock splits and stock buybacks.
Hedge funds that use event-driven strategies have medium
exposure to the underlying market direction.
• Directional strategies bet on anticipated movements in the
market prices of equities, debt securities, foreign currencies and
commodities. Hedge funds using these strategies have high
exposure to trends in the underlying market. The manager
focuses on predicting and understanding the opportunities
generated by trends in different market indicators.
COSTS OF HEDGE FUNDS

In addition to management and administration fees, hedge fund
managers often charge an incentive fee based on performance.
Incentive fees are usually calculated after the deduction of
management fees and expenses and not on the gross return
earned by the manager. This detail can make a significant
difference in the net return earned by investors.
Incentive fees may be calculated in relation to a high-water mark, a
hurdle rate or both. A high-water mark ensures that a fund
manager is paid an incentive fee only on net new profits. In
essence, a high-water mark sets a bar (based on the fund’s
previous high value), above which the manager earns incentive
fees. It prevents the manager from “double dipping” on incentive
fees following periods of poor performance.
EXAMPLE
ABC Hedge Fund is launched with a net asset value of $10 per
unit. At the end of the first year, the fund’s net asset value rises
to $12 per unit. For the first year, the manager is paid an
incentive fee based on this 20% performance. At the end of the
second year, the fund’s net asset value has fallen to $11 per
unit. The fund manager receives no incentive fee for the second
year and will not be eligible to receive an incentive fee until the
fund’s net asset value rises above $12 per unit.
A hurdle rate is the rate that a hedge fund must earn before its
manager receives an incentive fee. Hurdle rates are usually based
on short-term interest rates to reflect the opportunity cost of
holding risk-free assets such as T-bills.
EXAMPLE
ABC Hedge Fund has a hurdle rate of 5%, and the fund earns
20% for the year. The incentive fees will typically be based on
the 15% return above the hurdle rate, subject to any high-water
mark.
ADVANTAGES AND RISKS OF HEDGE FUNDS

There are many advantages of investing in hedge funds including
the focus on absolute returns, lower correlation with traditional
asset classes, and the potential for lower volatility and higher
returns. Table 13.5 outlines these advantages.
Table 13.5 | Advantages of Hedge Funds
Focus on Hedge fund managers seek to achieve positive or

Absolute, absolute returns in any market condition (up markets,
not down markets, trendless markets) not just returns
Relative, that beat a market index, which is the goal of most
Returns mutual funds.
A mutual fund manager might be satisfied with losing
less than the benchmark, but a hedge fund manager
in the same position would be disappointed with
the results.
Lower Although correlations can change over time, hedge

Correlation fund returns usually have a low correlation to the
with returns on traditional asset classes, such as equity
Traditional and debt securities. If these low correlations are
Asset maintained over time, hedge funds can provide
Classes diversification benefits and help lower overall
portfolio risk. The extent to which a hedge fund
provides diversification benefits depends on the
type of hedge fund and on market conditions.
Potential The different strategies and opportunity to use

for Lower derivatives, and short sell securities gives hedge
Volatility funds a greater potential to earn higher returns
and Higher relative to mutual funds. These characteristics also
Returns give hedge funds the opportunity to reduce overall
market volatility.
On the other side, hedge funds are subject to several types of

unique risk: lighter regulatory oversight, manager and market risk,
liquidity constraints, and investment strategy risk. Table 13.6
outlines these risks.
Table 13.6 | Risks of Hedge Funds
Light Hedge funds are generally not required by

Regulatory securities laws to provide the comprehensive
Oversight initial and ongoing information associated with
securities offered through a prospectus. This lack
of transparency may create a situation in which
hedge fund investors may not always know how
their money is being invested.
Market Risk Hedge funds do not seek to produce returns

“relative” to a particular index, but strive to
generate positive returns regardless of market
direction. This risk, also referred to as first-order
risk, is the risk associated with the direction of
interest rates, equities, currencies and
commodities.
Liquidity Unlike mutual funds, hedge funds are typically not

Constraints able to liquidate their portfolios on short notice.
Holding less liquid investments often produces
some of the excess returns generated by hedge
funds. This liquidity premium is part of the trade-off
against traditional investments. In light of this,
there are often various forms of liquidity
constraints imposed on hedge fund investors.
This risk is also referred to as second-order risk,
and is related to aspects of trading, such as
dealing, implementing arbitrage structures, or
pricing illiquid or infrequently valued securities.
Investment Even if hedge fund managers try to mitigate risk,

Strategy Risk the methods they use may be difficult to
understand. As a result, there is a risk that
investors may not fully understand the techniques
being used. It is the responsibility of investors to
understand the strategies and investment
products used by the hedge fund manager, as
well as the fund’s risk profile.
BEFORE INVESTING IN HEDGE FUNDS
As noted previously, hedge funds operate in a more relaxed
regulatory environment than traditional investments and in a culture
in which disclosure of management techniques, trades, and
analytics is not required. M any hedge funds are small, have
complex legal structures, and may rely on a single manager using
complex strategies. To “Know the product” is thus an important part
of the decision to invest in a hedge fund. Some of the key areas
investors should focus on include:
Fund track Consider only those single-strategy hedge

record funds that have at least a two-year track record
and $25 million under management.
Risk Investor’s risk profile should be consistent with

characteristics the risk characteristics of the hedge fund.
Identify different measures of the fund’s risk and
risk-adjusted return and compare them with the
same measures for the fund’s peers.
Hedge fund Examine the experience and reputation of the

manager hedge fund firm and manager. The fund manager
should have many years of experience with the
trading system under use. Focus on the
individuals making the investment decisions
rather than on the sales representatives trying
to sell the fund.
Hedge fund Read the marketing material, the prospectus,

features offering memorandum, or information statement.
Do not rely solely on sales presentations for
information. Understand the fund’s fee and
expense structure, the potential use of
leverage, and the liquidity terms.
Return Understand the nature of return statistics
statistics published in marketing materials. The results
should encompass enough market cycles to
prove the trading system to be reliable over
time.
Tax treatment Understand the tax implications of the fund.

Some hedge funds are taxed annually while
others are taxed only upon disposition. Some
funds regularly distribute income while others
distribute a combination of capital gains and
income.
Currency risk Know whether the fund is exposed to currency

risk, whether the manager intends to hedge that
risk, and whether the manager has expertise in
hedging currency risk.
WHAT ARE CLOSED-END FUNDS?

A closed-end fund is a managed pool of securities traded on a
stock exchange. The pool is similar to a mutual fund in that the
closed-end fund invests in most of the same types of assets, such
as stocks and bonds. However, unlike a conventional open-end
mutual fund that continually issues and redeems units, a closed-
end fund has a fixed number of shares. The number of shares or
units in closed-end funds remains fixed, except in rare cases of an
additional share offering, share dividend, or share buy-back.
Funds that have the flexibility to buy back their outstanding shares
periodically are known as interval funds or closed-end
discretionary funds. They are more popular in the United States.
Like mutual funds, closed-end funds pay management fees from
the assets of the portfolio. Unlike mutual funds, closed-end funds
generally have lower costs because of lower portfolio turnover and
lower marketing costs. Buying a closed-end fund is similar to
buying an individual stock, requiring no more than a brokerage
commission. In contrast, buying a mutual fund could require
payment of a front-end or back-end sales charge plus ongoing
trailer fees. These fees can eat up a significant proportion of an
investor’s return.
ADVANTAGES AND RISKS OF CLOSED-END

FUNDS
Closed-end funds offer certain opportunities for investment returns
not available to investors in regular mutual funds, such as short
selling or leverage. Thus, closed-end funds can boost total return.
In working with a closed-end structure, money managers are not
subject to unpredictable cash flow in and out of the fund. They
have the flexibility to concentrate on long-term investment
strategies without having to reserve liquid assets to cover
redemptions, as they would be with regular open-end mutual funds.
Open-end mutual funds must keep a certain percentage of their
funds liquid, in case of redemptions. Typically, a closed-end fund is
closer to being fully invested than an open-end fund.
Because the number of units of a closed-end fund is generally
fixed, capital gains, dividends, and interest distributions are paid
directly to investors rather than reinvested in additional units.
Therefore, tracking the adjusted cost base of these funds may be
easier than for open-end mutual funds. M oreover, because there
are only a fixed number of units to be administered, investors in
closed-end funds may benefit from lower management expense
ratios (M ERs) than open-end funds similar objectives.
Closed-end funds have risks relating mainly to trading, liquidity, and
leverage. They do not necessarily trade at their net asset value. In
an open-end fund, the fund NAV is the sum of the value of the
constituent securities, but in a closed-end fund, there is often a
discount to the NAV. This discount may become especially
significant in volatile markets, negatively affecting investors who
want to sell their shares. In bear markets, closed-end fund
shareholders may suffer as the value of the underlying assets
declines and as the gap between the discount and the net asset
value widens.
Partly because of the divergence of trading prices from net asset
value, closed-end funds are less liquid than open-end funds. With
trading taking place on a stock exchange, buyers and sellers must
be found in the open market—the fund itself does not usually issue
or redeem units. Also remember that commissions are paid at the
time of purchase and at the time of sale.
In addition to liquidity risk, there is leverage risk. A closed-end fund
can use borrowed money in the management of the portfolio, which
magnifies the gains and losses in the net asset value.
BEFORE INVESTING IN CLOSED-END FUNDS

One of the main requirements with the purchase of a closed-end
fund is understanding the discount or premium at which the fund
may trade. M arket demand as well as the underlying asset value
can create situations where the fund trades at a discount, at par or
at a premium relative to the combined net asset value of their
underlying holdings. For instance, an increase or decrease in the
discount can indicate market sentiment, which is the general
feeling or mood of investors to the anticipated price movement of
the stock market. The greater the relative discount, all other things
being equal, the more attractively priced the fund.
However, it is important to find out whether the discount at which a
fund is trading is below historical norms. A widening discount could
indicate underlying problems in the fund, such as disappointing
results from an investment strategy, a change in managers, poor
performance by the existing managers, increased management
fees or expenses, or extraordinary costs such as a lawsuit.
WHAT ARE EXCHANGE-TRADED FUNDS?
Exchange-traded funds (ETFs) are baskets of securities that are
constructed like mutual funds but traded like individual stocks on an
exchange. ETFs are similar to index mutual funds in that they will
hold the same stocks, bonds or other securities in the same
proportion as those included in a specific market index.
EXAMPLE
The iShares CDN S&P/TSX 60 Index Fund holds a basket of

stocks that represents the S&P/TSX 60 Index and trades under
the symbol XIU on the TSX. The S&P/TSX 60 Index consists of
60 of the largest and most liquid stocks traded on the Toronto
Stock Exchange. The iShares CDN S&P/TSX 60 will hold the
same 60 stocks as the S&P/TSX 60 Index.
An investment in an ETF combines attributes of both index mutual

funds and individual stocks. Like an index mutual fund, an ETF
represents a passive style of investing which attempts to match
the performance of an index, such as the S&P/TSX 60 Index
mentioned in the example above. Since ETF performance mirrors
the index it tracks, if the index falls, so will the ETF.
Like stocks, and unlike index mutual funds, ETFs are traded on an
exchange and can be bought and sold throughout the trading day.
In this way, ETFs provide investors with a flexible way to
participate in the performance of the underlying index.
In Canada, there has been significant growth in the number of
ETFs and the companies that offer them. As of April 2021, there
were a total of 824 ETFs listed on the Toronto Stock Exchange
offered by more than 30 ETF companies.
ADVANTAGES AND RISKS OF EXCHANGE-

TRADED FUNDS
Table 13.7 identifies the many advantages ETFs have over
conventional investment vehicles.
Table 13.7 | Advantages of ETFs
Buy the ETFs allow the investor to diversify and “buy the
Market market” or a segment of the market in one
transaction without having to purchase all the
stocks individually.
Professional As with mutual funds, the investor benefits from

Management professional management.
Low M ERs tend to be lower than on other index and

Management actively managed products. Both index mutual
Costs funds and ETFs tend to have lower M ERs than
active mutual funds because the fund managers
are not spending time or money researching
companies in which to invest.
Lower ETFs have lower operational costs in general, as

Operational they use stock exchanges’ sponsored facilities to
Costs record ownership of units and daily transactions.
M utual funds must keep a back office running to
keep such records.
Cash Drag ETFs do not have the same cash drag that index
mutual funds have. M utual funds must keep a
portion of their assets in cash or “liquid” to satisfy
any redemption requests. ETFs do not have this
requirement and can remain fully invested.
Tax ETFs are regarded as a tax-efficient investment.

Efficiency The relatively low trading turnover typically
generates few capital gains that must be
distributed to unitholders and taxed in their hands.
ETFs are subject to the same risks as individual stocks trading on
an exchange, including:
• M arket risk and sector risk if the ETF tracks a specific industry.
• Trading risk as there is no guarantee that the ETF will trade
close to its net asset value or that there will be an active
trading market for the ETF.
• If the ETF tracks a foreign index, then the investor is also
exposed to foreign security risk. M any foreign markets tend to
be less liquid and less efficient than North American markets
and may have more government intervention.
• Foreign currency risk because nominal returns in the investor’s
domestic currency will be reduced if the currency is strong
against the foreign currency.
• Not all ETFs fully replicate the benchmark index. The degree to
which an ETF fails to mirror the index returns is known as
tracking error. It is costly to perfectly match the index, so
managers take a representative sample that behaves close to
the index. Some ETFs may not include all the securities, and
some may include securities not in the index. M any ETFs have
restrictions regarding the percentage holdings of any one
security.
• Because ETFs are not subject to individual stock or sector
exposure limits that normally are part of a mutual fund’s
investment objective they are subject to concentration risk. If
particular sectors have had extraordinarily large gains, then it is
possible for the ETF to be highly concentrated in a single stock
(in excess of 10%) or sector (in excess of 40%).
COSTS OF EXCHANGE-TRADED FUNDS

Rather than paying a front-end or back-end load as is the case with
some mutual funds, the cost to purchase an ETF is the
commission charged by a broker or discount broker when both
buying and selling the ETF units.
Fees that are indirectly charged to the investor include
management fees, distribution fees and other operating expenses.
As previously stated, these tend to be lower than for most other
comparable mutual funds. International ETFs, especially those in
emerging markets, tend to have higher fees than domestic ETFs.
The M ERs on Canadian ETFs can range from as low as 0.17% to
as high as 1.70%. International M ERs range as high as 1.00%.
M ERs are typically substantially lower than for comparable equity
or index mutual funds, or even bond mutual funds.
BEFORE INVESTING IN EXCHANGE-TRADED

FUNDS
Aside from the fundamentals of the underlying ETF assets, the
value of an ETF lies in its low management costs. But not all ETFs
are created equally. The recent popularity of ETFs has spawned an
explosion of new issues.
For instance, there are ETFs that track portfolios of alternative
assets such as gold, oil, and international real estate. M ERs for
these specialty ETFs are normally higher than typical stock index
ETFs. Investors looking to purchase a specific ETF should make
sure costs are low and liquidity is high to justify the ETF label.
EXCHANGE-TRADED FUNDS
Can you compare exchange-traded funds to mutual funds?

knowledge.
WHAT ARE SEGREGATED FUNDS?

A segregated fund is actually an insurance contract with two
parts: an investment that produces the return and an insurance
policy that covers the risk. The segregated fund is like a mutual
fund, with all the associated market risks and benefits of
professional management. But a segregated fund comes with
death benefits and a maturity guarantee attached that protects the
investor’s principal from market declines. The guarantee ensures
that the investor will get back, at maturity or death, up to 100% of
their investment, regardless of how markets perform or the market
value, whichever is greater.
Segregated funds, like mutual funds, can be bought or sold at any
time. However, to qualify for the guarantee investors must hold the
fund for a minimum period, usually ten years. If the investor sells
prior to the maturity date, they will receive the market value, which
may be less than their original investment.
Because segregated funds are insurance contracts they are
regulated by provincial insurance regulators. This means you need
to be a licensed insurance representative to sell them.
Essentially, a segregated fund contract covers the following three
parties:
• The contract holder—the person who purchased the contract.
• The annuitant—the person on whose life the insurance
benefits are based.
• The beneficiary—the person who will receive the benefits
payable under the contract upon death of the annuitant (a
contract may have more than one beneficiary).
ADVANTAGES AND RISKS OF SEGREGATED

FUNDS
Clear advantages of segregated funds include maturity guarantees,
reset dates, death benefits, creditor protection and bypassing
probate.
Maturity guarantees. One of the key features associated with
segregated funds is the maturity guarantee, which is the promise
that the contract holder or beneficiary will receive at least a partial
guarantee of the return of the money invested. Provincial
legislation requires that the guarantee be at least 75% over a
contract term of at least a 10-year holding period. Some insurers
have increased the minimum statutory 75% guarantee to 100%.
EXAMPLE
Leslie has invested in a segregated fund over the past ten

years that includes a 100% maturity guarantee. Assume that the
amount invested was $100,000. The market value of the fund at
maturity is $95,000. Since the market value of the fund is less
than the amount invested, Leslie is paid a $5,000 maturity
guarantee.
Reset options. Although segregated fund contracts have at least

a ten-year term, they may be renewable when the term expires,
depending on the annuitant’s age. If renewed, the maturity
guarantee on a ten-year contract would “reset” for another ten
years.
The reset option allows the contract holder to protect accrued
values inside the fund.
EXAMPLE
If a $50,000 ten-year segregated fund has increased in value by

$11,000, the investor can use the reset option to protect the full
$61,000. But the reset option resets the 10-year clock on the
fund’s guarantee.
M any insurers issuing segregated funds have added greater

flexibility in the form of more frequent reset dates. In some cases,
holders of segregated fund contracts may lock in the accrued value
before the original 10-year period has expired (and extend the
maturity date by 10 years).
Death Benefits. The death benefits associated with segregated
funds meet the needs of investors who want exposure to long-
term asset classes while ensuring that their investments are
protected in the event of death.
The principle behind the death benefits is that the contract holder’s
beneficiary or estate will receive payouts amounting to at least the
original guaranteed amount. The amount of the death benefit is
equal to the difference, if any, between the net asset value of the
fund and the guaranteed amount.
Table 13.8 illustrates the death benefits when the market value of
the units held in the segregated fund is below, the same as, or
higher than the guaranteed amount.
Table 13.8 | Death Benefits
Market
Guaranteed Value Death Amount Paid to
Amount at Death Benefit Beneficiaries
$10,000 $8,000 $2,000 $10,000
$10,000 $9,000 $1,000 $10,000
$10,000 $10,000 None $10,000
$10,000 $11,000 None $11,000
As the table shows, death benefits are paid only when the market
value of the fund is below the guaranteed amount.
EXAMPLE
From the table above, when the market value at death is $9,000,
the beneficiary will receive a death benefit payment of $1,000.
Therefore, in addition to the payment of the $9,000 market value
of the fund, the total payment to the beneficiary is $10,000.
When the market value at death is above the guaranteed
amount, there is no death benefit payable because the
beneficiary receives the full market value of the investment
which is higher than the guaranteed amount.
Creditor Protection. Another advantage is that segregated funds

may offer protection from creditors that is not available through
other managed investment products. Creditor protection is
available because segregated funds are insurance policies. The
insurance company rather than the contract holder owns the fund’s
assets and insurance proceeds fall outside the provisions of
bankruptcy legislation.
EXAMPLE
Suppose that a self-employed professional died and left a non-

registered investment portfolio of $300,000 and business-related
debts of $150,000.
• If the portfolio were made up of mutual funds, then creditors

would have a claim on half of the portfolio, leaving only
$150,000 for the surviving family members.
• If the entire portfolio had been held in segregated funds, then
$300,000 would be payable directly to the deceased person’s
beneficiaries.
Bypassing Probate. Investing in segregated funds can help
investors avoid the costly probate fees levied on assets held in
investment funds. Probate is the official process of verifying a will
as genuine. Since segregated fund contracts are insurance policies,
and not assets of the contract holder, they are not regarded as part
of the deceased’s estate. The proceeds of a segregated fund pass
directly into the hands of the beneficiaries.
In addition, proceeds of a segregated fund are payable
immediately. There is no waiting for probate to be completed, and
payment cannot be delayed by a dispute over the settlement of
the estate. M oreover, by passing assets directly to beneficiaries
through a segregated fund, contract holders can ensure that their
beneficiaries save on fees paid to executors, lawyers and
accountants.
COSTS OF SEGREGATED FUNDS

Like mutual funds, segregated funds incur fees related to switching,
trailers, sales and management expenses. In addition, segregated
funds have costs related to maturity guarantees and death
benefits.
Investors should also recognize that there is a cost to investing in
a managed product that offers such guarantees. For segregated
funds, the cost is in the form of higher M ERs compared to mutual
funds that do not offer this guarantee.
The shorter the term of the maturity guarantees, the higher the risk
exposure of the insurer and the higher the cost of the guarantees.
Also, segregated funds with a large equity component have a
costlier guarantee than a similar segregated fund with a more
balanced portfolio. These relationships are based on the premise
that there is a greater chance of market decline (and hence a
greater chance of collecting on a guarantee) over shorter periods
and that the chance of loss increases with the portfolio’s risk.
The cost of the segregated fund also varies with the level of
principal protection the contract affords.
EXAMPLE
A fund with a 100% minimum benefit guarantee will be more

expensive than a fund offering a 75% minimum benefit
guarantee. Typically, a guarantee will add between 50 and 300
basis points (100 basis points = 1.00%) above the M ER of a
standard mutual fund. This ensures that a segregated fund will
typically lag the performance of its conventional mutual fund
counterpart.
BEFORE INVESTING IN SEGREGATED

FUNDS
There are certain factors to consider in the selection of a
segregated fund. Death benefits may have conditions that reduce
payouts to the beneficiary. It is important to check the contract for
details on exclusions and age limits. For example:
• Once the insured person reaches a threshold age, the
beneficiary may be required to accept a reduced percentage of
benefits.
• When deposits have been made over a period of time and
benefits vary according to the client’s age, the death benefit is
calculated according to a formula that factors in the amount of
deposits and the client’s age when they were made. Benefits
may be lower than expected.
• A client of a certain age might be excluded outright from buying
a company’s segregated funds. Some firms may require that
the individual on whose life the death benefits are based be no
older than 80 at the time the policy is issued.
SEGREGATED FUNDS
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segregated funds? Complete the online learning activity to
GUARANTEED MINIMUM WITHDRAWAL BENEFIT

PLANS
When clients near their retirement, losses in their portfolio can be
particularly serious. Earlier in the investment cycle, good years can
balance off bad years, but in retirement the extra return from later
good years can be lost, since part of the portfolio has to be
withdrawn for income.
To counter the risk of retirement funds being impaired by a few bad
years at the wrong time, insurance companies have developed
guaranteed minimum withdrawal benefit (GM WB) plans.
Industry experts predict there is the potential for tremendous
demand for this product, particularly as the baby boomers approach
retirement.
A GM WB is similar to a variable annuity.
With a variable annuity the amount of monthly payment to the
annuitant varies according to the value of the investments in a
segregated fund into which premiums are placed. M any variable
contracts provide a “floor” below which benefits may not fall. The
floor for benefits is usually equal to 75% of premiums paid,
regardless of what happens to the value of the variable
annuity fund.
With a GM WB:
• The client purchases the plan, and the GM WB option gives the
planholder the right to withdraw a certain fixed percentage (7%
is typical) of the initial deposit every year until the entire
principal is returned, no matter how the fund performs.
• At a minimum, clients receive their principal. The underlying
investment account can be based on a variety of indexes,
funds, etc.
Under one plan, clients can buy the GM WB several years in
advance of their withdrawals.
• In this case, the guaranteed amount can grow by 5% every
year until withdrawals begin. Every three years, throughout the
term of the plan, if the underlying fund has risen, the guaranteed
amount is reset upwards. When the guaranteed amount
increases, the payment period is extended, and the regular
payments may also be increased.
These plans have advantages besides guaranteeing principal
repayment and the possibility of sharing in the increased value of a
mutual fund.
EXAMPLE
If a client buys the plan several years before withdrawals begin,

the guarantee increases by 5% each year until withdrawals start,
even if the fund decreases in value. During this period, if the
market rises, the three-year reset is in effect. This reset
compounds the value of the 5% increases in the guarantee.
If a client starts to take payments immediately after purchasing the

plan, she will be susceptible to earlier losses in the portfolio. In
other words, she may never be able to receive more than the
principal repayment.
It is necessary to purchase the plan several years in advance of
withdrawal, in order to build up the guarantee. The bonuses come
in those years regardless of the behaviour of the underlying fund.
These plans are especially suitable for clients with 5 to 10 years to
retirement, who cannot afford significant losses in their portfolio
during that time. These clients also want to be able to share in the
growth of selected financial markets.
GM WB plans provide the potential for growth but with a
guaranteed income floor that provides a secure income stream as
a base. The income stream can now also be assured for the life of
the investor. This provides further peace of mind, knowing that the
investment can provide income for life.
GM WB plans come with fees levied to manage the underlying
mutual fund(s) and fees levied to fund the GM WB guarantee. The
investor may have to pay sales charges when depositing or
withdrawing from the contract depending on the sales charge
option of the fund(s) chosen.
PORTFOLIO FUNDS
Portfolio funds, which invest in other funds instead of buying
securities directly, allow investors to hold a diversified portfolio of
segregated funds through a single investment. The responsibility
for choosing or rebalancing the asset mix usually rests with the
fund company.
M anagement expenses for portfolio funds are generally higher than
for stand-alone segregated funds and guaranteed investment
funds, because the investor pays for the asset allocation service,
on top of the management costs for the underlying funds.
ATERNATIVE MANAGED PRODUCTS TERMINOLOGY
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alternative managed products? Complete the online learning
SUMMARY
1. Identify and distinguish between the features, advantages, and
risks of the various alternative managed products discussed.
PPNs
◦ Structured as debt instruments that include a principal
guarantee and interest payments. Performance is tied to an
underlying asset.
◦ Investors can access markets they normally could not
access with a small investment while still protecting the
principal invested.
◦ Less transparent than the information available with mutual
funds, and this makes them more difficult to evaluate.
◦ Risks include market, liquidity, credit and, currency risks.
Hedge Funds
◦ Lightly regulated pools of capital run by managers who have
great flexibility in applying a variety of investment strategies.
◦ M anager focus is on absolute returns in any market
condition, lower correlation with traditional asset classes,
and the potential for lower volatility and higher returns.
◦ Risks include complex investment strategies, lighter
regulatory oversight, market and, liquidity risks.
Closed-end Funds
◦ A managed pool of securities traded on a stock exchange
that has a fixed number of shares.
◦ Offer certain opportunities for investment returns not
available to investors in regular mutual funds, such as short
selling and leverage.
◦ Risk relates mainly to trading, liquidity, and leverage. They
do not necessarily trade at their net asset value.
Exchange-traded Funds
◦ Baskets of securities that are constructed like mutual funds
but traded like individual stocks on an exchange. ETFs are
similar to index mutual funds in that they will hold the same
stocks, bonds or other securities in the same proportion as
those included in a specific market index.
◦ Key advantages include diversification though ‘buying’ the
market, low management and operational costs, and tax
efficiency.
◦ Subject to the same risks as individual stocks, including
market and sector risk, trading risk, foreign exchange risk,
and tracking error.
Segregated Funds
◦ An insurance contract with two parts: an investment that
produces the return and an insurance policy that covers the
risk.
◦ Includes a maturity guarantee that protects the principal from
market declines. Death benefits, creditor protection and
opportunity to reset the term are additional advantages.
◦ Exposure to the markets, much like mutual funds, is a key
risk.
2. Identify and describe the costs associated with these
alternative managed products.
PPNs
◦ Lack of transparency in these products prevents investors
from clearly understanding all of the costs involved.
◦ Not protected by the Canada Deposit Insurance Corporation
(CDIC).
◦ Explicit costs include commissions, management fees, early
redemption fees, and structuring costs.
◦ Implicit costs include performance averaging formulas and
performance participation caps, and price returns vs. total
returns.
Hedge Funds
◦ Costs include administration fees, and incentive fees subject
to a high-water mark.
◦ A high-water mark ensures that a fund manager is paid an
incentive fee only on net new profits.
Closed-end Funds
◦ Costs include commissions charged at time of purchase and
less liquidity relative to mutual funds.
◦ Costs include commissions charged at time of purchase,
management fees, distribution fees, and other operating
expenses.
Segregated Funds
◦ Higher M ERs is an important cost to consider.
◦ Like mutual funds, segregated funds incur fees related to
switching, trailers, sales and management expenses. In
addition, segregated funds have costs related to maturity
guarantees and death benefits.
3. List and compare the requirements to consider before
investing in each product.
PPNs
◦ Creditworthiness of the issuer should be without question
and the degree of leverage being used.
◦ An understanding of the calculation method and the risk
factors associated with the underlying asset.
◦ The principal protection should be worth paying for.
Hedge Funds
◦ Fund and manager track record are key concerns.
◦ The underlying strategies and fund features must also be
considered.
Closed-end Funds
◦ Determine whether the discount at which a fund is trading is
below historical norms.
Understand the underlying asset being tracked and the risks
◦ associated.
◦ Historical performance.
Segregated Funds
◦ Review all contract details for limitations and other
conditions.
◦ Review the maturity guarantees and death benefit
requirements.
REVIEW QUESTIONS

SECTION 5
EVALUATING MUTUAL FUNDS

SECTION 5 | EVALUATING MUTUAL
FUNDS
Now that we have a better understanding of the types of mutual
funds available in the marketplace, our next step is evaluating fund
performance so that you can make better decisions when selecting
a mutual fund for a client.
Chapter 14 focuses on the techniques used to measure and
evaluate mutual fund performance. We look at comparing mutual
funds against a benchmark and how they are ranked relative to
their peers.
Chapter 15 provides a method of selecting individual mutual funds.
In this chapter, we stress that the selection of a particular mutual
fund is the last of the decisions that investors must make, and that
the decision follows from the discussions you’ve had with your
clients.
Chapter 16 discusses the fees charged and the services offered
by mutual funds. We explain the types of sales fees charged by
some funds, and the expenses that investors must bear in
exchange for the services provided by their funds. We also discuss
automatic plans through which investors may buy and redeem
mutual fund investments.
Understanding Mutual
14
Fund Performance
CONTENT AREAS
How is Portfolio Performance Evaluated?
How is Performance Assessment Conducted?
How is a Comparison Universe Used?
How is Quartile Ranking Used?
LEARNING OBJECTIVES
1 | Describe how portfolio performance is evaluated,

calculate and interpret the total return and risk-adjusted
rate of return of a portfolio.
2 | Describe how mutual fund performance is measured and

how the comparative performance of mutual funds is
determined.
3 | Define quartile and explain how to interpret quartile

performance results.
KEY TERMS

appraisal firms
benchmark
benchmark index
comparison universe
investment policy statement
peer group
performance assessment
performance universe
quartile
risk-adjusted rate of return
Sharpe ratio
survivorship bias
INTRODUCTION
Once a mutual fund has been selected, being able to measure and
evaluate performance, particularly over a certain time or evaluation
period, is an important function of the mutual fund sales
representative. You can use this information with your clients to
better assess the overall suitability of the fund you have
recommended. Performance measurement also gives you an
opportunity to evaluate how well the fund manager did over the
evaluation period relative to the cost of management.
You can measure fund performance by looking at its total rate of
return. This return is based on the interest and dividend income
generated within the fund as well as the increase (or decrease) in
the value of the securities. But is a 5% return good or is a 10%
return better?
Answering these questions requires a comparison of the return on
a mutual fund to the returns of similar funds or to an established
market benchmark—the S&P/TSX Composite Index for example.
How are performance benchmarks used? A mutual fund manager
who reports a 5% return when the fund’s comparison benchmark
reports a – 4% return over the same period can claim superior
performance for the year. In contrast, a manager who posts a 10%
return when the benchmark reports a 20% return performed poorly
over the evaluation period.
This chapter explores finding answers to the following question:
• Are the assets selected by the mutual fund manager adding
value to the funds’ performance beyond comparable funds or
beyond the level of a passive market index? Answering this
question involves performance assessment.
HOW IS PORTFOLIO PERFORMANCE

EVALUATED?
The success of a portfolio manager is determined by comparing the
total rate of return of the portfolio being evaluated with the average
total return of comparable portfolios. In this way, the portfolio
manager and the client can compare their returns to industry norms
and estimate their approximate ranking in relation to other portfolio
managers.
For most individual investors, the ranking can be estimated most
easily by comparing their performance with the averages shown in
one of the surveys of funds appearing regularly in financial
publications. Not only is it convenient, but many different funds are
measured in the surveys and the portfolio manager can compare
both the total return and the component returns of the portfolio. For
example, the equity component of a diversified portfolio can be
compared with the equity funds shown.
M anagers are often measured against a predetermined
benchmark that was specified in the investment policy statement.
An investment policy statement refers to a formal document that
guides the overall asset management of a portfolio.
One common benchmark is the T-bill rate plus some sort of
performance benchmark (e.g., T-bill rate plus 4%).
MEASURING MUTUAL FUND PERFORMANCE

Performance measurement involves the calculation of the return
realized by a portfolio manager over a specified time interval called
the evaluation period.
The most frequently used measure of mutual fund performance is
to compare NAVPS at the beginning and end of a period. Usually
this method is based on several assumptions, including the
reinvestment of all dividends. The increase or decrease at the end
of the period is then expressed as a percentage of the initial value.
Consider the following example:

This calculation assumes that the investor made no additions to or
withdrawals from the portfolio during the measurement period. If
funds were added or withdrawn, then the portfolio return as
calculated using this equation may be inaccurate.
CALCULATING THE RISK-ADJUSTED RATE

OF RETURN
It is not enough merely to compare the returns of two portfolios to
measure performance, without factoring in the risk assumed to earn
those returns.
EXAMPLE
M utual fund A and mutual fund B both had a total return of 7%

over the past 12 months. One might say that the two funds had
the same performance. However, when you look at the standard
deviation (a measure of risk) of both funds, you realize that for
the same period, Fund A had a standard deviation of 5% while
Fund B had a standard deviation of 10%. For the same return,
Fund B held twice the risk as Fund A. The comparison of return
now has a new perspective, as fund B took more risk than fund
A to achieve the same return.
A tool has been developed to take into consideration both the risk
and the return of a portfolio. The Sharpe ratio, used by mutual fund
companies and portfolio managers, compares the excess return of
the portfolio (i.e., the return on the portfolio minus the risk-free
return) to the portfolio’s standard deviation, thereby taking the
portfolio’s risk into account. It measures the portfolio’s risk-
adjusted rate of return using standard deviation as the measure
of risk.
Where:
Sp = Sharpe Ratio
Rp = Return of the portfolio
Rf = Risk-free rate (typically the average of the three-month
Treasury bill rate over the period being measured)
σp = Standard deviation of the portfolio
EXAMPLE
A Canadian Equity Fund called DEF had an average fund return

of 6% and a standard deviation of 5%. The average risk-free
return was 1%.
For this example, the Sharpe ratio of the fund is calculated as
shown below.
Sharpe ratio:
The fund had a positive Sharpe ratio, which means that it had an
average return greater than the average risk-free return.
OTHER FACTORS IN PERFORMANCE

MEASUREMENT
Dissimilarities in portfolios also make accurate performance
comparisons difficult. For example, portfolios may have different risk
characteristics and/or special investor constraints or objectives.
When such factors affect returns, the conclusions drawn from the
performance comparisons should be adjusted to reflect the impact
of the variables.
Because of the large number of variables in the management and
measurement of portfolios, assessing investment performance is
difficult. Regardless, when performance comparisons are made,
investors should be concerned primarily with longer-term results
since they best measure a manager’s ability in all phases of the
business cycle. Also of importance are consistency of results and
the trend of performance as indicated by the results over the last
few measurement periods.
HOW IS PERFORMANCE ASSESSMENT

CONDUCTED?
Performance assessment involves comparing a mutual fund
manager’s results with those of an established and reliable
benchmark to determine if there has been a comparatively “good”
return on investment. This assessment is based on two kinds of
benchmarks:
• Benchmark indexes—the performance of a well-known market
index.
• Comparison universe—the performance of a group of funds that
have comparable asset classes and risk profiles.
In addition, measures of performance used in comparing funds must
adhere to certain standards. In particular, measures should:
• Identify superior, ordinary and inferior performance.
• Not require manipulation, assuming the measure itself is
fundamentally sound.
• Be sufficiently realistic to be useful in practice.
A measure is useful only if it is based on data and comparable time
periods. You can rely on the major data providers for relevant
benchmark data, such as M orningstar and the Globe and M ail.
However, you must use the same time period when comparing
mutual fund performance to its benchmark, otherwise your analysis
will be irrelevant.
To interpret results in mutual fund performance accurately, you
need a basic understanding of measurement methods and their
strengths and weaknesses. Two methods for comparing mutual
fund portfolio performance to a benchmark are presented here.
BENCHMARK INDEXES
All mutual funds have a benchmark index against which their return
can be measured, for example, the S&P/TSX Composite Index for
Canadian equity funds, the S&P 500 for U.S. equity funds, or the
FTSE TM X Canada Universe Bond Index for Canadian bond funds.
A benchmark index is an index that reflects a mutual fund’s
investment universe and can be used as a standard against which
performance can be measured. The benchmark chosen must be
relevant—an equity fund cannot be compared against a bond index,
as the comparison is made on two different types of securities.
Table 14.1 shows the various benchmark indexes commonly used
to compare mutual fund performance.
Table 14.1 | Key Canadian Mutual Fund Benchmarks
Index Description Performance

uses
S&P/TSX The largest listed equities that Canadian

Composite trade on the Toronto Stock equity funds
Exchange as measured by
market capitalization
S&P/TSX 60 The 60 largest companies that Canadian
trade on the TSX as measured large-cap
by market capitalization equity funds
S&P 500 The 500 largest publicly held U.S. equity

companies that trade on U.S. funds
markets
MSCI EAFE The M SCI Inc. index of Non-North

Index European, Australasian, and American
Far East stocks equity funds
FTSE Canada Broad measure of the Canadian bond

Universe Bond Canadian government and funds
Index corporate bond market
FTSE Canada The return of 91-day Canadian Cash

91-Day T-Bill Treasury Bills component of
Index a portfolio or
money market
funds
MSCI Canada Large and mid-cap Canadian Canadian ESG

ESG Leaders companies with strong ESG funds
Index ratings
MSCI World Broad measure of global Global ESG

ESG Index companies with strong ESG funds
ratings
The benchmark indexes are used in the following ways:

• If a fund reports a return that is higher than the return on the
index, we can say that the fund has outperformed its
benchmark.
• If a fund reports a return that was lower than the return on the
index, we can say that the fund has underperformed its
benchmark.
HOW IS A COMPARISON UNIVERSE USED?

The most popular method of relative performance evaluation is to
compare a mutual fund’s return with the performance of a peer
group, which is made up of mutual funds with similar investment
mandates. The collection of mutual funds that form the basis for
comparison is also called a comparison universe or performance
universe. For example, if you wanted to measure the performance
of a Canadian large cap equity fund you would compare this fund’s
results with all other Canadian large cap equity funds.
If a fund posted a one-year return of 12% while the average

return of its peer group over the same period was 9%, we can
say that the fund outperformed its peer group over the
evaluation period.
Comparison universes are constructed by professional

performance appraisal firms such as M orningstar and the Globe
and M ail, for example. These firms collect performance information
from a large number of mutual funds and report this information on a
regular basis.
ISSUES THAT COMPLICATE MUTUAL FUND

PERFORMANCE
When comparing mutual fund performance, one must avoid
comparing the performance of two funds that are dissimilar (e.g., a
fixed-income fund versus a growth equity fund) or comparing funds
that have differing investment objectives or degrees of risk
acceptance.
One complicating factor occurs when the name or class of fund
does not accurately reflect the actual asset base of the fund.
Investors should be aware, for example, that funds classified as
Canadian equity funds may at times have significant portions of
their assets invested in equities other than Canadian stocks. This
is not to suggest that the fund manager is doing something wrong.
Each manager must consider market trends and adjust the timing of
the fund’s investments. It does, however, suggest that the
published results are often comparing apples with oranges.
This discrepancy between a fund’s formal classification and its
actual asset composition can impair attempts to create a portfolio.
For example, an investor who wished to allocate 10% of a portfolio
to gold stocks might be surprised to find that, at some points, gold
mutual funds are holding 50% of their assets in cash. This results in
an actual asset allocation of 5% in gold rather than the desired
10%.
RISK
Another factor that complicates comparisons between funds is that
there is often no attempt to consider the relative risk of funds of the
same type. One equity fund may be conservatively managed, while
another might be willing to invest in much riskier stocks in an
attempt to achieve higher returns.
Any assessment of fund performance should consider the volatility
of a fund’s returns. There are a number of different measures of
volatility, but each attempts to quantify the extent to which returns
will fluctuate. From an investor’s standpoint, a fund that exhibits
significant volatility in returns will be riskier than those with less
volatility. M easures used to quantify volatility include:
• the standard deviation of the fund’s returns
• beta
• the number of calendar years it has lost money
• the fund’s best and worst 12-month periods
• the fund’s worst annual, quarterly or monthly losses
Standard deviation measures how volatile a fund has been over a
past period to give an indication of how it might behave in the
future. If a fund has consistently earned a 5% return per year over
the past 20 years, although there is no guarantee, it would be
reasonable to expect that the fund will earn 5% in the future. If,
however, a fund’s annual return fluctuated from a negative 20% to a
positive 20% over a period of 20 years, it is much less likely that
the fund will earn a return of 5% in the coming year. Standard
deviation is a common measure of the consistency of a fund’s
return. The higher the standard deviation, the more volatile or
unpredictable the return may be.
Other methods, which look at different time periods, can be used to
calculate best-case and worst-case scenarios. Ratings systems
based on multiple periods avoid placing too much emphasis on
how well or poorly the fund did during a particular short-term period.
An advisor who deals with mutual funds should be aware of how
the fund tends to perform relative to the stock market cycle. Some
will outperform others in rising markets, but do worse than average
in bear markets. The beta, available on most fund performance
software, measures the extent to which a fund is more or less
volatile than the underlying market in which it invests. The greater
the variation in the fund’s returns, the riskier it tends to be.
Particular attention should be paid to periods during which the fund
lost money.
HOW IS QUARTILE RANKING USED?

Quartile ranking is used to assess performance of a fund manager
relative to its peer group. Like professional sports, where the best
performer is first among peers and the worst performer is last,
mutual fund managers are ranked from best to worst within their
peer group.
A quartile sorts performance into four equal parts or blocks. For
instance, if you are looking at a peer group of 100 Canadian equity
funds, there would be four quartiles made up of 25 funds each. The
quartiles are given a rank—1, 2, 3, or 4—to show how well a certain
fund performed compared to all other funds in the peer group:
• 1st quartile—Top 25 funds with the highest returns
• 2nd quartile—Next 25 best performers
• 3rd quartile—Next 25 performers
• 4th quartile—Bottom 25 performers in the peer group
The number of individual funds in a peer group can be any

number. For example, consider a Canadian Equity Balanced
Fund Universe comprised of 872 funds. In this case, the 1st
quartile would be comprised of the 218 top performers, the 2nd
quartile would be comprised of the next 218 best performers and
so on until the worst 218 performers, who would be ranked in the
fourth quartile.
Although a fund manager would strive to generate first quartile

results every year, in reality this would be very difficult to
accomplish. M ost fund managers would aim for stable and
consistent performance in the top two quartiles.
Figure 14.1 shows the quartile performance of ABC Equity Fund, a
hypothetical Canadian equity fund that is part of a universe of 100
other similar funds. Only a sample of the funds in this peer group
are presented and not the full 100 funds. Professional appraisal
firms would list all the funds classified within the selected classes.
Figure 14.1 | Sample Quartile Ranking

Quartile Rank: Canadian Equity
Funds
Year Year 2 Year 3 Year Year

1 4 5
ABC 2 3 2 3 3
Fund
DEF 1 1 3 4 2
Fund
GHI 1 1 2 1 1
Fund
JKL 4 3 4 3 4
Fund
The ABC Fund ranked comparatively average in performance,

hovering between the second and third quartile over the five year
evaluation period. However, the ABC Fund achieved a relatively
stable performance, given the fact that its returns, while never in
the first quartile, or top performers of the group, were never in the
fourth quartile either.
In comparison, the GHI Fund showed superior performance relative
to the other funds by consistently ranking in the top quartile in four
out of the five years. In contrast, the JKL Fund was the weakest
performer in this peer group.
When comparing performance, it’s also worthwhile pointing out that
the longer the evaluation period, the more stable the returns of the
comparison universe. You should not put too much importance on
quartile rankings over the short-term, such as one-year returns.
Shorter term rankings are more volatile. In assessing fund suitability
for a client, the consistent performers should rank higher in choice
than the volatile performers.
DRAWBACKS OF THE COMPARISON UNIVERSE
METHOD
The comparison universe method has pitfalls that can compromise
its accuracy and usefulness. For example, the contents of
comparison universes must be carefully defined so that you know
exactly what the portfolio is being compared against. This is not
always the case. A balanced fund universe may contain a range of
incomparable portfolios from mainly equity-based funds with a
modest bond component to bond funds with small stock exposure.
It is important to compare “apples to apples”.
A performance universe defined too broadly also does not help to
assess risk. In a universe comprised of equity portfolios, managers
who concentrate on particular subgroups of stocks, such as small-
capitalization firms, will have different risk characteristics than the
universe in general. Similarly, general bond universes are not
representative of managers specializing in high-yield bonds.
Because comparisons must be made among funds that take similar
risk profiles the benchmark universe may not be appropriate for all
fund performance measurements.
All comparison universes also exhibit some degree of survivorship
bias no matter how carefully the universes are constructed.
Survivorship bias develops as defunct portfolios drop out and are
excluded from rankings in subsequent quarters. A performance
universe is essentially a universe of survivors. Funds that are
terminated or cease to exist are usually those who have been
unsuccessful.
As a result of this bias, adequately performing managers can
appear to have underperformed as the investment period
lengthens. For example, a manager with median performance every
quarter will increasingly rank lower in the surviving universe in the
3-year, 5-year and 10-year return comparisons. This appearance of
deteriorating performance as the investment period lengthens
makes average and moderately good fund managers look more like
underperformers as the historical period of comparison lengthens.
Finally, appraisal firms and analysts each have their own unique
methods of universe construction and compilation. The differences
are substantial enough that a mutual fund manager may rank in the
top half of managers in one universe and in the bottom half of a
competing firm’s universe.
As you can see, the comparison universe approach would not work
as a passive investment strategy. Drawbacks of the performance
universe approach are summarized in Table 14.2.
Table 14.2 | Drawbacks of the Comparison Universe in

Performance Assessment
Problems Effects
Definition of Universes too broadly or too variably defined are

universes not comparable.
M atching of Universes that do not match for risk are not

risk profiles representative.
Universe Universes that are too small (e.g., through

size partitioning into sub-universes) are not reliable.
Survivorship Termination of unsuccessful funds may result in

bias performance universes that are biased.
Case Study | It’s All Relative: Benchmarking Portfolio

Performance (for information purposes only)
Barry recently received his quarterly investment portfolio

statement. His portfolio is a growth-orientated mix of eight funds,
with an approximate weighting of 60% equities, 30% bonds and
10% cash. Of the five equity mutual funds he holds, four of them
have returned over 10% during the last year. The fifth fund, the
ABC Emerging M arkets Equity Fund (the fund), has fallen in value
over the last 12-months. Barry is confused, as he has read in the
news that emerging markets are far-outpacing developed world
nations in economic growth. He concludes that it must be the fund
itself that is underperforming.
Barry meets with Tom, his mutual fund representative, to discuss
the performance of the fund and to review alternative investment
options for his portfolio’s emerging markets exposure. At the
meeting, Barry expresses his concerns regarding the fund to Tom,
and states that he wants to sell the fund and replace it with
another one.
Tom reviews Barry’s goals, re-confirms his investment profile and
reviews his portfolio’s mutual fund holdings. Barry and Tom
examine each of the mutual fund’s performance against their:
• Appropriate mutual fund peer groups (e.g. Canadian Equity
Large Cap)
• Relevant benchmark (e.g. the S&P/TSX Composite Index)
• Beta relative to the appropriate benchmark
Tom also pulls up the mutual funds’ M orningstar profiles, which
contain their risk-adjusted returns relative to their peers that are
captured through M orningstar’s 5-star rating system, five being
the best and 1 being the worst.
After conducting the analysis and making the appropriate
comparisons, Tom determines that all of the funds are performing
well. In particular, despite posting a negative return over the last
year, the ABC Emerging M arket Equity Fund has:
• Outperformed 90% of its peers in the emerging markets equity
group
• Exceeded the return of the M SCI Emerging M arkets Equity
Index, which posted a larger loss than the fund over the past
12-months as emerging market equity indices fell around the
world
Achieved a beta of 0.8, meaning that it was less volatile than
• the relevant Index
• Was rated 5-stars by M orningstar for its relative and risk-
adjusted performance
Tom also explains to Barry that, while emerging markets equities
had a poor year, their long-term outlook continues to be strong,
presenting important growth and diversification opportunities for
his portfolio. The fund has posted better-than-average returns
over 3-, 5- and 10-years, and Tom reiterates the importance of
maintaining a long-term perspective when considering a fund’s
performance.
MUTUAL FUND PERFORMANCE TERMINOLOGY
There are different methods of determining and comparing

mutual fund performance. Can you define the terminology
associated with fund performance? Complete the online
SUMMARY
1. Describe how portfolio performance is evaluated, calculate and
interpret the total return and risk-adjusted rate of return of a
portfolio.
◦ Performance evaluation looks at how the mutual fund
manager outperformed or underperformed comparable funds
or a predetermined benchmark.
◦ Performance measurement involves the calculation of the
return realized by a portfolio manager over a specified time
interval called the evaluation period.
◦ In measuring performance, the risk assumed to earn those
returns must be taken into account. This is done through the
use of the Sharpe ratio.
2. Describe how mutual fund performance is measured and how
the comparative performance of mutual funds is determined.
◦ Benchmark indexes are well known market indexes (e.g., the
S&P/TSX Composite Index, the FTSE TM X Canada
Universe Bond Index) to which the performance of the
mutual fund can be compared.
◦ The comparison universe (also called performance universe
or peer group) is composed of a universe of mutual funds
with similar characteristics compared to the one under
evaluation.
◦ When comparing mutual fund performance, one must
compare the performance of two funds that are similar or
comparing funds that have the same investment objectives
or degrees of risk acceptance.
◦ Any assessment of fund performance should consider the
volatility of a fund’s returns.
3. Define quartile and explain how to interpret quartile
performance results.
◦ A quartile sorts performance into four equal parts or groups
within the peer group, also called the comparison universe,
or the universe of funds.
◦ The first quartile represents the best performers in the group
with the highest returns, while the fourth quartile represents
the worst performers of the group.
REVIEW QUESTIONS

Selecting a Mutual Fund 15
CONTENT AREAS
How does Volatility impact Mutual Fund Returns?
What are the Steps in Selecting a Mutual Fund?
What Other Elements should be Considered when Analyzing

and Selecting Mutual Funds?
LEARNING OBJECTIVES
1 | Describe the risk-return trade-off between the different

types of mutual funds, and list and define the different
sources of volatility that impact fund returns.
2 | List and describe the steps in selecting a mutual fund

and perform calculations related to the different
measures of volatility.
3 | List and analyse the four elements of mutual fund

selection: people, philosophy, process,
and performance.
KEY TERMS
alpha
assets under management (AUM)
beta
Canadian Investment Funds Standards Committee

(CIFSC)
default risk
exchange rate risk
growth at a reasonable price (GARP)
growth investing
holdings-based style analysis
interest rate anticipation
interest rate risk
market risk
momentum investing
returns-based style analysis
reward-to-risk ratio
sector rotation
sector trading
security selection
simple rate of return
style analysis
style drift
unique risk
value investing
INTRODUCTION
In Section 2, you learned that clients must have financial objectives
and must select investments that are consistent with those
objectives, keeping in mind financial circumstances, personal
circumstances, investment knowledge and risk profile.
You learned that one of the most important decisions for clients is
the asset allocation decision, which determines how much of each
asset class should be held in their portfolios. Asset allocation can
be aggressive with a heavy weight given to the equity component,
conservative with a heavy weight given to the money market
component, or anything in between. The asset allocation must
reflect financial objectives and all constraints, including of the
client’s risk profile.
It was also stressed that portfolios should be well diversified. In
this framework, selecting a mutual fund or group of mutual funds is
the final thing that you and your clients must do. In many cases, it
is the mutual fund sales representative who does all the analysis
and makes specific mutual fund recommendations to the client.
This chapter explains what to look for when selecting individual
mutual funds. The process involves looking at a fund’s risk and
return profile and past performance data. M utual fund sales
representatives must be able to explain and interpret sources of
published mutual fund performance information. In this, however,
there is no method of selecting individual mutual funds that can
guarantee positive returns. Usually, the best that investors can do
is to base their decisions on past performance. Unfortunately, the
past is not always a good predictor of the future.
HOW DOES VOLATILITY IMPACT MUTUAL

FUND RETURNS?
You saw in Chapter 8 that different securities have different risk
and return characteristics. The same is true for mutual funds.
It seems reasonable to expect that the risk and return of different
types of mutual funds should depend on the securities making up
their investment portfolios (recall that risk is defined as the volatility
of return over time). If this is the case, you would expect money
market mutual funds to be less risky than bond funds, and bond
funds to be less risky than equity funds. In fact, this is precisely the
case.
The mutual fund industry has created a variety of funds designed to
meet the diverse needs of the Canadian investing public. Because
each fund type or group will hold different types of securities and
will pursue different investment objectives, the risk and return
between the various funds will also differ.
Figure 15.1 illustrates the risk-return trade-off between the different
types of mutual funds.
Figure 15.1 | Risk and return between different types of mutual

funds
There are other types of mutual funds in addition to the ones
presented in Figure 15.1. For example:
• The returns on short-term bond funds are riskier than money
market funds and less risky than bond funds.
• The returns on preferred dividend funds are riskier than bond
funds but less risky than equity mutual funds.
• Global mutual funds, depending on the types of securities they
hold, can be almost anywhere on the risk/return spectrum.
The most important thing to remember is that the risk level or
volatility in returns of a mutual fund is directly related to the risk
level or volatility in the returns of the securities it holds in its
investment portfolio. This means that funds of the same type (for
example, equity mutual funds), cannot be expected to have
necessarily the same level of volatility.
In addition, it is possible that funds generally regarded as lower in
volatility may actually have higher volatility than others. For
example, zero coupon bonds are very volatile. It is likely that a
zero-coupon bond fund will be more volatile than a bond fund,
especially in a period of volatile interest rates.
What is the source of this volatility? Why does the return earned
from a security not stay the same over time? The simple answer is
that when there are more buyers than sellers of a particular
security, to be a successful buyer you must outbid your rivals. This
bidding activity pushes up the price of the security, which affects
the returns. Similarly, when there are more sellers than buyers, the
successful seller must be willing to let his security go at a lower
price than the other sellers. This will push prices down.
There are always investors in the marketplace looking for money-
making opportunities. Investors may suddenly decide that a given
stock is trading at too low a price and put in orders to buy it in
expectation that the price will rise. They may have just received
information about a new product that the company has developed
or a new acquisition, and they believe that this new product or
acquisition will increase the company’s future profitability.
Although other factors may change a security’s price, new
information is the key. When new information about a security
becomes available, investors’ beliefs change about the value of the
security, and buying and selling occurs. If the new information is
favourable, the price of the security will move up; if unfavourable,
then the price will move down. In this process, some investors
have better information than others, often the result of superior
analysis.
Some securities are very sensitive to new information. For
example, the stock of a high technology company will react strongly
to new information about the company’s products. A new discovery
can result in a substantial price increase. Similarly, the price of a
bio-technology firm may be negatively affected by the news that a
drug has failed to obtain approval by regulators. Other securities
are not particularly sensitive to new information. For example,
although the shares of the bio-technology stock may be negatively
affected by bad news, the bonds of that same company may not
be affected to the same degree.
If a security’s price is affected by new information, and if new
information arrives frequently, then its price will tend to be volatile,
and so will the returns that it generates. This source of volatility is
specific to a given security and is known as unique risk. When
more than one security is held in a portfolio, these unique risks
tend to cancel each other out. Well-diversified portfolios, those
consisting of a large number of different securities, will almost
completely eliminate unique risk.
Even well-diversified portfolios have risk, however. After the unique
risks are eliminated through diversification, you are still left with
market risk. For example, rising interest rates tend to make
investors uncertain about the future profitability of all stocks, which
tends to depress the stock market as a whole. M arket risk cannot
be eliminated through diversification. All mutual funds except
money market funds have some amount of market risk, depending
on the composition of the portfolio. If a mutual fund tries to
specialize in a few “good bets” in the hope of earning higher
returns, it will be subject to unique risk as well, due to the lack of
diversification.
Other sources of volatility, discussed earlier in this course and
reviewed in Table 15.1, have to do with the specific nature of a
security.
Table 15.1 | Sources of Volatility in Mutual Funds
Type of Source of risk Ways to reduce

risk risk
Unique Sensitivity of a security’s price to Diversify

risk new information leading to
(also changes in demand
called
Specific
risk)
Default The unique risk that a bond Avoid specializing
risk coupon will not be paid in
corporate bonds
Market Changes in the overall market None

risk affecting an entire class of
(also securities
called
systematic
risk)
Exchange Changes in the relative value of Hedging

rate risk the currencies of the countries of
investment
Interest Changes in interest rates leading Avoid specializing

rate risk to changes in fixed-income in fixed-income
securities prices securities
The point is that the volatility of any security or mutual fund is the
result of the interplay of a number of risk factors. Because mutual
funds are made up of different securities with different risk factors,
the volatilities of the funds also are different.
VOLATILITY AND MUTUAL FUND RETURNS
Can you identify the relative volatility of mutual funds and

their sources? Complete the online learning activity to
WHAT ARE THE STEPS IN SELECTING A

MUTUAL FUND?
Analyzing volatility is one of the key steps in the process of
selecting a mutual fund. To select individual funds within each
mutual fund category, it is recommended that you follow a step-by-
step process similar to that shown in Figure 15.2.
Figure 15.2 | Steps for Selecting a Mutual Fund
1. Refer to sources of published mutual fund performance data.

2. Identify funds with appropriate investment objectives.
3. Look for funds with the best long-term performance.
4. Among the best long-term performers, look for best
performance from year-to-year.
5. Among best year-to-year performers, find those with lower
volatility.
6. Among the funds with low volatility, find ones where the
current investment manager was responsible for the good
performance.
7. Compare fund facts documents and compare prospectuses.
8. Examine fees and charges.
9. Analyze the size of the mutual fund.
10. M ake the decision.
Each step is taken up in more detail in the sections that follow.
RESEARCH THE PERFORMANCE DATA

There are numerous sources of data about mutual fund
performance, many of them Internet-based. The Globe and M ail
newspaper provides a twice-yearly 15-year mutual fund review, in
February and November (see www.theglobeandmail.com).
M orningstar Canada (www.morningstar.ca) is another commonly
used source of objective data about mutual fund performance.
Depending on how deep you dig, data for each mutual fund could
include a return indicator, a volatility indicator, whether the fund is
eligible for deferred tax plans, total assets, net asset value per
share (NAVPS), the distributions paid, M anagement Expense Ratio
(M ER), sales fee structure, quartile rankings over three, five and
10 years, and performance data over short and longer terms along
with benchmark comparisons. In many cases, a graph is included
showing how an investment of $10,000 in a particular mutual fund
has done over the period since its inception and it includes the
appropriate benchmark comparison to show whether the fund has
performed above or below its benchmark.
FOCUS ON APPROPRIATE INVESTMENT

OBJECTIVES
After gathering performance data, you and your client must focus
on funds that are similar in terms of investment objectives. It is
improper, not to mention misleading, to attempt to compare the
performance of funds with different objectives. For example, money
market funds are expected to offer lower performance than equity
funds over the long run and also to be much lower in risk.
Comparing a money market fund with an equity fund in terms of
performance therefore would not be appropriate. Finding that a
particular equity fund is a better performer than a particular money
market fund would tell you nothing about the performance of the
equity fund in relation to its risk category.
FOCUS ON BEST LONG-TERM

PERFORMANCE
After finding funds with appropriate investment objectives, look for
the funds with the best long-term performance. For example, if the
ABC Equity Fund has a 10-year compound rate of return of 18.1%,
it means that an investor who bought that fund 10 years ago and
held it until the record date of the listings would have earned an
average annual return of 18.1%. This includes the reinvestment of
all dividends, those distributed by the fund as well as dividends that
reflect the capital gains earned on the mutual fund’s portfolio of
common shares sold at a gain. The 18.1% is the net return the
investor would have earned, after all management fees and
expenses were paid by the fund. However, it does not include
charges that individual investors may have paid, such as sales
fees.
M any mutual funds have limited performance data, because they
have been in existence for only one to three years. This lack of
long-term data may be a problem. A client seeking good long-term
performance, a goal consistent with investment in an equity fund,
will find it difficult to judge the potential for long-term performance of
a fund that has been in existence for such a short time. Even if
short-term performance is good, there is no guarantee that in a
different phase of the economic cycle the fund will continue to do
so well. A fund with a strong 10-year performance, on the other
hand, usually has been through at least one complete market cycle
and perhaps two.
An equity fund with less than three years of performance data does
not give a good idea of how the fund will perform over the longer
term. When comparing mortgage funds, as suitable shorter-term
investments, however, three years would be a more acceptable
period. Performance data for both bond funds and equity funds
should be long enough to cover one complete market cycle, at
least five years.
FOCUS ON BEST YEAR-TO-YEAR

PERFORMANCE
After finding comparable funds with good long-term performance,
look for funds with the best performance from year to year. In
comparing two funds, the one with less variation in simple rates of
return from year to year is a more consistent performer. A simple
rate of return is the return earned by the fund over a given year or
period. Simple rates of return are useful for looking at the
consistency of returns. Consistency is important. Although equity
funds are intended for the long-term, if liquidity is needed, the fund
with a more consistent performance is less likely to be sold at a
loss.
Simple rates of return also tell effectively how well a mutual fund
performs when the markets have turned bearish, anticipating a fall.
Some investors focus on this aspect of a mutual fund’s
performance. For example, if a mutual fund went up 25% in a year
when the overall market increased by 27%, but went down 25%
when the overall market declined by 20%, the fund may not be an
ideal investment for a conservative client. Such a client would
prefer a fund that went up 18% in the first instance, for example, but
went down 8% in the second instance, offering greater protection
on the downside.
FOCUS ON GOOD PERFORMERS WITH

LOWER VOLATILITY
Some sources indicate the relative volatility of mutual funds and are
based on the funds’ standard deviation of return. Recall that
standard deviation is a statistical measure of risk. The larger the
standard deviation, the greater the volatility of returns and therefore
the greater the risk. The more a return departs from the mean, the
higher the deviation, and thus the higher the volatility. In general,
for funds with the same long-run compound rate of return, those
with lower volatility should be preferred (all other things being
equal).
M easures of volatility other than standard deviation include ratios,
such as the reward-to-risk ratio and the Sharpe ratio, and beta.
REWARD-TO-RISK RATIO
Some published sources provide a measure that shows return for
risk. This measure is called the reward-to-risk ratio. In its simplest
form, it is just the return earned by the fund over a period divided
by the standard deviation.
For example, a fund might earn a one-year return of 14% and have
a standard deviation of return of 28% per year. The reward-to-risk
ratio is 0.5. This means that this fund earns 0.5% for every 1% of
standard deviation. If another fund had a ratio of 0.6, you would say
that the fund was able to earn a better return for that same 1% of
standard deviation.
EXAMPLE
The return on ABC fund was 9.8% last year, while its standard
deviation was 5.5% over the same period. What is the reward-
to-risk ratio for the ABC Fund?
The reward-to-risk ratio for the ABC Fund is 1.78. This means that
ABC earns 1.78% of return for every 1% of standard deviation.
SHARPE RATIO
As indicated in the previous chapter, the Sharpe ratio shows how
well the return of a portfolio compensates the investor for the risk
taken. It is often used to compare the performance of mutual funds
among themselves and against benchmarks. If a fund manager is
being measured against a benchmark, the portfolio’s Sharpe ratio
can be compared to the Sharpe ratio of the applicable benchmark.
The higher the Sharpe ratio, the more return the portfolio got for the
same level of risk. A group of portfolios can therefore be ranked by
their risk-adjusted performance:
A mutual fund with a Sharpe ratio greater than the Sharpe ratio
• of the benchmark outperformed the benchmark.
• A mutual fund’s Sharpe ratio that is smaller than the

benchmark’s signals underperformance.
• A negative Sharpe ratio means the mutual fund had a return
less than the risk-free return.
EXAMPLE
A Canadian Equity Fund called DEF had an average fund return

of 6% and a standard deviation of 5%. The Canadian Equity
Benchmark had an average fund return of 8% and a standard
deviation of 10%. The average risk-free return was 1%.
For this example, the Sharpe ratio of the fund and its benchmark
are calculated as shown below.
Sharpe ratio:
Benchmark:
Both the fund and the benchmark had a positive Sharpe ratio,
which means that both had an average return greater than the
average risk-free return. However, the DEF risk-adjusted return
was higher than the benchmark’s risk-adjusted return. That
means that DEF was able to earn a greater return for each unit
of risk compared to the benchmark. Even though the benchmark
produced a higher total return, the benchmark employed twice as
much risk to do so.
Both the reward-to-risk ratio and the Sharpe ratio give an indication
of how successful the fund has been in earning a return per unit of
risk (standard deviation).
BETA
The beta or beta coefficient (discussed earlier in this course)
compares the volatility of an equity fund to the volatility of the stock
market as a whole. Any equity fund that moves up or down to the
same degree as the stock market has a beta of 1.0. Any equity
fund that moves up or down more than the market has a beta
greater than 1.0, and an equity fund that moves less than the
market has a beta of less than 1.0. Thus, the higher the beta, the
higher the fund’s volatility compared to the stock index volatility.
The lower the beta, the lower the fund’s volatility compared to the
stock index volatility.
FOCUS ON FUNDS WITH SUCCESSFUL

INVESTMENT MANAGERS
After isolating high-performing funds with low volatility, look for
funds in which success can be attributed to the performance of the
current investment manager. Good performance is the result of a
combination of luck and good management. If good performance
persists over a long period, it’s likely that good management is the
cause rather than luck. Over short periods, it is harder to say.
There are two issues with manager data. First, few funds have
retained the same manager(s) over long periods. Second, many
funds are managed by investment advisory firms, and there may be
no way of knowing which individuals have been responsible for the
funds. If reliable data are available, however, a fund with good
performance over the long run with the same manager in charge
suggests that the continuation of good performance is partly due to
the manager’s skill.
One additional performance measure to consider is the alpha on a
fund. Alpha is a measure of the manager’s performance. If alpha is
positive, the manager has produced more return than predicted by
the manager’s beta and thus the manager has added value to the
portfolio. The greater the alpha, the better the manager has done.
On the other hand, an alpha value of zero indicates the manager
has achieved only normal performance, meaning the manager has
added nothing. If alpha is negative, the manager has
underperformed for the level of risk taken on.
COMPARE FUND FACTS DOCUMENTS AND

COMPARE PROSPECTUSES
At this point in the selection process, you and your client have
reduced the field down to only a few competing funds. Now is the
time to get the fund facts documents and prospectuses from the
candidates. Even if funds are in the same category (equity funds,
for example), there may be significant differences in investment
practices and in the potential make-up of the investment portfolio.
Your clients will want to make sure that the fund they select
provides the best possible match to their investment objectives.
These disclosure documents will provide complete data on sales
charges, valuation, minimum investment requirements and so forth.
This information can be quite relevant. Some funds, for example,
require initial investments of $100,000 or more.
EXAMINE FEES AND CHARGES

Performance data reflect management fees and operating
expenses charged to the fund. They do not include charges paid
by individual investors, however, such as acquisition and
redemption fees. If the investment time horizon is short, high sales
fees will substantially reduce the returns that can be earned.
M anagement fees are included in return calculations. While higher
management fees may be easier to ignore in good times, they can
lead to higher capital losses in poor times. All things being equal, it
is better to choose a fund with a lower M ER (management
expense ratio).
The same reasoning applies to sales fees. If liquidity is a concern,
sales fees can end up being very costly. For example, if a client
holds a mutual fund investment for 10 years, but had to pay a
5% acquisition fee, you can think of that fee as being spread out
(or amortized) over the life of the investment. If the fund has
performed well, the sales fee will not have had too bad an impact.
However, if the client is forced to sell after one year, the fund would
have had to earn 5% after management fees and expenses just for
the client to break even.
The same logic applies to funds with redemption fees, but to a
lesser extent. M ost redemption fees decline over time, such that a
fund held for the long term will not charge a fee upon redemption.
However, if the fund is sold prematurely, those fees could be quite
high.
M ost reported sources of data indicate whether the funds charge
acquisition and redemption fees. These details are available in the
fund facts document and prospectus. If the fund is expected to be a
long-term investment, a redemption fee may be more beneficial to
the client than an acquisition fee. Keep in mind though that a
redemption fee reduces the flexibility of choice when a client wants
to get rid of the investment sooner than expected for any reason.
For funds with similar overall characteristics, select the one with the
lowest M ER. Over a long investment time horizon, a high M ER
can result in a much lower amount of accumulated returns.
ANALYZE THE SIZE OF THE FUND

One factor in selecting a mutual fund is the size of the fund relative
to other funds in the same category. M any people share the belief
that as mutual funds grow beyond a certain size their beneficial
economies of scale start to break down. Very large mutual funds
may be at a disadvantage compared to smaller funds because they
cannot shift their large portfolios as rapidly. Also, large purchases or
sales in the relatively small Canadian market tend to have an
impact on the price of the securities the funds are trying to buy or
sell.
M any investors shy away from newer, smaller funds because they
have been untested in the market and have not gone through a full
market cycle. Others, however, feel it is best to take advantage of
the momentum that newer funds offer, before they become too
large or perform less well.
MAKE THE DECISION

M aking the final decision involves selecting the fund with the best
long-term performance relative to risk (volatility), obtained by the
manager responsible for the fund’s performance. You and your
clients may end up selecting a fund in which you have great
confidence. In many cases, investors must make trade-offs among
the factors on which they base their decisions. For example, the
fund with the best long-term performance might be an inconsistent
or volatile performer, have relatively high sales fees, or require an
initial investment far beyond investors’ means.
After a fund is selected, there is no guarantee that the fund will
perform as anticipated. The fund manager might change, the
economy could enter a phase that a previously high-performing
manager might not understand as well, or the manager could even
have a string of bad luck. The weakness of any selection process
is that investors are prisoners of past data, and the future is never
quite the same or entirely knowable.
WHAT OTHER ELEMENTS SHOULD BE

CONSIDERED WHEN ANALYZING AND
SELECTING MUTUAL FUNDS?
You will find mutual funds in most asset classes. The Canadian
Investment Funds Standards Committee (CIFSC), the body that
oversees mutual fund classification, lists more than 50 categories
containing more than 7,000 funds. The CIFSC tracks investment
funds on a security-by-security holdings basis. For purposes of
category assignment, security types are grouped into five broad
asset classes: Cash, Fixed-Income, Equity, Commodity, and Other.
The CIFSC calculates all holdings figures and other portfolio
statistics used for categorization, based on a time-weighted
average over a 36-month period, with an emphasis on the most
recent 12 months of data. Theoretically, a client can buy any
specific exposure in equities (Canadian, U.S., sector, dividend,
international, global, emerging market, small cap, larger cap, index);
fixed-income (Canadian, U.S., foreign, high yield); balanced (tactical,
Canadian, global); or money market (Canadian, U.S.) funds. See
the CIFSC website at www.cifsc.org for full classification details.
Given the enormous breadth of choice, how do you select
appropriate mutual funds and create a portfolio? This becomes
more than a simple investment decision. Buying a mutual fund
means having a business relationship with the management firm.
Therefore, qualitative as well as quantitative elements must be
weighed. Assuming a risk assessment is completed and an asset
allocation is in place, you must then consider four elements of
mutual funds before selecting suitable candidates: people,
philosophy, process and performance.
PEOPLE
“People” refers to the personnel of the investment firm that
manages a particular fund. Ideally, a fund should be headed by a
portfolio manager with several years of experience and backed by
a team of analysts, client service staff, back office staff and
technology. An ideal organization should have strong, stable
ownership and be well capitalized to fund future growth. The
portfolio managers should have an equity stake in the firm, with
performance bonus incentives.
PORTFOLIO MANAGER AND INVESTMENT TEAM

Evaluation of the portfolio manager and the investment team may
be the most important part of the mutual fund assessment process.
Without a good portfolio manager leading a competent investment
team, all other factors become irrelevant.
Portfolio managers should have several years of experience
successfully managing money in their area of specialization, long
enough to encompass at least the ups and downs of one market
cycle (generally five years or more). Also, it is helpful if their
experience matches the investment specialization in the type of
funds that clients desire.
Portfolio managers should be able to focus largely on investment
management. M anagers are responsible for a broad range of duties
beyond investment research. There are ethical and regulatory
compliance requirements and business issues, plus client service,
marketing and sales. Good investment management firms have
enough resources to address these needs and allow their
investment professionals to focus on portfolio management.
OWNERSHIP
Strong and stable ownership supplies the leadership necessary to
grow the business and keep employees motivated. Strong
ownership provides staff with all the tools they need and sets the
tone for culture and morale. It also creates an atmosphere of
certainty that keeps the firm focused on providing the best
investment analysis possible.
FIRM’S BUSINESS
Steady growth in clients and in assets under management (AUM )
is a good sign. The number of client accounts and the level of
AUM should be sufficient to enable the firm to pay for overhead,
technological infrastructure, and salaries plus bonuses and profit
sharing.
Another key point to consider is the diversification of the client and
product list. It is not uncommon to find firms with a handful of large
clients comprising the bulk of AUM . The more diverse the client list,
however, the smaller the potential negative impact on the firm’s
asset base if a client takes its assets away.
The firm should also offer a sufficient breadth of products. Given
the cyclical nature of the investment industry, where one moment
small-cap stocks might be in favour and then value stocks the next,
it is prudent business practice to have a broad product base.
COMPENSATION
If equity (thus profit sharing) is not available to all employees,
management should have well- structured performance incentives
in their place. Bonuses should be based on performance, aligning
the interests of the fund investors with the investment manager. It
is ideal if managers are required to invest their personal money
alongside that of their clients. Studies have shown that managers
are more likely to outperform their benchmarks when pay is closely
linked to performance.
COMPLIANCE
Superior investment management organizations should possess
internal checks and balances against poor practices and conflicts of
interest. The integrity of the manager reflects on the quality of the
firm.
Good compliance practice extends to all aspects of the business.
Compliance should be the domain of a senior non-investment
officer. All trades made by the firm should be frequently and
regularly audited. Trades made by the portfolio managers should be
routed through the firm’s trading desk, where transactions for
buying and selling securities occur. M anagers should not conduct
trades for their own account, their spouse’s or those of members of
their immediate family. Senior investment staff should sign a
disclosure statement of personal holdings.
PHILOSOPHY
Another factor to consider when choosing a fund is the firm’s
investment philosophy. An investment philosophy is a coherent
way of thinking about how markets work and how they might be
incorrectly priced. Several philosophies co-exist in the market, any
one of which could be correct at a given time. There is no right or
wrong philosophy, in other words. Superior investment firms should
clearly articulate their investment philosophy. The more clearly they
can explain it, the more likely they will be able to execute it
consistently and successfully, and the better clients can harmonize
their investment philosophy and risk profile to that of the
investment firm.
Equity and fixed-income investment philosophies can each be
classified into distinct management styles, shown in Tables 15.2
and 15.3.
Table 15.2 | Philosophies of Equity Investing
Value A conservative approach to money management.

Investing Value investors want to buy a firm or equity fund for
less than what the assets in place are worth. They
avoid paying large premiums for growth companies
and seek bargains in mature companies that are out
of favour. Value investors have a better chance of
succeeding if given a long time horizon (at least five
years).
Growth A style concerned more about the future prospects
Investing of a firm than its present price. A firm might be trading
for more than its intrinsic value, but growing earnings
are expected to increase the value beyond its
current price. Growth investors seek companies in
sectors entering a period of expansion. Growth
sectors have limited competition, high-quality
research and development programs, relatively low
labour costs, and strong returns on invested capital.
Growth investors usually estimate earnings growth
and buying on high expected future rates or high
historical rates.
Sector Sector rotation is a portfolio manager’s attempt to

Rotation profit through timing. It is based on the belief that
different industries will perform well during certain
stages of the economic cycle. Industries expected to
outperform would be overweighted. M ore emphasis
is placed on industry weighting than on security
selection.
Momentum M omentum managers believe that strong gains in

Investing earnings or stock price will translate into stronger
gains in earnings or stock price. They tend to use
technical or quantitative stock selection models with
some fundamental variables to smooth out the
volatile nature of the style. It is a high-risk, high-
return strategy. M omentum portfolios typically have
high turnover rates as failing stocks are sold.
Portfolios also tend to be more concentrated in
certain areas of the economy than other funds.
Growth at a GARP is a value approach to buying earnings

Reasonable growth. GARP managers, like growth managers,
Price seek companies with projections of growing earnings
(GARP) and high and increasing ROEs (return on equity)
relative to the industry average. Unlike growth
managers, GARP managers avoid stocks with high
P/Es (price/earnings ratios).
Table 15.3 | Philosophies of Fixed-Income Investing
Interest This strategy involves moving between long-term

Rate government bonds and very short-term T-bills,
Anticipation based on a forecast of interest rates over a certain
time horizon. Price sensitivity to interest rate
movements increases as the term to maturity
increases and the coupon decreases.
Security Selecting bonds involves fundamental and credit

Selection analysis and quantitative valuation of individual
securities. Fundamental analysis of a bond
considers the nature of the security and the potential
cash flow. Credit analysis evaluates the likelihood
that the payments will be received as contracted.
Credit analysis also considers the issuer’s industry
conditions, the economy and other macroeconomic
factors, as well as factors specific to the issuer.
Sector Sector traders vary the weights of different types of

Trading bonds held within a portfolio. A portfolio manager
forms an opinion on the valuation of a specific sector
of the bond market based on its credit fundamentals
and on relative valuations compared to historical
norms and technical factors, such as supply and
demand.
Investors willing to assume interest rate risk can add
return to their portfolios by holding high-yielding
securities from a specific sector.
PROCESS
If philosophy is the belief system on which assets are managed,
process is the methodology by which value is accrued to the fund.
No one process at any time can be said to be superior to another,
but good investment organizations should have two outstanding
qualities of process:
• elements that are verifiable and transparent
• decision-making procedures that are team-based
PROCESSES
Processes are the tools used and the way they are coordinated to
manage and grow assets. Processes can include records of
company visits and manager interviews, screening and selection
criteria, proprietary economic analysis, sector and stock weight
ranges, maximum and minimum number of holdings, risk monitoring,
and a selling discipline. Outstanding organizations demonstrate
unique tools or innovative ways of combining these tools.
TEAM-BASED APPROACH
Whatever process and tools are used, mutual fund investors
should favour firms that emphasize a team-based approach to
managing money. Under the team-based approach, an individual
may or may not have total decision-making power, but the structure
of the investment process is team-dependent. That means no
individual has a dominant influence on the investment process.
An investment approach that emphasizes a team-based decision-
making process is especially good in the context of succession
planning and business continuity. Continuity is important over the
long run if the firm is to profitably and reliably execute the firm’s
investment process despite any losses of key personnel.
EXAMPLE
A firm may have a team of analysts supporting a number of
portfolio managers. The team’s job is to screen an initial
universe of stocks down to a small group that meets the firm’s
valuation criteria. Though individual managers can buy any
stocks within the group, they usually cannot go outside the
approved list. M anagers may come and go over the years, but
the fund will retain a disciplined investment process because it
resides with the team rather than an individual.
All things equal, it is preferable to select a fund with a team-based

approach than one that relies on an individual.
PERFORMANCE
Performance is the legacy of the investment philosophy as it is
applied through the investment process by the people of the firm.
Performance considers more than just added value over a given
benchmark. It also accounts for a manager’s consistency and
frequency of relative performance plus the risk taken to get good
returns. Performance also takes into consideration the consistency
of investment style over time. Good management more
consistently and more frequently outperforms its benchmark and its
peers per unit of risk. It is easy to judge past performance but
difficult to project it into the future.
Style analysis is the study of style drift (change in a manager’s
investment style over a period of time) in a fund’s holdings or
returns over time. Style drift is given important consideration in
performance analysis for several reasons (performance analysis
was discussed in Chapter 15). For example, a small-cap manager
that invests in large caps during a period of small-cap
underperformance cannot be said to be a skillful small-cap manager.
The more style drift that exists in a manager’s investment
approach, the more difficult it becomes to separate manager skill
from sheer coincidence.
Two methods of style analysis are returns-based and holdings-
based.
• Returns-based style analysis was developed by Nobel
Prize-winning economist William Sharpe. He suggested that a
fund’s investment style can be determined by comparing the
fund’s returns (usually 36 to 60 months of data) to the returns
of a number of selected passive style indexes. These indexes
represent different investment styles or asset classes such as
large-cap value, large-cap growth, small-cap growth, small-cap
value, government bonds or cash equivalents.
Example: The return of ABC large-cap Canadian equity index
fund is compared to the S&P/TSX 60 index, which includes the
60 largest companies of the S&P/TSX index.
• Holdings-based style analysis examines each stock in the
portfolio and maps it to a style at a specific point in time. Style
can be determined by capitalization, price-earnings ratio or
dividend yield. Once a large enough history of snapshots is
generated, a profile of the fund’s average style can be
developed and used as the custom benchmark.
Case Study | Sizing Up Samantha’s Options: Picking the Right

Mutual Fund (for information purposes only)
Samantha is meeting with mutual fund representative Christine to

review her mutual fund portfolio. Samantha is a conservative
investor whose portfolio’s strategic asset allocation consists of
65% bonds, 30% equities and 5% cash. In preparation for the
meeting, Christine has reviewed and analyzed Samantha’s mutual
fund holdings. In doing so, she has determined that one of
Samantha’s funds is not suited for her portfolio and she has
prepared a recommendation to replace it.
At the meeting, Christine explains to Samantha that during her
review of Samantha’s portfolio, she determined that the XYZ US
Equity Fund was not an appropriate fit for her portfolio. Given
Samantha’s conservative investment profile, she should only be
investing in a fund that:
• consists of blue chip, high quality, dividend-paying large cap
companies’ stocks
• has a lower than 1.0 beta relative to the benchmark, the S&P
500 Index
• has a relatively small standard deviation
• is hedged to manage foreign-exchange exposure to reduce
return volatility
• has a solid long-term track record with steady returns
Christine explains to Samantha that the XYZ US Equity Fund
failed on all of these fronts based on her analysis, as it includes a
number of mid-cap investments, it had a beta of 1.2, a standard
deviation of +/- 19%, does not use hedging and has had return
swings that were far too big over the last 10-years.
Instead, Christine recommends the LM N US Dividend Fund,
which, based on her review:
• consists of top-quality, blue chip dividend-paying large cap US
companies with steady, long-term stock performance
• has a beta of 0.7 relative to the S&P 500 Index benchmark,
keeping volatility low
• a standard deviation of +/- 12%, one of the lowest in its peer
group
• of the fund’s prospectus, foreign currency exposure is fully
hedged, further reducing return volatility
• has maintained steady, year-to-year returns over its long
existence
Samantha asks if there are any other ways to determine the
quality of the fund. Christine shows her the fund’s M orningstar
report, highlighting for her the fund’s 5-star rating based on its
relative, risk-adjusted performance, while also noting the fund’s
large cap, dividend stock focus. She shows Samantha the
simplified prospectus, which notes the long-standing tenure of the
fund manager and highlight’s the fund’s mandate to generate a
low-volatility/consistent return experience for investors. Samantha
is delighted with the recommendation and directs Christine to
switch the funds.
INVESTMENT PHILOSOPHIES
How well can you match investment philosophies to their

definitions? Complete the online learning activity to assess
your knowledge.
SUMMARY
1. Describe the risk-return trade-off between the different types
of mutual funds, and list and define the different sources of
volatility that impact fund returns.
◦ The volatility of returns of a mutual fund is directly related to
the volatility of the returns of the securities it holds in its
investment portfolio.
◦ The risk-return trade-off between the different types of
mutual funds goes from money market funds showing the
lowest level of risk to specialty funds showing the highest
level of risk.
◦ When there are more buyers than sellers of a particular
security, to be a successful buyer you must outbid your
rivals. When there are more sellers than buyers, the
successful seller must be willing to let his security go at a
lower price than the other sellers.
◦ New information has an impact on the price of a security. If
the new information is favourable, the price of the security
will move up; if unfavourable, then the price will move down.
◦ Unique risk relates the sensitivity of a security’s price to new
information leading to changes in demand.
◦ M arket risk represents the changes in the overall market
affecting an entire class of securities.
2. List and describe the steps in selecting a mutual fund and
perform calculations related to the different measures of
volatility.
◦ Refer to sources of published mutual fund performance data.
◦ Identify funds with appropriate investment objectives.
◦ Look for funds with the best long-term performance.
◦ Among the best long-term performers, look for best
performance from year-to-year.
◦ Among best year-to-year performers, find those with lower
volatility.
◦ Among the funds with low volatility, find ones where the
current investment manager was responsible for the good
performance.
◦ Compare fund facts documents and compare prospectuses.
◦ Examine fees and charges.
◦ Analyze the size of the mutual fund.
◦ M ake the decision.
◦ The reward-to-risk ratio is the return earned by the fund over
a period divided by the fund’s standard deviation.
◦ The Sharpe ratio shows how well the return of a portfolio
compensates the investor for the risk taken. It is often used
to compare the performance of mutual funds among
themselves and against benchmarks.
◦ The beta or beta coefficient compares the volatility of an
equity fund to the volatility of the stock market as a whole.
◦ Alpha is a measure of the manager’s performance. If alpha is
positive, the manager has produced more return than
predicted by the manager’s beta and thus the manager has
added value to the portfolio.
3. List and analyse the four elements of mutual fund selection:
people, philosophy, process, and performance.
◦ After completing a risk assessment and an asset allocation,
you must then consider four elements of mutual funds before
selecting suitable candidates: people, philosophy, process
and performance.
◦ “People” refers to the personnel of the investment firm that
manages a particular fund.
◦ Evaluation of the portfolio manager and the investment team
may be the most important part of the mutual fund
assessment process.
◦ An investment philosophy is a coherent way of thinking
about how markets work and how they might be incorrectly
priced.
◦ Equity investment philosophies can each be classified into
distinct management styles: value, growth, sector rotation
and growth at a reasonable price (GARP), while fixed-
income investment philosophies can each be classified into
interest rate anticipation, security selection and sector
trading management styles.
◦ Processes are the tools used and the way they are
coordinated to manage and grow assets. Processes can
include records of company visits and manager interviews,
screening and selection criteria, proprietary economic
analysis, sector and stock weight ranges, maximum and
minimum number of holdings, risk monitoring, and a selling
discipline.
◦ Performance accounts for a manager’s consistency and
frequency of relative performance plus the risk taken to get
good returns. It also takes into consideration the
consistency of investment style over time.
REVIEW QUESTIONS

Mutual Fund Fees and Services 16
CONTENT AREAS
What are the Fees and Charges of Mutual Funds?
What are Accumulation Plans?
What are Systematic Withdrawal Plans?
How are Mutual Funds Taxed?
LEARNING OBJECTIVES
1 | Distinguish among the various fees and charges that apply to mutual fund
investors and to mutual funds themselves.
2 | Compare and contrast the different types of accumulation plans that mutual
funds offer and describe the concept of dollar cost averaging.
3 | Compare and contrast the different types of systematic withdrawal plans

available to mutual fund investors and assess which withdrawal plan best
suits a client’s circumstances.
4 | Describe the tax effects of mutual fund redemptions and income

distributions.
KEY TERMS
Key terms are defined in the Glossary and appear in bold text in the chapter.
account closing fee
accumulation plan
acquisition fee
adjusted cost base
annuitant
annuity
back-end load
deferred sales charge
dollar cost averaging
explicit costs
fixed-dollar (constant) withdrawal plan
fixed-period withdrawal plan
frequent trading charge
front-end load
fund sponsor
implicit costs
life withdrawal plan
load
management expense ratio (MER)
management fee
no-load fund
operating expenses
pre-authorized investment plan
purchase price per unit
ratio withdrawal plan
redemption fee
right of redemption
sales charges
sales commission
service fee
set-up fee
systematic withdrawal plan
T3 form
T5 form
trading costs
trailer fee
trailing commission
transfer fee
trustee fee
turnover rate
variable annuity
voluntary accumulation plan
INTRODUCTION
M utual funds charge a number of different fees. Some of them, such as management
fees, are charged by all funds, while others, such as acquisition fees and redemption
fees, are charged by some. The first objective of this chapter is to explore the different
types of fees and charges.
The second objective is to look at the special services provided by many mutual funds.
These special services include accumulation and redemption plans through which
investors can regularly buy or sell mutual fund securities. A popular concept discussed
in this chapter in relation to accumulation plans is dollar cost averaging. The chapter
concludes with a discussion of tax implications of mutual fund ownership.
To advise clients appropriately and well, a mutual fund sales representative needs a
thorough understanding of mutual fund fee structures, special services, and tax
implications.
WHAT ARE THE FEES AND CHARGES OF MUTUAL
FUNDS?
M utual funds incur two types of fees: sales charges (or sales commissions) and
management fees. Sales charges are the fees charged to individual investors when
they buy and sell mutual funds shares (these fees are generally called loads).
Management fees are the fees payable by the fund to the fund’s service providers.
The management fees are charged out as expenses against the entire fund’s earnings
and are disclosed in the fund facts document.
All mutual funds charge management fees. M anagement fees are deducted from the
fund’s return to pay for professional management and administrative services provided
to the fund. These fees depend on the nature of the fund and range on average from
0.5% of net assets per year to 3% of net assets per year or more.
M utual funds can be categorized on the basis of the type of sales charges, or load that
is levied. Sales charges are typically either front-end fees, paid upon the purchase of
mutual fund units, or back-end fees, paid on redemption of mutual fund units. These
fees exist to compensate sales personnel. In some rare cases, sales charges are
charged on an annual basis for a fixed period. A sales fee that is paid upon purchase is
called a front-end load. A sales fee that is paid upon redemption is called a back-end
load or a deferred sales charge. M utual funds that do not charge sales fees are
known as no-load funds.
NOTE
The Canadian Securities Administrators have adopted rules that will lead to a ban on
back-end load or deferred sales charges on mutual funds. The rules are scheduled to
take effect in all provinces and territories on June 1, 2022.
In addition to the management fees and load charges, mutual fund investors may pay
an annual charge called a trailer fee. The trailer fee is the annual fee based on a fixed
percentage of assets. It is paid to mutual fund sales representatives to service existing
clients rather than concentrate solely on making new sales to earn income. Trailer fees
can range anywhere from 0.25% per year for money market funds to 1.00% per year for
equity funds and are included in the overall management fees.
M ost load funds have optional sales charges that allow the investor to choose
between front-end or back-end charges. The actual level of the sales charge levied by
load funds depends on the type of fund, its sponsor and method of distribution, the
amount of money being invested, and the method of purchase (i.e., lump sum
purchases versus accumulation plans spread out over a period of time). A client may be
able to negotiate the front-end load with the salesperson, especially if a large amount of
money is involved, as this load is set by the distributor. The back-end load is set by the
dealer and is not negotiable.
M any 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. However, some discount brokers may levy modest “administration fees” to
process the purchase and/or redemption of no-load funds. Like other funds, no-load
funds charge management or other administrative fees.
Trying to calculate the impact of the various types of fees on mutual funds can be very
complicated. The Ontario Securities Commission and Industry Canada’s Office of
Consumer Affairs have developed a new online calculator that allows investors to
determine the impact of mutual fund fees on investment returns over time. The M utual
Fund Fee Impact Calculator is located at www.getsmartaboutmoney.ca.
FEES PAID BY INDIVIDUAL MUTUAL FUND INVESTORS

Different kinds of fees can be charged to investors when they invest in mutual funds.
You must differentiate these fees, when they are applied and how to calculate each of
them. You should also know that mutual funds offered by direct distribution companies,
banks and trust companies, are generally sold to the public on a no fee basis (no-load
funds), with little or no direct selling charges. The fees paid by individual investors
generally include acquisition fees, redemption fees, transfer fees, and others.
ACQUISITION FEES
Acquisition fees (also called front-end loads or sales charges) are charged by many
mutual fund distributors. An acquisition fee is a sales charge based on the dollar value
invested in a mutual fund, and it is payable at the time units of the fund are acquired.
Investors should be aware that the front-end load effectively increases the purchase
price of the units, thereby reducing the actual amount invested.
EXAMPLE
A $1,000 investment in a mutual fund with a 4% front-end load means that $40
(4% × $1,000) goes to the distributor by way of compensation, while the remaining
$960 is actually invested.
Sales charges and deferred sales charges must be disclosed in the fund facts
document both as a percentage and in dollars of the amount invested. In the example
above, the fund facts would state that the front-end load charge would be 4% of the
amount purchased and $40 of the $1,000 invested. While this is not explicitly stated in
the fund facts document, the $40 sales charge represents 4.17% of the amount actually
invested in units since only $960 will be invested out of the $1,000 paid ([$40 ÷ $960]
×100 = 4.17%).
To determine a fund’s offering or purchase price per unit when it has a front-end load
charge, you must first determine the NAVPS and then make an adjustment for the load
charge. Using a NAVPS of $12 and a front-end load of 4%, the offering or purchase
price per unit is calculated as:
So:
The above calculation shows that if you buy a fund with a NAVPs of $12 and a 4%
front-end load, the fund units would actually cost you $12.50. Note that the sales charge
of 4% of the offering price is the equivalent of 4.17% of the net asset value (or net
amount invested):
Table 16.1 shows the difference between the two methods of sales charge calculations
for a $1,000 purchase.
Table 16.1 | Calculating Acquisition Fees
Front-End Net Amount Front-End Load Front-End Load

Load Invested in As A Percentage As A Percentage
Purchase (Acquisition the Mutual of the Purchase of Net Amount
Amount Fees) Fund Amount Invested
$1,000 $20 $980 2% 2.04%
$1,000 $30 $970 3% 3.09%
$1,000 $40 $960 4% 4.17%
$1,000 $50 $950 5% 5.26%
It is important to note that the sales charges indicated in the fund facts document are
maximum charges. In many cases, investors can negotiate lower sales charges
regardless of the amount they wish to invest. Competition for investment dollars is
fierce, which is why these charges are almost always negotiable.
REDEMPTION FEES
Some funds have acquisition fees and some have fees that must be paid when
investors sell units of the fund. A fee payable at the time of liquidation is called a
redemption fee, also sometimes referred to as a deferred sales charge or back-end
load.
M utual fund sales representatives and advisors still get their total fee upfront, paid for
by the fund sponsor. In return, fund sponsors hope to have dedicated long-term assets
from which to generate management fees. Fund sponsors use a decreasing deferred
sales charges schedule to recover their costs from investors who opt out of the fund
early.
In most cases, deferred sales charges on a back-end load fund decrease the longer the
investor holds the fund. For example, an investor might incur the following schedule of
deferred sales charges with this type of fund:
Table 16.2 | Back-End Load Schedule
Year Funds Are Redeemed Deferred Sales Charge
Within the first year 6%
In the second year 5%
In the third year 4%
In the fourth year 3%
In the fifth year 2%
In the sixth year 1%
After the sixth year 0%
EXAMPLE
An investor purchases units in a mutual fund at a NAVPS of $10. If the investor

decides to sell the units in the fourth year when the NAVPS is $15, the fund will
charge a 3% back-end load or commission.
If the back-end load is based on the original purchase amount, the investor would
receive $14.70 a unit, calculated as follows:
Selling/Redemption Price = NAVPS − Sales commission
= NAVPS − (NAVPS × sales percentage)
= $15 − ($10 × 3%)
= $15 − $0.30
= $14.70
If instead the back-end load is based on the NAVPS at the time of redemption, the
investor would receive $14.55, calculated as follows:
Selling/Redemption Price = $15 − ($15 × 3%)
= $15 − $0.45
= $14.55
M ost mutual funds with some type of sales charge now give your clients the choice of
paying either an acquisition fee or a redemption fee. These are often referred to as
“options” (for example, the initial sales charge option or the deferred sales charge
option). In some cases, the units of the fund are subdivided into different series. For
example, if an investor buys Series A units, an initial sales charge applies. If your client
buys Series B units, a deferred sales charge applies.
OTHER FEES
There are several other types of fees that mutual funds charge, these include:
• Transfer fees are sometimes levied when mutual fund investors wish to switch
investments out of one fund and into another, when those funds are managed by
the same fund manager. M ost no-load funds do not charge for this service, but
funds that charge sales charges may charge up to 2% of the value of assets
transferred. Again, these fees may be negotiable.
• Some mutual funds try to discourage investors from redeeming their units soon after
purchase by imposing a frequent trading charge. In some cases, no charges are
applied, but investors are permitted to undertake only a limited number of trades. If
the number of trades exceeds the maximum, the investor’s holdings in the fund may
be redeemed.
• If your clients hold mutual fund investments within RRSPs, RRIFs or RESPs they
may have to pay annual trustee fees and administration fees for these plans.
These fees typically range from $20 to $100 or more per year. M any firms waive
such fees if the plan value exceeds a certain amount, such as $25,000.
• Some mutual fund distributors charge a one-time fee the first time an investor
purchases mutual fund units. Funds that charge sales charges do not generally
charge set-up fees.
• M any fund distributors levy a charge when clients close their mutual fund accounts.
These account closing fees are sometimes waived if the account is closed
because of the investor’s death.
FEES AND EXPENSES PAID BY MUTUAL FUNDS

M utual funds make payments to the investment company that is responsible for
distributing a particular group of funds. These fees are for services related to the
administration of the funds (the operating expenses) and for investment advisory
services (the management fee). In the case of one company, for example, each mutual
fund must pay a percentage of its net asset value as management fee. The maximum
fees range from 0.3% for the Premium Canadian M oney M arket Fund up to 4% for an
International Equity Fund. These fees are stated on an annual basis, are calculated
daily and are paid monthly.
M anagement fees in general range from a low of about 0.5% per year to a high of about
3% per year. Differences in management fees are the result, at least in part, of
differences in the costs of providing services to investors. M anaging a money market
fund does not require as much security analysis as managing an equity fund, for
example. Foreign funds tend to be more costly to manage, and their management fees
are higher as a result.
There are operating expenses in addition to management fees that mutual funds must
pay to their investment companies. These operating expenses arise from the fund’s
day-to-day activities and may include:
• interest, operating and administrative costs
• securities filing fees
• taxes charged to the funds
• legal and audit fees
• trustee, custodial and safekeeping fees
• investor servicing costs
• costs of financial and other reports, fund facts and simplified prospectuses
Individual investors are not charged directly for the fees that the mutual fund must pay.
All fees and expenses are charged to the fund itself and, as a result, decrease the
fund’s net asset value. In this way, each fund investor automatically pays a
proportionate share of those charges.
M utual funds must report the management expense ratio (M ER)—the annual total of all
fees and expenses divided by average net assets—in the fund facts document and
simplified prospectus. Because the management expense ratio includes expenses in
addition to management fees, it will always be higher than management fees stated as
a percentage of net asset value.
FEES AND EXPENSES PAID BY FUND MANAGERS

Some fees and expenses are not paid by the mutual fund but are paid instead by the
investment company that manages the fund. As a result, these fees and expenses are
not borne directly by the funds’ investors. However, since the money paid out by the
investment company must come from the management fees provided by the mutual
funds, investors in those funds pay these fees indirectly.
M any investment companies pay mutual fund distributors an amount based on the net
asset value of the distributor’s clients’ holdings in their fund. Sometimes referred to as a
trailing commission or trailer fee, this fee is meant to compensate mutual fund sales
representatives and advisors for providing ongoing services to clients. This fee is also
referred to in some simplified prospectuses as a service fee.
Trailer fees generally follow a pattern as shown in Table 16.3 below.
Table 16.3 | Pattern of Trailer Fees
Fund Type Sold with a Front-End Load Sold with a Back-End Load
Equity 1.0% 0.5%
Balanced 1.0% 0.5%

Bond 0.5% 0.25%
M oney M arket 0.25% 0.25%
MUTUAL FUND COSTS: ANALYSIS AND IMPLICATIONS

Costs are a drag on returns and are impossible to avoid. Given two funds with similar
styles and mandates, you should generally select the lower cost fund. However, a
fund’s true cost is not easily apparent. Costs appear in two forms: explicit and implicit.
EXPLICIT COSTS
Explicit costs are those directly borne by the investor. They fall into three categories:
management fees, operating expenses and sales charges. M anagement fees, the
largest single expense, compensate the investment firm, known as the fund sponsor.
The fees help pay for the salaries of the investment professionals and contribute to the
firm’s profit margin. Operating expenses pay for the costs of running the fund and
include taxes, record keeping, auditing fees, rent and utilities. Operating expenses
typically range from 0.10% to 0.50% of fund assets.
The management fees and operating expenses are usually bundled into a single
amount known as the management expense ratio (M ER). The M ER is the total of
management fees and operating costs paid by a fund and is expressed as a percentage
of its average net assets. The magnitude of a given M ER depends on the four factors
shown in Table 16.4: the type of assets, the size of the fund, the fund manager, and the
trailer or service fees.
Table 16.4 | Four Factors Affecting the Management Expense Ratio
Type of A money manager who primarily invests in Canadian T-bills has a less
assets complex job than one who invests in foreign equities, which is reflected in
managed by the management fees. Fees for domestic equity mandates generally run
fund from 1.5% to 3% of fund assets, domestic bonds 1% to 2%, foreign
equity 2% to 4%, and less than 1% for index funds.
Size of fund Portfolios with fewer assets under administration, such as start-ups or
small cap funds, are relatively more expensive to run than well-
established large cap funds, because the smaller fund’s costs are
supported by a lower asset base.
Manager Some funds are managed by the fund sponsor’s management team, but
of fund some fund companies farm out management of the fund to a specialist
firm, or a sub-advisor, and handle only marketing and client service.
Generally, the M ER of a fund managed by a sub-advisor will be higher
than a similar fund run by an in-house management team.
Trailer or These fees are paid to fund distributors such as mutual fund sales
service representatives, discount brokers or financial advisors. The fees allow
fees them to service existing clients and not just concentrate on new sales to
earn income. A fund that does not have to pay mutual fund sales
representatives or other distributors will cost less than a fund that does.
After management fees and operating expenses, the third type of explicit cost is the
sales charges, paid to mutual fund sales representatives and financial advisors who
recommend the funds to their clients. The charges are applied to the investor
separately from the M ER.
Information on M ERs and sales charges can be found in the fund facts document.
IMPLICIT COSTS
The M ER includes all expenses charged to the fund; however not all expenses borne
by the investors appear in the M ER. Trading costs are implicit costs, measured by
brokerage fees and turnover, and are not expensed in the M ER. Instead these costs
are capitalized. To illustrate, a stock purchased for $1,000 plus $30 in commissions will
be kept on the fund’s books as costing $1,030. This represents a higher breakeven
hurdle for a manager to overcome.
Trading costs in the form of the Trading Expense Ratio (TER) must also be shown in
the fund facts document. The TER represents the amount of trading commissions
incurred to manage the portfolio as a percentage of the total assets of the fund. The
total fund expenses as presented in the fund facts document is the sum of the M ER
and the TER.
Here is an example of fund expenses, as presented in a fund facts document.
Annual Rate (As A % of The Fund’s Value)
Management expense ratio (MER)
The total of the Fund’s management fee and operating expenses. 2.42%
Trading expense ratio (TER)
The Fund’s trading costs 0.07%
Fund Expenses 2.49%
Generally, the more often a fund manager trades, the greater the negative impact on
fund performance through trading costs. Trading frequency is measured by calculating
the fund’s turnover rate, which is the proportion of a total fund’s assets traded in a
year. Turnover rate is a statistic usually available in the fund’s simplified prospectus and
some fund companies include this information in their fund facts document. A fund that
has a 100% turnover rate over the course of a year has sold and bought its entire
portfolio.
Turnover varies with the investment style. Value funds (those that primarily hold stocks
considered to be undervalued in price) typically have turnover rates of less than 50%,
while growth funds frequently top 100% or more. Funds that focus on specific countries,
regions or sectors will almost always have high turnover. Index funds may have almost
no turnover depending on the base index tracked.
Brokerage fees, implicitly borne by investors, may vary by the size of the fund sponsor.
Larger companies have an edge on their smaller counterparts, because the large
amounts of money managed by bigger firms allow them to negotiate lower trading
costs, thereby reducing impact when trading securities. Even if a fund is small, the fund
sponsor may have a substantial institutional business enabling it to negotiate lower
trading costs.
In general, managers with high turnover rates have a greater risk of underperforming. In
addition to the higher costs built into the book value of the portfolio, high turnover
creates capital gains tax liabilities and the possibility that winning stocks are sold too
early. High turnover managers can outperform their benchmarks, but they will have a
more difficult time than lower turnover managers.
Exhibit 16.1 | Cost Matters…Up to a Point
Costs should not be the dominating criteria in the fund selection process. There are
funds with high M ERs, for example, that are top-performing and trade very actively. It
is important that you and your clients understand the costs and the value of services
you receive for the costs involved. Here are several points worth considering.
• Do not compare funds strictly on the basis of M ER. In light of different trading
styles and costs, comparing funds solely on the basis of M ER may be misleading.
• Compare performance and volatility before comparing costs.
• A fund’s total costs are more important for some funds than for others. For
example, the relative return net of expenses of a fixed-income or money market
fund is far more negatively affected by high costs than an equity fund. The lower
volatility and lower return profile of fixed-income investments means a decreased
ability to overcome costs. Therefore, when selecting a fixed-income fund of any
class, favour those with the lowest cost base. The same can be said of index
funds where the variance between fund returns is often accounted for by
management fees.
• The shorter the time frame, the less costs matter. Conversely, the longer the time
frame, the more costs matter. The volatility and randomness of investment returns
over short time periods make it difficult to evaluate suitability based on cost. There
is very little correlation between fees and performance in the short term. But over
the long term (at least five years), the drag imposed by high costs is compounded,
making for a substantial penalty on final investment returns.
• Costs have no correlation to a manager’s ability to manage an investment fund. In
other words, a low M ER does not guarantee a better return and a high M ER does
not necessarily mean a lower return.
Be aware of funds that charge unbundled fees. At first glance these funds have
• unusually low M ERs. A fund that has unbundled fees charges only the operating
expense portion directly to the fund. M anagement fees are charged separately
from the operating expenses and are usually invoiced directly to the investor. This
is typically the case with a fund of funds structure. While this arrangement has
some benefits, such as transparency of costs, it can be misleading when
compared to regular mutual funds, which charge all management and operating
expenses directly to the fund.
• Keep in mind that funds operating less than a year will report an M ER reflecting
only the management fee. The level of operating expenses will be unknown until
the fund has been in existence at least a year.
• While costs are inversely correlated to a fund’s size, occasionally a fund sponsor
will absorb a portion of the fees on their smaller or newer funds until they reach a
level of assets where the total fund costs are at a level comparable to other
similar funds. As the fund grows, the sponsor will absorb fewer of the costs until
the cost structure is comparable to other funds in its class.
WHAT ARE ACCUMULATION PLANS?

M any mutual fund companies offer investors the facility of making automatic periodic
purchases of units of a particular mutual fund. This is called an accumulation plan,
referred to in many simplified prospectuses as a pre-authorized investment plan.
Accumulation plans usually involve the payment of a fee.
A voluntary accumulation plan allows your clients to specify the amount and timing of
the periodic investments they are willing to make. They may cancel the plan at any time
for any reason, although a small plan termination fee may apply. Clients may usually
decide to invest monthly, quarterly, semi-annually or annually. M inimum purchase
amounts tend to be smaller for accumulation plan purchases than for one-time
purchases.
DOLLAR COST AVERAGING

Accumulation plans offer two benefits to your clients: investment discipline and dollar
cost averaging. M any of your clients will find it difficult to plan their investments
throughout the year. By year end, they find they have not yet made the investments
they had hoped to make when the year had begun. By waiting until the end of the year
to invest, they might find that they lack funds. Even if funds are available, that they have
lost out on the compounding of their investment returns. Accumulation plans help to
prevent this.
The second benefit of accumulation plans is that they remove the need for your clients
to time the market. M arket timing is an attempt to predict the moment to invest in
stocks or bonds or to shift investments to different asset classes. It is a difficult thing to
do well. Some mutual fund sales representatives suggest that clients should avoid
market timing. Instead, they should set a desirable asset allocation consistent with their
risk profile and other key factors and then make regular monthly investments according
to that asset allocation.
By investing on a monthly basis, your clients will not miss out on market upswings. In a
falling market, it is true that clients will pay a higher average cost than if they were to
wait until the market hit bottom. But if they make regular purchases, some of their
investment dollars will be invested at or close to the market bottom.
The key idea is that by investing regular dollar amounts, the average cost of investment
over the long run tends to be lower. This is the principle behind dollar cost averaging.
Table 16.5 shows, in a simplified way, how dollar cost averaging can be of benefit. In
the table, two clients each invested $12,000 in the same mutual fund over the same 12-
month period. Client A bought $6,000 in June and $6,000 in December while Client B
bought $1,000 per month over the 12 months.
Table 16.5 | Dollar Cost Averaging
Client Number of units Number of units

Month NAVPU A purchased Client B purchased
January 10.00 $1,000 100.00

February 10.10 $1,000 99.01
M arch 10.20 $1,000 98.04
April 10.30 $1,000 97.09
M ay 10.40 $1,000 96.15
June 10.50 $6,000 571.43 $1,000 95.24
July 10.60 $1,000 94.34
August 10.70 $1,000 93.46
September 10.80 $1,000 92.59
October 10.90 $1,000 91.74
November 11.00 $1,000 90.91
December 11.10 $6,000 540.54 $1,000 90.09
Totals $12,000 1,111.97 $12,000 1,138.66
With the information presented in the table, you can calculate the average cost per unit
when dollar cost averaging is used and when it is not used. Without dollar cost
averaging, the total number of units purchased is 1,111.97 and the total investment is
$12,000. Therefore, the average per unit cost is $12,000 ÷ 1,111.97, or $10.79. With
dollar cost averaging, the same total dollar amount is invested ($12,000) but more units
are purchased (1138.66). Therefore, the average per unit cost is lower, $12,000 ÷
1138.66, or $10.54.
The situation is reversed in a falling market; dollar cost averaging will result in higher
average per unit cost. But the key thing to remember is that with dollar cost averaging,
your clients stand a much better chance of investing some of their money when the
market is at its lowest point, thereby getting more units for their money.
Case Study | Persistent Peter: Slow and Steady Wins the Race (for information
purposes only)
Peter is meeting with Shaina, a mutual fund representative at his bank. Peter is 26 and
has just started his first full-time job since graduating from university. Peter explains to
Shaina that, while his income is modest, he is confident that over time it will rise as his
career advances. However, he also recognizes that he has very few obligations at
this point in his life and no debt. So, he wants to take advantage of having greater
discretionary cash flow to save before life – marriage, a home mortgage, children, etc.
– makes saving more difficult.
While Peter is unsure of what the future holds, he knows that starting a retirement
savings plan now will pay off years down the road. He’s also heard from his parents
that he’ll need a lot of money to retire comfortably, and he is unsure how he’ll ever get
to save that much. Shaina explains that even a small amount saved on a consistent
and regular basis into the right investment can build up steadily; and, eventually, it will
amount to a substantial nest egg when it is needed to fund his retirement.
Shaina points out to Peter how saving just $100 bi-weekly will amount to $2,600 in a
year. If he intends to retire at 65, he’ll have almost 40-years to save. Over time, as his
income rises, he can adjust his bi-weekly amount to reach his targeted savings goal or
he can look forward to a larger retirement fund.
Shaina uses her retirement savings calculator to show how saving $100 bi-weekly
over 40-years into a portfolio that returns 6% will amount to over $430,000. But given
that Peter has such a long investment time horizon he has the capacity to invest in a
more growth-focused portfolio. Shaina adjusts the savings plan rate of return to 7%,
and advises Peter that his retirement savings would grow to over $570,000.
Shaina then explains to Peter that using no-load mutual funds makes it easy and
convenient to save through a regular investment plan, and its benefits will pay off for
many years to come.
WHAT ARE SYSTEMATIC WITHDRAWAL PLANS?

A mutual fund’s shareholders have a continual right to withdraw their investment in the
fund simply by making the request to the fund itself and receiving in return the dollar
amount of their net asset value. This characteristic is known as the right of
redemption and it is the hallmark of mutual funds.
To help your clients who need periodic income, and who wish to stay invested within
the fund, many funds offer one or more systematic withdrawal plans. In simple terms,
instead of withdrawing all the money in a mutual fund, the client instructs the fund to pay
out part of the capital invested plus distributions over a period of time. Withdrawals may
be arranged monthly, quarterly or at other predetermined intervals.
There are five types of systematic withdrawal plans, which differ in the way in which the
periodic receipt of money is calculated. The five types of systematic withdrawal plan are
known as fixed-dollar, ratio, fixed-period, life, and annuity.
FIXED-DOLLAR (OR CONSTANT) WITHDRAWAL PLAN

With a fixed-dollar (constant) withdrawal plan, clients request to receive a periodic
fixed amount of money through the redemption of units of their mutual fund. This is
currently the most common type of systematic withdrawal plan. Clients can often
request to receive the proceeds from redemptions on a weekly basis up to an annual
basis. Typically, clients must be willing to receive at least $100 per payment, but that
amount varies from fund to fund.
M ost fixed-dollar withdrawal plans require that clients have a minimum value of fund
investments before the plan is accepted. This minimum is usually $10,000 but can range
from $5,000 to $25,000. There is often a modest annual service fee levied, such as $10
or $25, to maintain a systematic withdrawal plan.
It is important to note that the client decides exactly how much money is to be paid out.
In some cases, when the payout is small, the income and capital gains earned by the
fund units are sufficient to meet the payment requirement without reducing the client’s
initial capital. However, if the payout is larger than the combination of income and capital
gains earned by the fund units, part of the payout will be made by reducing some of the
client’s initial capital.
Not all clients realize that a reduction in capital might be required to maintain a minimum
periodic payment. As a result, mutual funds offering systematic withdrawal plans are
required to have a statement similar to the following in their simplified prospectuses:
“If these payments are larger than the amount your investment in the fund is
earning, your account will eventually run out of money.”
Table 16.6 | Example of a Fixed-Dollar Withdrawal Plan
Your client requires $10,000.00 per year.
Beginning of Year Percentage End of Year Amount of

Year Value of Holdings Earned Value of Holdings Withdrawal
1 $ 100,000.00 10% $ 110,000.00 $ 10,000.00
2 $ 100,000.00 –5% $ 95,000.00 $ 10,000.00
3 $ 85,000.00 14% $ 96,900.00 $ 10,000.00
4 $ 86,900.00 –15% $ 73,865.00 $ 10,000.00

5 $ 63,865.00 20% $ 76,638.00 $ 10,000.00
Fixed-dollar withdrawal plans are most suitable for clients who look to their mutual fund
investments for most of their income. The periodic amount requested under the plan
would likely be based on the client’s expected expenses.
RATIO WITHDRAWAL PLAN

Rather than request a fixed amount of money to be received on a regular basis, a client
may request to receive a fixed percentage of the fund value. For example, a client might
request a 10% payout of fund value annually.
Under this method, the client would be faced with the same potential erosion of their
capital if income plus capital appreciation is not at least equal to the specified ratio. For
example, if the total of income plus capital appreciation is less than 10% when the
requested withdrawal ratio is 10%, then some of the initial capital will have to be used
to meet the payout requirement.
Under a ratio withdrawal plan, the ratio is always based on the current portfolio value.
Technically, this means that clients will never fully exhaust their mutual fund investment
under this type of plan. Only in the unrealistic situation of a 100% payout ratio would the
fund be completely paid out.
Table 16.7 | Example of a Ratio Withdrawal Plans
Your client wishes to withdraw 12% per year.
Beginning
of Year Percentage
Value Percentage End of Year of Amount of
Year of Holdings Earned Value of Holdings Withdrawal* Withdrawal
1 $ 100,000.00 10% $ 110,000.00 12 % $ 13,200.00
2 $ 96,800.00 –5% $ 91,960.00 12 % $ 11,035.20
3 $ 80,924.80 14% $ 92,254.27 12 % $ 11,070.51
4 $ 81,183.76 –15% $ 69,006.20 12 % $ 8,280.74
5 $ 60,725.46 20% $ 72,870.55 12 % $ 8,744.47
*W ithdrawals are assumed to be based on end-of-y ear v alue of holdings.
Ratio withdrawal plans are most suitable for clients looking to supplement income from
other sources. The reason other sources should be available is that with fluctuating
market values, a ratio withdrawal plan will not result in a constant dollar amount paid out.
FIXED-PERIOD WITHDRAWAL PLAN

Under a fixed-period withdrawal plan, your client will receive money over a period of
time until the mutual fund investment is completely paid out. In this type of plan, the
client chooses a period over which payments will be received. In each year, the client
receives an amount equal to whatever value there is in the fund investment divided by
the number of years remaining until the end of the period.
For example, if the selected period is five years and the initial fund value is $100,000,
then the investor will receive (100,000 ÷ 5 =) $20,000 the first year. In the second year
the client will receive whatever the remaining value of the fund is divided by four. This
continues until the client receives all remaining value in the last year.
Table 16.8 | Example of a Fixed-Period Withdrawal Plan
The plan is to be liquidated over five years.
Beginning
of Year
Value Percentage End of Year Rate of Amount of
Year of Holdings Earned Value of Holdings Withdrawal Withdrawal
1 $ 100,000.00 10% $ 110,000.00 1/5 $ 22,000.00
2 $ 88,000.00 –5% $ 83,600.00 1/4 $ 20,900.00
3 $ 62,700.00 14% $ 71,478.00 1/3 $ 23,826.00
4 $ 47,652.00 –15% $ 40,504.20 1/2 $ 20,252.10
5 $ 20,252.10 20% $ 24,302.52 1/1 $ 24,302.52
This type of plan would be most suitable for a client who has been saving for something
that requires funding over a known or limited period, such as a child’s post-secondary
education. The funds will be required over a fixed period of usually four years, so the
withdrawal pattern is selected to match that period. The periodic payments will fluctuate
under this plan depending on the volatility of the mutual fund from which payments are
made.
LIFE WITHDRAWAL PLAN

The life withdrawal plan is similar to the fixed-period plan, except the period selected
is the expected remaining lifetime of the client. This remaining lifetime can be estimated
from life insurance mortality tables.
Table 16.9 | Example of a Life Withdrawal Plan
This plan reduces the holdings to zero over the client’s expected lifetime. If we
assume that the client will live for a further 20-year period, we will have:
Year Beginning of Percentage End of Year Rate of Amount of
Year Value Earned Value Withdrawal Withdrawal
of Holdings of Holdings
1 $ 100,000.00 10% $ 110,000.00 1/20 $ 5,500.00
2 $ 104,500.00 –5% $ 99,275.00 1/19 $ 5,225.00
3 $ 94,050.00 14% $ 107,217.00 1/18 $ 5,956.50
4 $ 101,260.50 –15% $ 86,071.43 1/17 $ 5,063.03
5 $ 81,008.40 20% $ 97,210.08 1/16 $ 6,075.63
etc. etc. etc. etc. etc. etc.
ANNUITIES
The last type of withdrawal plan is an annuity. An annuity is generally a contract
between an individual and a life insurance company in which the individual, called the
annuitant, gives a certain amount of money to the insurance company. In exchange,
the insurance company agrees to make regular payments to the individual. These
payments might be over a guaranteed term whether or not the individual lives to the
end of the term. If the individual dies before the end of the guaranteed term, payments
would continue to be made to the surviving spouse or other named beneficiary.
Alternatively, annuity payments may end with the death of the annuitant (i.e., annuity
payments extend over the life of the annuitant no matter how long the annuitant lives).
Annuities are offered by some mutual fund companies in conjunction with life insurance
firms.
While most annuity payments are fixed, one type of annuity is similar to a ratio
withdrawal plan in which payments will likely vary from payout to payout. This type of
annuity is known as a variable annuity. With a variable annuity, payments to the
annuitant will fluctuate in keeping with the changes in the value of the mutual fund from
which payments are made.
HOW ARE MUTUAL FUNDS TAXED?

After acquiring shares in a mutual fund, the investor may wish to dispose of his or her
shares or units and use the proceeds. The mechanics of disposing of fund units are
fairly straightforward.
• The client contacts his/her advisor (or discount brokerage) and makes a request to
sell or redeem fund units.
• The broker then places the trade request with the fund, or the fund’s distributor.
• At the end of the valuation day, the fund calculates the net asset value and the
proceeds are sent to the investor.
As we have seen, most funds offer the investor a variety of methods of receiving funds
if the investor does not want to redeem a specific number of shares or units. These
withdrawals have tax consequences on fund holders.
TAX CONSEQUENCES
M utual funds redeem their shares on request at a price that is equal to the fund’s
NAVPS. If there are no back-end load charges, the investor would receive the NAVPS.
If there were back-end load charges or deferred sales charges, the investor would
receive NAVPS less the sales charges. M utual funds can generate taxable income in a
couple of ways:
• Through the distribution of interest income, dividends and capital gains realized by
the fund
• Through any capital gains realized when the fund is eventually sold
ANNUAL DISTRIBUTIONS
When mutual funds are held outside a registered plan (such as an RRSP or RRIF), the
unitholder of an unincorporated fund is sent a T3 form and a shareholder is sent a
T5 form by the respective funds. This form reports the types of income distributed that
year – foreign income and Canadian interest, dividends and capital gains, including
dividends that have been reinvested. Each is taxed at the fund holder’s personal rate in
the year received.
EXAMPLE
An investor purchases an equity mutual fund for $11 per share and in each of the
next five years receives $1 in annual distributions, composed of $0.50 in dividends
and $0.50 in distributed capital gains. Each year the investor would receive a T5 from
the fund indicating that the investor would have to report to the Canada Revenue
Agency an additional $1 in income. The T5 may indicate offsetting dividend tax
credits (from dividends earned from taxable Canadian corporations).
It is sometimes difficult for mutual fund clients to understand why they have to declare
capital gains, when they have not sold any of their funds. There is, however, a simple
explanation. The fund manager buys and sells stocks throughout the year for the mutual
fund. If the fund manager sells a stock for more than it was bought, a capital gain
results. It is this capital gain that is passed on to the mutual fund holder. Unfortunately,
capital losses that arise when selling a stock for less than it was bought cannot be
passed on to the mutual fund holder. The losses are held in the fund and may, however,
be used to offset capital gains in subsequent years.
DISTRIBUTIONS TRIGGERING UNEXPECTED TAXES

During the year a mutual fund will generate capital gains and losses when it sells
securities held in the fund. Capital gains are distributed to the fund investors just as
interest and dividends are distributed. If the distribution of capital gains is carried out
only at year end, it can pose a problem for investors who purchase a fund close to the
year end.
Consider an investor who purchased an equity mutual fund through a non-registered
account on December 1 at a NAVPS of $30. This fund had a very good year and
earned capital gains of $6 per share. These capital gains are distributed to the investors
at the end of December either as reinvested shares or as cash.
As is the case with all distributions, this caused the NAVPS to fall by the amount of the
distribution, to $24 (see Exhibit 16.2 below). At first glance, one might think that the
investor is just as well off, as the new NAVPS plus the $6 distribution equals the original
NAVPS of $30.
Unfortunately, the $6 distribution is taxable in the hands of the new investor, even
though the $6 was earned over the course of the full year. For this reason, some
financial advisors caution investors against buying a mutual fund just prior to the year-
end without first checking with the fund sponsor to determine if a capital gains
distribution is pending. Exhibit 16.2 provides an example.
Exhibit 16.2 | Distributions and Taxes
An investor with a marginal tax rate of 40% purchases a mutual fund with a NAVPS of
$30. The portfolio is valued at $30. The fund distributes $6 as a capital gains dividend or
distribution. The value of the investor’s portfolio after the distribution and the tax
consequences would be:
Value of portfolio before distribution: $ 30.00
Value of portfolio after distribution:
NAVPS $ 24.00
Cash or Reinvested Dividends $ 6.00
$ 30.00
Tax Consequences:
Assuming that the $6 was a net capital gain: 50% ×
$6.00 ×
40%
= $1.20
Taxes
Payable
Note: Even though the fund may call this distribution a “dividend” it is simply a
distribution of capital gains. No dividend tax credit would apply.
Transactions that occur WITHIN the fund (such as the fund buying and selling
individual securities such as stocks and bonds) could result in income distributions
such as a capital gain to fund investors in the year the distribution occurs.
If you are a mutual fund investor and you sell your shares this transaction is yours
and does not occur WITHIN the fund. You simply sell your shares and receive the
cash. This transaction could result in a capital gain (but resulted from your own action
– not the actions of the fund itself).
CAPITAL GAINS
When a fund holder redeems the shares or units of the fund itself, the transaction is
considered a disposition for tax purposes, possibly giving rise to either a capital gain or
a capital loss. Only 50% of net capital gains (total capital gains less total capital losses)
is added to the investor’s income and taxed at their marginal rate.
Suppose a mutual fund shareholder bought shares in a fund at a NAVPS of $11 and
later sells the fund shares at a NAVPS of $16, generating a capital gain of $5 per share
on the sale. The investor would have to report an additional $2.50 per share in income
for the year (50% × $5 capital gain). This capital gain is not shown on the fund’s T5, as
this was not a fund transaction.
ADJUSTING THE COST BASE

A potential problem may arise when an investor chooses to reinvest fund income
automatically in additional non-registered fund units. The complication arises when the
fund is sold and capital gains must be calculated on the difference between the original
purchase price and the sale price. The total sale price of the fund will include the original
units purchased plus those units purchased over time through periodic reinvestment of
fund income.
This mix of original and subsequent units can make it difficult to calculate the adjusted
cost base of the investment in the fund. If careful records have not been kept, the
investor could be taxed twice on the same income. M any investment funds provide this
information on quarterly or annual statements. If these statements are not kept, it may
be very time consuming to attempt to reconstruct the adjusted cost base of the
investment.
Consider the case where an investor buys $10,000 of fund units. Over time, annual
income is distributed and tax is paid on it, but the investor chooses to reinvest the
income in additional fund units. After a number of years, the total value of the portfolio
rises to $18,000 and the investor decides to sell the fund.
A careless investor might assume that a capital gain of $8,000 has been incurred.
This would be incorrect, as the $8,000 increase is actually made up of two factors:
the reinvestment of income (upon which the investor has already paid taxes) and a
capital gain.
The portion of the increase due to reinvestment must be added to the original
investment of $10,000 to come up with the correct adjusted cost base for calculating
the capital gain. If, for example, the investor had received a total of $3,500 in
reinvested dividends over the course of the holding period, the adjusted cost base
would be $13,500 (the original $10,000 plus the $3,500 in dividends that have already
been taxed). The capital gain is then $4,500, not $8,000.
REINVESTING DISTRIBUTIONS
M any funds will, unless otherwise advised, automatically reinvest distributions into new
shares of the fund at the prevailing net asset value without a sales charge on the
shares purchased. M ost funds also have provisions for shareholders to switch from
cash dividends to dividend reinvestment, and vice versa.
Distributions have an impact on the NAVPS of a fund. When dividends and capital gains
are distributed, the NAVPS falls by the amount of the distribution. When the distribution
is reinvested, the net result is that the investor owns more units, but the units are each
worth less.
For example, the NAVPS of a fund is $9.00 the day before a dividend distribution. The
fund decides to pay a dividend of $0.90 per unit. After the distribution is made, the
NAVPS of the fund will fall by $0.90 to $8.10. As Table 16.10 shows, if this fund had
1,000,000 units outstanding, the NAVPS before the distribution would be $9,000,000 ÷
1,000,000 = $9.00. The NAVPS after the distribution would be $8,100,000 ÷ 1,000,000 =
$8.10.
Table 16.10 | Impact of a Distribution on Total Net Assets
When Distributions
Before Distribution After Distribution Are Reinvested
Assets
Portfolio $8,075,000 $8,075,000 $8,075,000
Cash 950,000 50,000* 950,000
Liabilities
Expenses (25,000) (25,000) (25,000)
Total Net Assets $9,000,000 $8,100,000 $9,000,000

* Distributions pay able: $950,000 cash – ($0.90 div idend × 1,000,000 units outstanding).
Because the investors receive their distribution in new units, the fund now has
1,111,111.11 units worth $8.10 each ($900,000 ÷ $8.10 = 111,111.11 plus the original
1,000,000 units). Total fund assets are still $9,000,000. The $900,000 never actually
leaves the company, but is reinvested in the fund.
What impact does this have on the individual investor? As stated above, the investor
ends up with more units worth less each. The net effect is that the investor’s portfolio is
worth the same amount. Table 16.11 illustrates this. Assume that the investor owned
1,000 units of the fund. The investor would receive a distribution worth $900.00
(1,000 units × $0.90). The distribution is invested into new units. These new units now
have a NAVPS of $8.10. The investor would receive $900 ÷ $8.10 = 111.11 units. The
investor now has a total of 1,111.11 units (1,000 + 111.11).
Table 16.11 | Impact of Distribution on Value of Investment
Before Distribution After Distribution
1,000 units × $9.00 $9,000
1,111.11 × $8.10 $9,000
TAX CONSEQUENCES
Can you calculate the tax consequences of three different clients who have
invested in mutual funds? Complete the online learning activity to assess your
knowledge.
SUMMARY
1. Distinguish among the various fees and charges that apply to mutual fund investors
and to mutual funds themselves.
◦ Sales charges are the fees charged to individual investors when they buy and
sell mutual funds shares (these fees are generally called loads).
◦ A sales fee that is paid upon purchase is called a front-end load; a sales fee that
is paid upon redemption is called a back-end load or a deferred sales charge;
mutual funds that do not charge sales fees are known as no-load funds.
◦ M anagement fees are the fees payable by the fund to the fund’s service
providers and are charged out as expenses against the entire fund’s earnings
and are disclosed in the fund facts document and simplified prospectus.
◦ M anagement fees are deducted from the fund’s return to pay for professional
management and administrative services provided to the fund.
◦ Trailer fees are meant to compensate mutual fund sales representatives for
providing ongoing services to clients.
◦ Explicit costs are those directly borne by the investor. They fall into three
categories: management fees, operating expenses and sales charges.
◦ Trading costs are implicit costs, measured by brokerage fees and turnover, and
are not expensed in the management expense ratio.
2. Compare and contrast the different types of accumulation plans that mutual funds
offer and describe the concept of dollar cost averaging.
◦ Accumulation plans offer investors the facility of making automatic periodic
purchases of units of a particular mutual fund.
◦ A voluntary accumulation plan allows your clients to specify the amount and
timing of the periodic investments they are willing to make. They may cancel the
plan at any time for any reason, although a small plan termination fee may apply.
◦ The key idea behind dollar cost averaging is that by investing regular dollar
amounts, the average cost of investment over the long run tends to be lower.
3. Compare and contrast the different types of systematic withdrawal plans available
to mutual fund investors and assess which withdrawal plan best suits a client’s
circumstances.
◦ Instead of withdrawing all the money in a mutual fund, the fund can pay out part
of the capital invested plus distributions over a period of time. Withdrawals may
be arranged monthly, quarterly or at other predetermined intervals.
◦ With a fixed-dollar (constant) withdrawal plan, clients request to receive a
periodic fixed amount of money through the redemption of units of their mutual
fund.
◦ Under a ratio withdrawal plan, the ratio is always based on the current portfolio
value. Technically, this means that clients will never fully exhaust their mutual
fund investment under this type of plan.
◦ Under a fixed-period withdrawal plan, your client will receive money over a period
of time until the mutual fund investment is completely paid out. In this type of
plan, the client chooses a period over which payments will be received.
◦ The life withdrawal plan is similar to the fixed-period plan, except the period
selected is the expected remaining lifetime of the client.
◦ An annuity is generally a contract between an individual and a life insurance
company in which the individual, called the annuitant, gives a certain amount of
money to the insurance company. In exchange, the insurance company agrees
to make regular payments to the individual.
4. Describe the tax effects of mutual fund redemptions and income distributions.
◦ M utual funds are redeemed at a price equal to a fund’s net asset value per share
(NAVPS). M utual funds redeemed while held in registered funds do not have any
immediate tax consequences.
◦ Investors holding mutual funds in non-registered accounts are subject to tax on
capital gains realized when the fund is sold and on annual distributions of income
and capital gains earned within the fund.
◦ When dividends and capital gains are distributed, the NAVPS falls by the amount
of the distribution, and the investor receives more units from the distribution itself.
REVIEW QUESTIONS
Now that you have completed this chapter, you should be ready to answer
the Chapter 16 Review Questions.
If you have any questions about this chapter, you may find answers in the
online Chapter 16 FAQs.
SECTION 6
ETHICS, COMPLIANCE AND

MUTUAL FUND REGULATIONS
18 Applying Ethical Standards to What You Have

Learned
SECTION 6 | ETHICS, COMPLIANCE AND
MUTUAL
FUND REGULATIONS
Section 6 is all about the rules and ethical principles you must
adhere to as a mutual fund sales representative.
Chapter 17 discusses mutual fund regulations, the mandate and
scope of securities administrators in Canada and Self-Regulatory
Organizations, compliance supervision, registration requirements,
sales activities, dealing with complaints, and prohibited practices.
This chapter also covers important topics such as federal privacy
guidelines as well as anti-money laundering and anti-terrorist
financing legislation.
In Chapter 18, we outline the ethical responsibilities and practices
expected of all mutual fund sales representatives. As we
mentioned in Chapter 1, one of the primary goals of this course is
the awareness that delivering excellent client service requires more
than just an understanding of the types and features of mutual
funds. Your ethical and regulatory responsibility is key to
developing long lasting client relationships.
Mutual Fund Dealer
17
Regulation
CONTENT AREAS
What are the Mandate and Scope of Securities

Administrators?
What are Self-Regulatory Organizations?
What are the Registration Requirements?
How do Representatives and Dealers Meet the Know Your

Client Rules?
What are the Steps in Opening a Mutual Fund Account?
What are the Prohibited Selling Practices?
What are the Rules for Communications with Clients?
What are Your Other Legal Responsibilities?
LEARNING OBJECTIVES
1 | Describe the role, mandate, and scope of the securities

administrators in Canada.
2 | Describe the role and objectives of the M utual Fund

Dealers Association (M FDA) and the Autorité des
marchés financiers (AM F).
3 | List and explain the registration requirements for

becoming registered as a mutual fund dealing
representative.
4 | Describe the “know your client rules” within the context

of suitability, the circumstances in which suitability of a
client account must be re-assessed, know your product
and opening accounts for clients.
5 | List and explain account opening procedures, including

the relationship disclosure, the steps in completing the
new account application form (NAAF), differentiate
among the types of accounts and the circumstances in
which Know Your Client Information requires an update.
6 | List and distinguish among the prohibited mutual fund

sales practices.
7 | Describe the rules applicable to sales and performance

communications with clients, including the procedures for
handling complaints.
8 | Summarize the importance of the federal privacy

guidelines and the anti-money laundering and anti-
terrorist financing legislation as part of the requirements
of a mutual fund sales representative.
KEY TERMS

administrative bodies
branch compliance officer (BCO)
client name account
disclosure
discretionary trading
dual employment
electronic commerce (e-commerce)
electronic document
electronic signature
enforcement
Financial Action Task Force (FATF)
frequent trader
money laundering
National Registration Database
New Account Application Form (NAAF)
nominee account
nominee owner
“on book” for brokers
Personal Information Protection and Electronic

Documents Act (PIPEDA)
policy statements
privacy commissioner
prohibited selling practices
referral arrangement
registration
regulatory bodies
securities administrator
securities commission
termination
terrorist financing
unsolicited orders
INTRODUCTION
M utual funds and their distribution are regulated by provincial and
territorial securities legislation and regulations. The federal
government does not regulate mutual funds. Provincial and
territorial legislation and regulations are aimed at protecting
investors and maintaining high ethical standards in the issuance
and distribution of securities both in the primary and secondary
markets. This chapter explains many of the legislative and
regulatory requirements applicable to mutual funds and their
implications.
The M utual Fund Dealers Association (M FDA) is a self-regulatory
organization that is empowered by the provincial and territorial
securities administrators to enforce and set rules with regard to its
members in Canada. All mutual fund dealers operating outside of
Quebec are required to be members of the M FDA, unless they
apply for and receive an exemption. The Autorité des marchés
financiers (AM F) is the primary mutual fund regulator in Quebec.
All mutual fund dealers and their employees must follow the rules
and guidelines set out in provincial and territorial legislation, rules,
national instruments and if the dealer is a member of an SRO, the
SRO’s rules and policies. Failure to comply can result in a
suspension or revocation of your registered dealing representative
status, which could in turn impair your mutual fund dealer’s right to
trade in securities.
Therefore, it is imperative that you:
• know the laws and regulations that apply to you as a dealing
representative
• know your products
• know your clients and their investment needs
• determine the suitability of the investments held in your clients’
accounts
• ensure that your clients receive the most current copy of the
fund facts document for any fund they intend to purchase along
with any and all other documentation
• refer to your supervisor in cases where you have any doubt
WHAT ARE THE MANDATE AND SCOPE OF
SECURITIES ADMINISTRATORS?
Each of the 13 provinces and territories in Canada is responsible
for the administration of their own securities legislation. To achieve
this, they have created their own securities administrators (also
called regulatory bodies, securities commissions or
administrative bodies). Some provinces have distinct securities
commissions (like the Ontario Securities Commission (OSC)) while
others have granted this regulatory responsibility to another
provincial agency. In Quebec, for example, the securities
administrator is the Autorité des marchés financiers. Collectively,
the securities administrators of each province make up the
Canadian Securities Administrators (CSA).
The securities administrators have broad powers and their
operations break down into three main categories: registration,
disclosure, and enforcement, summarized in Figure 17.1.
Figure 17.1 | Powers of the Securities Administrators
Registration Unless exempt, everyone who sells securities

(mutual funds, stocks, bonds, etc.) or advises
investors about securities, must be registered with
the appropriate securities administrator or
commission. Registration ensures that the
registrants (including mutual fund sales
representatives, advisors) have completed required
courses or have specific designations and identifies
the registrants to the securities administrators so
they can be monitored for ethical behaviour in
selling securities or advising about securities. The
registration process in summary will ensure that a
particular individual’s fitness for registration has
been thoroughly evaluated. This includes (as noted
above) reviewing the applicant’s integrity, financial
solvency, and general competence
(i.e. proficiencies). In addition, a securities
administrator may also evaluate whether there are
other factors that may justify denying an individual’s
application for registration. A securities administrator
can suspend or cancel registration if it deems such
action is in the public interest. It also has authority
over the establishment and operations of any stock
exchange in its jurisdiction.
Disclosure The securities administrators ensure that all

documents and other required information are
prepared in accordance with requirements and
provided to appropriate parties in a timely manner.
These documents include insider trading reports,
annual and interim financial reports, and reports of
material changes in the affairs of entities that have
issued securities to the public. The securities
administrators also review all prospectuses to
ensure that the facts contained therein represent
full, true, and plain disclosure. Complete, accurate
and timely disclosure allows your clients to make
fully informed investment decisions.
Enforcement Violations can be carefully investigated and

offenders may be prosecuted. Securities
administrators have the authority to subpoena
witnesses, seize documents for examination and
operate as administrative tribunals. The securities
administrators may also prosecute a violator in the
courts, which may result in imprisonment and/or
substantial fines.
The securities administrators periodically issue policy statements.

These statements set out the position of the securities
administrators on various issues and topics and can take one of
three forms:
National National Instruments and National Policies have

Instruments been adopted by all provinces and territories.
and Although there is no federal regulator in Canada,
National National Policies and National Instruments act to
Policies ensure consistency across the country. (Note that
the primary difference between a National
Instrument and a National Policy is that a National
Instrument has the force of law, whereas a
National Policy does not. A National Policy may be
considered more akin to a guideline as it informs
market participants and registrants of the manner in
which a securities administrator may exercise its
statutory discretionary authority or interpret a
securities law.)
Provincial Provincial policies are particular to the individual

Policies province that issued the policy.
The mutual fund industry is a heavily regulated segment of the

securities industry and is subject to comprehensive requirements,
prohibitions and restrictions found in the various provincial and
territorial securities acts, regulations and rules, National
Instruments and the policy statements issued by the securities
administrators. In addition, the M FDA has the ability to set and
enforce its own rules and policies. In this regard, the M FDA has
passed its own rules, by-laws and guidelines regarding business
conduct and other matters pertaining to the acceptable and
expected behaviour of its registrants. Select rules will be discussed
in more detail later in this chapter.
REGULATORY CHANGE YOU SHOULD KNOW

On October 3, 2019, the CSA released its final amendments to
National Instrument 31-103 Registration Requirements, Exemptions
and Ongoing Registrant Obligations. This initiative, known as the
Client Focused Reforms (the CFRs), made changes to the
representative conduct requirements with the following intent:
• To better align the interests of securities advisers, dealers, and
representatives (registrants) with the interests of their clients
• To improve outcomes for clients
• To clarify for clients the nature and terms of their relationship
with registrants
The M FDA is aligning its rules with the CFR amendments.
We discuss these topics in more detail below.
WHAT ARE SELF-REGULATORY

ORGANIZATIONS?
The securities administrators granted the M utual Fund Dealers
Association (the “M FDA”) the authority to regulate mutual fund
dealers. The M FDA is the self-regulatory organization (SRO) for
mutual fund dealers across Canada, other than in Quebec, and is
responsible for regulating all sales of mutual funds by its members
(mutual fund dealers and their dealing representatives).
OBJECTIVES OF THE MFDA

The main objective of the M FDA is to protect Canadian mutual fund
investors and ensure that they have the same level of protection
regardless of which mutual fund dealer or dealing representative
they deal with. The M FDA has the power to enforce standards and
conduct investigations and is responsible for the enforcement of its
rules and policies applicable to its members, their employees, and
agents. Specifically, the M FDA has the power to:
• assess and handle complaints
• investigate possible violation of its rules and policies
• conduct disciplinary actions
• impose fines and suspend rights and privileges of membership
in the M FDA
MFDA INVESTOR PROTECTION CORPORATION (MFDA

IPC)
The M FDA Investor Protection Corporation (M FDA IPC) provides
protection from losses for eligible customers arising from the
insolvency of a M FDA dealer member. Each claim is considered
according to the policies adopted by the Board of Directors of the
M FDA IPC. The M FDA IPC does not cover customers’ losses
that result from changing market values, unsuitable investments, or
the default of a mutual fund or its manager.
The coverage provided is limited to $1,000,000 per customer
account for losses related to securities, cash balances, segregated
funds, and certain other property held in an account of a M FDA
dealer. M FDA IPC coverage is not currently available to customers
with accounts held in the province of Quebec.
Similar investor protection is also available for investors on the
IIROC platform. This is referred to as the Canadian Investor
Protection Fund. For more information as to the limits of this
protection please consult with your compliance department
AUTORITÉ DES MARCHÉS FINANCIERS

Quebec is unique in terms of the regulatory structure of its financial
industry in that it has consolidated the regulatory framework
governing the sector to simplify administration, both for consumers
and market participants, through the establishment of a single
regulatory organization, the Autorité des marchés financiers (AM F).
The AM F ensures compliance with the regulatory requirements
relating to the ability to distribute products and services. The AM F
also issues an individual’s or entity’s right to practice.
Under the authority of the AM F, the Chambre de la sécurité
financière (CSF) manages all the educational licensing and
continuing education requirements in Quebec. The programs
required for mutual fund licensing, as regulated by the securities
administrators and M FDA, are also applicable in Quebec.
COMPLIANCE SUPERVISION
National Instrument 31-103 and applicable M FDA Rules provides
that each mutual fund dealer must maintain a compliance system
that provides assurance that the dealer and the individuals acting
on its behalf comply with securities legislation and manage
business risk in accordance with prudent business practices. The
compliance system to be satisfactory requires that there be day to
day supervision to provide a means of identifying cases of non-
compliance, taking remedial action, and minimizing compliance risk
in key areas of the mutual fund dealer’s operations. Each branch or
office of an M FDA dealer is required to have a person responsible
for compliance and registered as a branch manager – often called a
branch compliance officer (BCO) or compliance officer.
Regardless of title, they have responsibility to ensure that dealing
representatives deal fairly, honestly and in good faith with their
clients, comply with both securities legislation and the dealer’s
policies and procedures and maintain an appropriate level of
proficiency. The required level of proficiency can be established by
completion of the Branch Compliance Officer’s Course, and is
maintained through monitoring compliance related developments.
M utual fund dealers are required to maintain records of all
compliance and supervisory activities undertaken by it and its
partners, directors, officers, compliance officers and branch
compliance officers as required by the M FDA’s Rules and Policies.
In other words, as important as it is that the compliance function as
contemplated by the M FDA rules is carried out, such a function
must also be thoroughly documented by the mutual fund dealer and
its employees or agents.
Both National Instrument 31-103 and M FDA Rules require every
mutual fund dealing representative has a duty to deal fairly,
honestly and in good faith with their clients. Each mutual fund
dealer should have materials available to its dealing
representatives that outline the services and products the
representatives can make available to their clients; dealing
representatives should comply with their dealer’s policies as well
as the following general guidelines for dealing with clients.
M FDA Rule No. 2 “Business Conduct,” sets out the standards
applicable to all M FDA members and their respective dealing
representatives. The M FDA conduct rules are summarized in the
points below. A mutual fund dealing representative must:
• deal fairly, honestly and in good faith with his/her clients
• observe high standards of ethics and conduct in the transaction
of business
• not engage in any business conduct or practice that is
unbecoming or detrimental to the public interest
• be of such character and business repute and have such
experience and training as is consistent with the standards
acceptable to the industry
WHAT ARE THE REGISTRATION

REQUIREMENTS?
Employees and agents who participate in the sale of mutual funds
for a mutual fund dealer to the public must be registered with the
appropriate provincial or territorial securities administrator as a
mutual fund dealing representative in each province or territory in
which their clients reside. An individual needs to be registered if he
holds himself out as being in the business of selling mutual funds or
actually undertakes such activity. It is generally accepted that until
registered as a dealing representative (or officer or director of a
mutual fund dealer), an individual may not carry out the following
actions which are broadly defined to include that which is
mentioned below (as well as any “act in furtherance of trade” which
will also include marketing and advertising activities):
• provide any advice or recommendations on mutual funds
• hand out a fund facts document, a mutual fund prospectus, AIF
or annual or semi-annual financial report
• hand out an order form for mutual funds
• assist a client with the completion of an order form for mutual
funds
• provide information about a specific mutual fund
An individual may, prior to registration being received:
• receive a redemption request for the purpose of processing the
redemption
• receive a completed order form for the purpose of forwarding it
to a registered salesperson
• provide basic information to current unitholders regarding their
current holdings (e.g., net asset value for the fund, number of
units held in the account, income, and capital gains
distributions)
• refer clients to a registered mutual fund dealing representative
EDUCATIONAL QUALIFICATIONS
Before becoming eligible for registration as a mutual fund dealing
representative, an applicant must pass an examination recognized
by the applicable provincial or territorial securities administrator.
Available courses which can be of assistance in passing a
recognized examination include the Investment Funds in Canada
(IFC) course and the Canadian Securities Course (CSC), offered
by CSI Global Education Inc., among others.
SUPERVISION AND TRAINING FOR NEW DEALING

REPRESENTATIVES
All mutual fund dealing representatives are required to complete a
training program within 90 days from the day that they first start
acting as a dealing representative and must be closely supervised
for six months unless the dealing representative has completed a
training program and supervision period in accordance with the
M FDA Rule with another member or was registered to trade in
mutual funds prior to the date the applicable M FDA Rule came into
effect.
THE REGISTRATION PROCESS

Registration varies from province to province or territory, but the
general process is as follows:
1. The candidate for registration successfully passes the
proficiency examination for the course.
2. The sponsor of the proficiency course notifies the candidate of
the examination results.
3. The candidate (through his or her dealer) files a registration
application and the appropriate fee with the provincial or
territorial securities administrator. Additional documentation
may also be required, depending on the jurisdiction. One is
registered only once notice has been received from the
applicable securities administrators.
4. To remain a registered dealing representative, the
representative or his/her dealer must pay a fee annually within
specified time frames. However, it is not necessary to rewrite
the proficiency course examination. It is important to note that
if an individual is not registered within three years of successful
completion of the proficiency examination, or within three years
of termination or suspension of the individual’s registration,
there is a general requirement that proficiency requirements
must be met again, unless an exemption is available or
obtained. There currently are formal continuing education
requirements.
5. The registered dealing representative and the registrant’s
dealer must notify the appropriate securities administrator
promptly in writing within five business days (10 days in
Quebec) of any changes in specified information provided on
the dealing representative’s registration application, including:
◦ branch transfer or change in address
◦ change of name (state reason)
◦ disciplinary action of a professional body or regulatory body
◦ termination of employment/registration (state reason)
◦ charged with a criminal offence
◦ personal bankruptcy (Ontario and Quebec)
◦ civil judgment or garnishment
In most provinces and territories, you may not advertise the fact
that you are registered with the securities administrator as a mutual
fund dealing representative nor imply that the securities
administrator in any way has approved of your actions.
THE NATIONAL REGISTRATION DATABASE

An application for registration is filed electronically on the National
Registration Database (Form NRD 33-109F4), with the
appropriate fee. National Instrument 31-103 sets out all the
requirements for initial and continuing registration. These
requirements include, but are not limited to, the following:
mutual fund dealing representatives may only be employed or
• sponsored by a single mutual fund dealer.
• mutual fund dealing representatives are not permitted to carry
on other forms of employment without the prior approval of the
appropriate securities administrator and SRO of which their
firms are members. These are often referred to as outside
activities or outside business activities. Due to the potential for
client confusion and conflicts, prior to entering into any
additional employment, registrants must declare these to their
dealer for review and analysis.
Applicants must complete a detailed registration application setting
out details of their past businesses, employment, and conduct, and
agree that the securities administrators may obtain a copy of the
applicant’s criminal record, if one exists, from the RCM P.
The registration application asks questions about the applicant and
any companies with which the applicant has been associated,
including:
• any disciplinary actions against the applicant with regard to any
government issued license to deal in securities or with the
public in any other capacity requiring registration or licensing
• any disciplinary actions regarding an approval by any securities
commission, SRO or other similar regulatory body or
professional body
• any past criminal convictions or current charges or indictments
• any bankruptcies or proposals to creditors
• any civil judgments or garnishments
DUAL EMPLOYMENT
M any provinces have issued policy statements permitting persons
to be dually registered (known as dual employment) as mutual
fund dealing representatives and life insurance agents.
A mutual fund representative who works for or is sponsored by a
member of the M FDA may have, and continue in, another gainful
occupation, provided that:
• the M FDA and the securities regulatory authority in the
jurisdiction do not prohibit from engaging in such activity
• the representative’s dealer is aware and approves of the other
occupation
• the representative obtains written approval from the dealer prior
to engaging in the activity
• the other gainful occupation must not bring the M FDA, its
members or the mutual fund industry into disrepute
• clear written disclosure is provided to clients that any activities
related to the other occupation are not the business or
responsibility of the dealer
The dealer must establish and maintain procedures to ensure
continuous service to clients and to address any potential conflicts
of interest. M FDA Rules indicate that all “securities related
business” must be conducted through the member, with exceptions
for the sale of deposit instruments not on account of the dealer
member and the activities of bank employees conducted in
accordance with the Bank Act. “Securities related business” means
any business or activity that constitutes trading or advising in
securities in any jurisdiction in Canada.
TRANSFER AND TERMINATION OF

REGISTRATION
A dealing representative’s registration is automatically suspended
as soon as he or she ceases to be employed or sponsored by a
mutual fund dealer (or other type of registered dealer). The dealer
must notify the applicable securities administrator of the
termination of the employment and the reason for termination
within 5 business days. Before a dealing representative’s
registration can be re-activated, notice in writing must be received
by the applicable securities administrators from another registered
dealer of the employment or sponsorship of the dealing
representative by that other dealer within 6 months.
The re-activation of the registration must be approved by the
securities administrators before a dealing representative can act on
behalf of his or her new dealer. If the securities administrator(s)
does not receive a request for reactivation of the dealing
representative’s registration and its transfer to another dealer within
the permitted period of time, the registration will lapse. This period
is generally six months. If the registration lapses the dealing
representative must reapply for registration.
Termination of employment or sponsorship by a registered dealer
includes transferring to another branch or office of a registered
dealer in another province or territory. If a dealing representative
transfers to another province or territory, notice using the National
Registration Database must be provided to the securities
administrator in the new province or territory. Under no
circumstances may a person sell mutual funds without having
received confirmation of registration from the appropriate securities
administrator, or continue to sell funds when registration has been
suspended, terminated, or lapsed for any reason.
Case Study | Suitable for Sunil: Proper Conduct is About More

Than the Right Products (for information purposes
only)
Rania is an account manager at a major Canadian bank. She

recently passed her IFC exam and is excited about providing
clients with investment advice. Sunil is a client at Rania’s bank. He
recently received a $5,000 bonus from his employer. Sunil has his
investment portfolio at the bank. He visits Rania’s branch on his
lunch break seeking investment advice for the new funds. He is
referred to Rania.
During the meeting, Rania discusses Sunil’s goals and reviews his
investment objectives, time horizon and risk tolerance. When he
first set up his investment account, Sunil was a conservative
investor, as his investment knowledge was very basic and he
wanted to learn more before taking on more risk in his portfolio.
Since then, Sunil has increased his investment knowledge, and is
now more comfortable with risk and the long-term benefits
provided by the growth potential of equities. After a lengthy
discussion, Sunil and Rania agree that he is now a balanced
investor.
Rania recommends that Sunil change his existing portfolio from a
conservative profile to a balanced one, and that he contribute his
$5,000 to the new balanced portfolio. Sunil is very pleased with
the recommendation and is impressed with Rania’s investment
knowledge. Rania does not yet have access to the bank’s
investment platform, so she enlists the assistance of her peer,
mutual fund representative Kumar, to execute the trade.
Rania explains the situation to Kumar, and Kumar verbally confirms
Sunil’s comfort level with Rania’s recommendation. Satisfied, he
executes the trades, switching the existing funds and adding the
new funds to the balanced portfolio. Sunil signs the trade
confirmation documents and departs.
Later that day, the branch compliance office (BCO), Terrance, calls
Kumar to his office. He notes that the trades for Sunil have been
flagged for being in conflict with the client’s KYC, which shows him
as a conservative investor who has purchased a balanced
portfolio. Kumar explains that he confirmed the client’s profile that
was established by Rania and that the client signed the trade
confirmation that clearly showed the switch to the balanced
portfolio and the new investment into the same portfolio.
Terrance admonishes Kumar. First, Kumar did not update the
client’s KYC information and have the client sign the appropriate
form that confirms the update. Second, Kumar did not conduct the
investment discussion with the client himself, only taking Rania’s
word for it that the discussion was appropriately thorough as per
proper procedures. He advises Kumar to update the client’s KYC
and to have the client return immediately to sign the form.
Terrance then meets with Rania and admonishes her for providing
investment advice and making mutual fund recommendations
without being registered to do so. Rania states that she did
everything properly, conducting a thorough review with the client.
She notes the client was happy with her recommendation.
Terrance agrees that Rania completed the correct steps and that
the mutual fund recommendation was appropriate for the client.
However, despite passing the IFC exam, she is not yet registered
to sell mutual funds, and therefore it was not appropriate for her to
provide any specific investment advice to the client and to make
mutual fund investment recommendations.
CLIENT FOCUSED REFORMS

The CFR amendments cover key industry requirements for the
KYC and KYP rules, conflicts of interest, suitability and relationship
disclosure. The CSA developed the CFRs based on the concept
that client interests must come first in the client-representative
relationship so that representatives who are in an advisory role
(i.e., provide investment recommendations to clients) make suitable
recommendations to their clients. The CFRs amend the current
KYC requirements and create a formal KYP requirement. These
changes support what the regulators refer to as enhanced
suitability determination obligations.
IIROC and the M FDA actively participated with the CSA in the
development of the CFR amendments. Both SROs are making
changes to their rules, policies, and guidance to align with the
amendments and ensure a consistent and further harmonized
approach to securities regulation in Canada.
Applying due diligence to ensure that each investment
recommendation is appropriate for the client is a fundamental
industry obligation. This is the suitability obligation and for
regulators, it is critical that representatives appreciate, apply, and
thoroughly document the components of suitability.
The CFRs were phased in during 2021. The key amendments and
reforms introduced by the CFRs include a conflicts of interest
amendment that came into force on June 30, 2021:
• Conflicts of Interest: The amended rule requires firms and
individuals to address material conflicts of interest in the best
interest of the client. The CFRs outline how these conflicts are
expected to be identified, documented, addressed, and
disclosed.
The remaining amendments came into force on December 31,
2021:
• Know Your Client: The CFRs set out an expanded list of
information representatives must collect to meet their KYC
obligations. The basic premise is that if you don’t really know
your client, how can you recommend a suitable investment
strategy? Representatives must also take reasonable steps to
obtain the client’s confirmation of the accuracy of any
information collected. The amendments also have an
expectation that client information be reviewed at minimum
intervals for currency and updated if the representative
becomes aware of a significant change.
• Suitability: The CFRs highlight that representatives must put
client interests first when making a suitability determination.
Along with KYC and KYP, representatives are expected to
have appropriate information to determine whether an
investment is suitable for a client and puts the client’s interest
first.
• Know Your Product: The new KYP obligation requires firms
to take ‘reasonable steps’ to understand any securities that are
purchased and sold for, or recommended to, their clients. The
CFRs require firms to have policies and procedures in place to
properly assess, approve, and monitor all securities they make
available to clients.
• Relationship Disclosure: The CFRs expand the disclosure
requirements to include letting clients know about potentially
significant items related to investment products being offered,
such as costs.
The following sections focus on these rules in greater detail.
CONFLICTS OF INTEREST
As part of the CFRs, the CSA proposed changes to conduct
requirements to better align the interests of registrants (i.e., mutual
fund sales representatives, advisors) with the interests of their
clients. The goal is to improve outcomes for clients and make
clearer to them the nature and terms of their relationship with you,
their representative.
M utual fund dealers must develop and maintain policies and
procedures to identify, disclose, and address existing and potential
material conflicts involving clients. For any registrant or service
provider of end clients, a conflict of interest will arise in any
situation where a provider of a product or service has an interest
that overlaps or diverges from that of the client being served.
Effective June 30, 2021, Part 13 of NI 31-103 required registered
firms and individuals to identify, address, and disclose material
conflicts of interest. You must address such conflicts in the best
interests of your clients and provide guidance to explain when a
conflict of interest is considered material.
To comply with NI 31-103, you must avoid material conflicts of
interest if there are no appropriate controls available in the
circumstances that would be sufficient to otherwise address the
conflict in the best interest of the client.
The CFR changes to the conflict provisions introduce several
requirements to the existing conflict rules, as noted in NI 31-103.
They can be summarized as follows:
• Both firms and individual registrants acting on behalf of their
firms must go through a process to identify material conflicts of
interest that currently exist between a client of the firm or an
individual acting on behalf of the firm.
• The material conflicts must be addressed in the best interests
of the client.
• To the extent that such conflicts cannot be addressed in the
best interests of the client, the material conflicts must be
avoided.
• The firm must disclose any material conflict of interest that may
impact a client at the time of account opening, or in a timely
manner if the conflict is identified at a later time.
For each conflict identified, the disclosure provided to clients must
be prominent, specific, and written in plain language outlining the
following matters:
• The nature and extent of the conflict in question.
• The impact and risk it may pose to the client.
• The way in which it has been or will be addressed.
The CFR amendments specifically point out that it is not sufficient
for a registrant to rely solely on disclosure as a means to satisfy its
obligations under the conflict provisions. Finally, individual
registrants have similar obligations to those of the firm and must
report conflicts to their firm promptly.
KNOW YOUR CLIENT

KYC and suitability are two of the three pillars of registrant
expectations (the other is the KYP rule). These concepts are
interdependent. If you neglect even one, you may not be fully
compliant with regulatory expectations. For example, if you do not
fully know your clients or understand a particular product, you will
find it difficult to make a suitable trade or product recommendation.
Understanding the interplay of these “golden rules” of the securities
industry (that is, KYC, KYP, and suitability) is critical.
The CFRs add to the existing KYC requirements and clarify the
KYC information representatives must gather in order to meet
suitability obligations. Required KYC information will include the
client’s:
• Personal circumstances (not limited to financial circumstances)
• Financial circumstances
• Investment knowledge
• Investment needs and objectives
• Risk profile (guidance clarifies that this includes both the
customer’s risk tolerance and their risk capacity)
• Investment time horizon
DID YOU KNOW?
As indicated in Chapter 4, a client’s risk profile requires an

understanding of their willingness to accept risk (risk
tolerance) and their ability to endure a potential financial
loss (risk capacity). According to NI 31-103, a client’s risk
profile should reflect the lower of their risk tolerance and
their risk capacity.
No single question can determine a client’s willingness to
accept risk or endure financial loss. Behavioural-based
interview questions and questionnaires can help to pinpoint
how the client defines risk and how much they are willing to
accept risk. The answers to a behavioural-based
questionnaire, by applying a scoring system, can be used to
determine a client’s risk profile.
The CFRs also change the requirements with respect to confirming
KYC accuracy and timeliness. These changes will require
registrants to:
• Take reasonable steps to obtain client confirmation that their
KYC information is accurate
• Keep KYC information current by updating it when becoming
aware of a significant change.
• Review KYC information with the client every 36 months even
if the registrant hasn’t interacted with the client.
SUITABILITY
M aking a suitability determination is part of your fundamental
obligation to deal fairly, honestly, and in good faith with your clients.
In addition, you must always put the client’s interests first, which
means ahead of your own interests, such as higher compensation
or other incentives for making a particular recommendation. Note
that conducting a suitability determination does not guarantee a
particular client outcome.
A suitability determination must be made before an investment
action is taken. Investment actions include the following:
• Account openings
• Purchases and sales
• Deposits, exchanges, or transfers
• Recommendations
• Any other investment actions including a recommendation or
decision to continue to hold investments
Suitability cannot be determined without first complying with KYC
and KYP requirements. A suitability determination must also take
the following into account:
• The impact of the action on the client’s account, including the
concentration of investments within the account and the
liquidity of such securities.
• The potential and actual impact of costs on the client’s return
on investment.
• A reasonable range of alternative options available to the
representative through the representative’s firm.
IMPACT OF COSTS
When making investment recommendations, you must consider the
potential and actual impact of costs to a client’s account. Costs
typically include all direct and indirect costs, fees, commissions and
charges including trailing commissions, and any other indirect
compensation that may be associated with the purchase, sale, or
holding of an investment. Costs may also include bid/ask spreads.
These costs can have a significant impact on a client’s return over
time. You must put your client’s interests first when selecting from
multiple and otherwise suitable options available to the client and
document the reasons for the selection. Your recommendations
and advice must meet a standard of reasonableness.
REASONABLE RANGE OF ALTERNATIVES

When making a recommendation or decision based on a suitability
determination, (for example, purchase of shares or an investment
fund), you must also consider a reasonable range of alternative
recommendations or decisions available at the registrant’s firm at
the time the suitability determination is made. What constitutes a
“reasonable” range of alternatives in this context depends on the
particular circumstances, including the securities or services being
offered, the skill and proficiency of the registrant, and the client’s
specific circumstances.
You must exercise professional judgment when opting for one
recommendation over another and be able to provide your analysis
and rationale for their recommendation. You should be prepared to
defend your choice in a manner that supports the product
recommendation or service to the client. All of the factors
assessed should be clearly documented in order to support your
recommendation.
CLIENT’S BEST INTEREST

After complying with these requirements, you should have
sufficient information:
• to determine whether an investment action is suitable for a
client, and
• to put the client’s interests (vs. the interests of the
representative) first.
Even where you have made an investment recommendation based
on detailed research and has reasonably determined that the
recommendation is suitable, you must also ensure that the client’s
interests are prioritized over your own. For example, you should
always follow your firm’s policies and recommended investments
even if you would receive more compensation for recommending
an alternative product.
OTHER CONDITIONS THAT TRIGGER SUITABILITY

In addition to taking specific investment actions (as defined above)
for a client, other trigger events may also require a suitability
determination. All mutual fund representatives generally recognize
that they should be routinely reassessing suitability where market
conditions dictate. These more “informal” opportunities to speak
with the client may arise frequently, and when they do, you should
note these conversations in the client file.
As noted in an earlier section, an “investment action” includes
account opening as well as decisions to buy or sell positions in a
client account, depositing, exchanging, or transferring securities for
a client’s account, and taking any other investment action for a
client or making a recommendation or decision to take any such
action.
Other triggering events include:
• A new representative is designated as responsible for the
client’s account.
• The representative becomes aware of a change in a security in
the account that could result in the security or account not
satisfying the suitability determination requirement.
• The representative becomes aware of a change in KYC
information that could result in the security or the client account
not satisfying the suitability determination requirement.
M FDA rules also consider a triggering event to occur when
securities are received into or delivered out of the client’s account
by way of deposit, withdrawal or transfer-in/out. In these situations,
a representative must review a client’s account within a reasonable
time, including its securities, to determine suitability.
CLIENT DIRECTED TRADES

Representatives are responsible for suitability for both solicited and
unsolicited trades. Where you receive an unsolicited order that is
unsuitable in relation to the client’s objectives, risk tolerance, and
other circumstances, it is not sufficient to merely mark the order as
unsolicited. You should take appropriate measures to deal with the
unsuitable order. The extent of this obligation depends in part on
your relationship with the client.
Appropriate measures to deal with an unsuitable order may include
providing the client with cautionary advice or recommending
changes to other investments within the account. The cautionary
advice should be documented, along with confirmation of the
client’s instructions to proceed despite the advice provided (for
example, asking the client to provide written instructions that also
acknowledge the caution provided). If the unsolicited action is
contrary to the client’s recorded KYC information, the KYC
information may need to be updated (keep in mind that it is
inappropriate to update the KYC in an effort to justify the suitability
of an order that is otherwise unsuitable if there are no changes in
the client’s investment objectives, risk profile, or other relevant
circumstances). In some circumstances, it may be prudent to
simply refuse the trade.
The CFRs contemplate this type of situation and codify regulatory
expectations in this regard. Where a representative receives
instructions that do not align with the representative’s suitability
obligation as described, the representative may carry out the
instructions only if they have informed the client that the trade is
not suitable and recommended an alternative course of action that
is suitable.
If you are unsure of how to deal effectively with an unsuitable
unsolicited order you should consult your supervisor or compliance
department to understand the firm’s internal procedures for dealing
with such situations and clearly document the outcome of this
process in the client file.
KNOW YOUR PRODUCT RULE

Equally important in making a suitability determination is an
understanding of the product being recommended – how it is
constructed, its features, risks, and costs, and a general idea of
how it is likely to perform in various market conditions. This
companion obligation of the KYC rule is referred to as the Know
Your Product (KYP) rule.
Clients have a right to know what they are agreeing to purchase
and a rightful expectation that their representatives know what they
are selling. Without this knowledge, you can neither assess
suitability nor explain the product’s features and risks. And if you
are unable to explain the product, the client, arguably, will not be
able to give proper instructions to buy or sell the product in
question.
DID YOU KNOW?
The M FDA is amending its rules in line with the CSA’s CFR
initiative. Specifically, amendments will apply to Rule 2.2.5
(Know Your Product) and 2.2.6 (Suitability Determination),
and corresponding changes will be made to Policy No. 2
(M inimum Standards for Account Supervision).
VULNERABLE CLIENTS
Representatives need to have a heightened sensitivity in their
dealings with vulnerable clients. With respect to elderly clients,
many will rely on their investments to supplement retirement
income, investments that will be difficult to recover from financial
losses given the client’s shorter time horizon.
Some representatives, however, rather than protecting these
clients take advantage of the fact that vulnerable clients may have
complete reliance on them on financial matters. This may be due to
the client’s limited investment knowledge, a long-standing
relationship, and a change in circumstances (i.e., becoming a
widow). Sometimes that vulnerability may be the result of cultural
issues that give deference to the representative.
Determining who is considered “vulnerable” will ultimately drive the
application of any additional policies and procedures. Because it is
not just elderly clients who are vulnerable, you must consider how
to approach any client who appears to be in distress or in need of
assistance. It is for these reasons that the ability to observe and
detect a change in long standing client behaviour is key to being
able to support clients who may fall into this category.
The most common types of infractions related to vulnerable clients
include:
• Unsuitable investment advice, particularly the use of higher risk
investments to boost client income.
• NAAF updates to justify trading.
• Investment objectives that benefit the estate instead of the
client.
• Accepting trading instructions for a client’s account from a family
member without receiving authorization from the account holder
or an appropriate power of attorney.
• Accepting loans or gifts from clients.
• Accepting executor power from clients.
The recent CSA, IIROC, and M FDA regulatory initiatives regarding
vulnerable clients are summarized below:
• Representatives should take reasonable steps to add a trusted
contact person (TCP) to a client file, including how this person
is monitored and in what circumstances they can be contacted.
• In carrying out enhanced KYC, KYP, and suitability
determinations, representatives must pay particular attention to
vulnerable clients.
• Representatives must be able to identify red flags that may
indicate diminished capacity, financial abuse, or misuse of a
power of attorney.
• In some circumstances representatives can place temporary
holds on the purchase, sale, withdrawal, and transfer of cash or
securities from a client’s account.
• Special considerations for communicating with vulnerable
clients (particularly during onboarding of a client) or marketing to
these clients.
• From the dealer’s perspective, providing policies and
procedures related to escalation and complaint handling that
best fits with the dealer and its client base, as well as a training
program to help representatives protect vulnerable clients (and
the dealer).
THE ROLE OF KYC INFORMATION IN

OPENING AN ACCOUNT
Know your client information is critical for opening accounts and
taking orders. Information about individuals with a financial interest
in an account, information about changes in the client’s
circumstances, and requirements relating to anti-money laundering
and anti-terrorist financing laws must be obtained.
FINANCIAL INTEREST IN AN ACCOUNT

The investment experience and knowledge of all individuals who
have trading authority over the account should be obtained, as well
as KYC information for anyone with a financial interest in the
account, such as joint account holders and beneficiaries of trusts
and trust accounts for children. With a trust, the trustee has trading
authority over the account, and therefore his or her investment
experience and knowledge should be obtained, as well as the KYC
of the beneficial owner of the account. For spousal RRSPs, the
contributing spouse does not have a financial interest in the
account, so KYC information is required for the non-contributing
spouse only.
CHANGES IN CIRCUMSTANCES – UPDATING CLIENT

INFORMATION
M FDA rules require that the dealer or representative must take
reasonable steps to keep the client’s KYC information current,
including updating the information within a reasonable time after
becoming aware of a material change in client information, and must
maintain evidence of any client instructions regarding any material
changes. All such changes must be approved by the individual
responsible at the dealer for approving new client accounts.
When approving material changes, branch managers should review
the previous KYC information to determine if the change appears
reasonable, and ensure that material changes have not been made
to justify trades that would be considered unsuitable or would
disregard the principle of putting the client’s interests first. M FDA
rules require that at least annually, the mutual fund dealer in writing,
request each client to notify them if the KYC information previously
provided to the dealer has materially changed. As indicated earlier,
a representative must review KYC information with the client at
least once every 36 months even if the registrant hasn’t interacted
with the client. Ultimately, having a well-documented and up to date
client file will only benefit the registrant and the mutual fund dealer.
If during normal interactions with a client the representative has
discerned a fact that is suggestive of a material change, this should
be well documented and to the extent required, the client account
should be appropriately updated.
WHAT ARE THE STEPS IN OPENING A

MUTUAL FUND ACCOUNT?
The M utual Fund industry is fortunate to conduct its business in a
self-regulatory environment, but the primary responsibility for self-
regulation rests with each mutual fund dealing representative. The
first step in ensuring compliance to the rules and policies that
govern the mutual fund business is the accurate completion of
documentation when opening new accounts. M aintaining accurate
and current account documentation will allow the dealing
representative and the supervisory staff at the mutual fund dealer
the necessary tools to perform a suitability assessment of the
investments in the client account. As noted above, in addition to
accurate account documentation (which is essentially the contract
between the mutual fund dealer and the client) the mutual fund
dealing representative should also document and maintain detailed
notes regarding the regular and routine interactions with the client.
RELATIONSHIP DISCLOSURE
Securities regulation requires that for each new client account
opened, the mutual fund dealer must provide the client with written
“relationship disclosure information.” This disclosure includes all the
information that a reasonable client would consider important about
their relationship with the mutual fund dealer and the dealing
representative. Relationship disclosure information may be
provided in a standalone document or it may be included in the
account opening documentation.
Regardless of the manner in which the relationship disclosure
information is provided to the client, it must include the following
information:
• The nature of the client account and the advisory relationship
• The products and services offered by the dealer, as well as
any limits or restrictions, including whether the dealer will
primarily offer proprietary products
• A description of the dealer’s procedures regarding the receipt
and handling of client cash and cheques
• A statement that the dealer must determine that all
recommendations and actions are suitable for the client and put
the client’s interest first
• A definition of the various terms used in the collection of KYC
information and an explanation of how the information will be
used
• A description of any benefits received by the dealer or
representative from a third party related to the client’s purchase
or ownership of an investment through the dealer
• A disclosure of the operating and transaction charges the client
may be required to pay, and a description of the general impact
on the client’s return from management expense fees and other
ongoing fees
• A general explanation of how investment performance
benchmarks might be used to assess performance
Relationship disclosure provided in a standardized document
should be approved by the dealer’s head office and/or branch
office. M utual fund dealers are also required to maintain evidence
that relationship disclosure has been provided to the client. If
relationship disclosure information is incorporated into account
documentation and it is client-signed, maintaining a copy of the
signed account documentation is sufficient evidence. In the event
that the dealer chooses to provide relationship disclosure as a
standalone document, the dealer may evidence client delivery by
requesting a client signed acknowledgement or by maintaining
copies of disclosure documents sent to the client in their
respective file at the dealer. It is recommended that, for relationship
disclosure documents that are not client-signed, the dealing
representative maintain detailed notes of client meetings and
discussions evidencing that the relationship disclosure information
has been provided.
As with any client account documentation, it is expected that when
there is a significant change in the relationship disclosure
information previously provided to the client that the dealer will take
reasonable steps to notify the client of the change in a timely
manner.
NEW ACCOUNTS
The first step in satisfying the Know Your Client Rule is to
establish the client’s account in accordance with securities
regulation as well as the policies and procedures established at the
mutual fund dealer. Each new client account accepted by the
dealing representative should be reviewed and approved by the
person responsible at the dealer for approving new accounts within
a reasonable time frame. Account numbers should not be assigned
until the client’s full legal name and address is confirmed.
In addition, it is also expected that a New Account Application Form
is completed for each new client account. As an aside, it is never
acceptable conduct to permit or suggest to a client that any form
required by the dealer be executed by the client “in blank”, to be
completed by the mutual fund dealer representative at a later time.
This is not considered acceptable conduct and is most likely to
result in enforcement action being taken against the representative.
Typically, the New Account Application Form will include the
necessary Know Your Client (“KYC”) information. If the KYC
information is not included in the New Account Application Form,
KYC information must be captured on a separate form. Regardless
of how the KYC information is documented it must include, among
other things, the client’s personal information, financial information,
risk tolerance, investment objectives, and disclosure of whether the
client is an insider or significant shareholder of a public corporation.
The information collected regarding risk tolerance and investment
objectives should be sufficiently precise to enable the dealer and
the dealing representative to meet their suitability assessment
obligations. A detailed description of the New Account Application
Form is described in the following section entitled “The New
Account Application Form (NAAF).
THE NEW ACCOUNT APPLICATION FORM

(NAAF)
The application form or account opening form, often referred to as
the New Account Application Form (NAAF), is used to open
new accounts and may also be used to record changes to the
personal information (KYC and other information) in a client’s file.
The NAAF represents the first opportunity for the dealer and
representative to carefully and clearly document the relationship
with the client. For these reasons, this “discovery process” should
be organized in such a fashion to at minimum capture the required
information as expected by the M FDA as well as any other
information that be necessary in order to demonstrate that the
dealer and representative know their client. The order form, which
is sometimes incorporated into the account opening form, is used
to subscribe for units or shares of a mutual fund. Typically, both the
account opening form and the order form are produced or approved
by the mutual fund dealer’s head office, and dealing
representatives must use them without alteration. It is both
permissible and useful, however, to make appropriate notations on
these forms or elsewhere in a client’s file for record-keeping
purposes.
The order form is the key document in the sales and compliance
chain. A completed order form is only the customer’s offer to
purchase mutual funds, however. This offer need not be accepted
by the mutual fund, although refusal is uncommon. A Branch
Compliance Officer should refuse to open an account or process
an order for a client who has not completed all of the “KYC”
information or who refuses to supply information that is required
under M FDA Rule 2.2.1.
Another common reason for refusing an order is that the purchaser
is a frequent trader. Frequent traders buy and sell mutual fund
units actively, sometimes holding positions for as little as one day.
With no-load funds, frequent traders can often buy and sell without
incurring any costs. The cost of the trades to the dealer, the fund
company, and the mutual funds in question can be significant in
terms of both time and money. M any funds have adopted short-
term trading fees to counter the practice of frequent traders.
The account opening should be done in person. However,
depending on the specific dealer’s policies the initial order and
subsequent transactions may be processed by telephone, by the
toll-free line or electronically (Internet or fax).
All information about clients and client transactions are confidential
and subject to the mutual fund dealer’s privacy policy and related
obligations. Neither the information obtained about the client nor
the contents of the client’s file may be disclosed except with the
client’s permission or by order of a securities administrator or other
authority or as may be required to comply with the client’s
instructions. A client cannot be required to consent to allowing the
disclosure of his or her personal information as a condition of
accepting the account, except where such information is
reasonably necessary to provide the specific product or service
that the client has requested.
COMPLETING THE NEW ACCOUNT APPLICATION

FORM
The structure and format of order forms vary among mutual fund
dealers, although their content is very similar. Remember, only a
registered dealing representative should help a client complete the
non-administrative/clerical portions of the order form.
There is no standard prescribed account application form.
Figure 17.2 shows a sample New Account Application Form
(NAAF).
Figure 17.2 | Sample New Account Application Form

The first step as a dealing representative is to obtain a client’s
personal data including the following:
Full Legal This must be obtained in full, without

Name abbreviations.
Permanent This is the address in full of the client’s permanent

Address residence, which must be obtained even if the
client wishes to use a different mailing address.
Mailing This is the client’s preferred mailing address. P.O.

Address Boxes and RR numbers are acceptable mailing
addresses only in rural areas.
Social Requesting the SIN is a legal requirement. For

Insurance non-registered accounts, if the client refuses to
Number (SIN) supply the SIN, you should indicate in writing on
the account form that the client “refused to supply
the SIN number.” The order may be executed and
the account opened even if the SIN number is not
obtained. You must make a reasonable effort to
obtain a client’s SIN for tax purposes. Failure to
make such effort may render you liable for a $100
fine per infraction. You may advise clients that if
they fail to provide their SIN, they may be liable to
the Canada Revenue Agency (CRA) for a $100
fine. A SIN number is required for all registered
accounts; without a SIN, the account cannot be
registered with the CRA.
Date of Birth Although only mandatory for registered accounts,

the client’s date of birth should be known to
ensure he or she has reached the age of majority.
M inors can legally purchase mutual funds but are
not contractually bound and can therefore revoke
the purchase at any time prior to reaching the age
of majority and receive the full amount of the
investment back, even if the fund’s units have
dropped significantly in value. If it is an RRSP
account, the birth date will also indicate when the
client’s RRSP matures for ultimate conversion to
a RRIF, annuity, or other maturity option. In the
case of a registered account, an order should not
be executed nor the account opened without the
client’s date of birth.
TYPES OF ACCOUNTS
The NAAF also indicates the type of account/purchase (e.g., non-
registered, TFSA, RRSP, RRIF). Clients opening RRSP accounts
should be told about designating a beneficiary. Although this is not
mandatory, clients should be informed that the proceeds of their
RRSP would go to their estate if a beneficiary is not named. If the
proceeds of the RRSP go to the estate, there could be additional
costs (such as probate fees) and delays in the distribution of the
proceeds. Other types of accounts, such as joint accounts and
accounts in the name of corporations, estates, trusts, partnerships,
minors, investment clubs, school boards, public utilities, or religious
societies require special documentation. If the purchase is paid for
by a contribution to a spousal RRSP, this should be indicated on
the form.
JOINT ACCOUNTS
Personal information for all clients (and all co-applicants) must be
obtained. For a joint mutual fund account, all parties must have
identical time horizons, investment objectives and risk tolerance, as
a single recommendation must meet the needs of all owners of the
account. The investment knowledge of different owners of the
account may differ.
All joint accounts should be registered in the names of all joint
account holders and KYC information should be obtained from all
account holders. Joint tenancy, trading instructions, including
redemption requests, may be accepted from any one joint holder,
unless the joint holders have indicated otherwise. Policies may
vary among dealers.
All joint applicants must sign the account opening form. Note,
however, joint tenancy is not recognized in Quebec.
TENANTS IN COMMON
If more than one person owns an account and it is not specifically
identified as being a joint account, each owner owns a pro-rata
share of the account, unless ownership is divided in another
manner and noted on the account. Where an account is held as
“Tenants in Common”, there is no right of survivorship and each
owner (unlike a joint account with rights of survivorship), unless
otherwise specified, can only give instructions with regard to the
pro-rata portion of the account he or she owns. Each mutual fund
dealer is required to have policies addressing the ownership of
accounts by more than one party.
CORPORATIONS
The mutual fund dealer should obtain a certified copy of the
corporation’s trading resolution confirming who has trading authority
for the corporation and that there are no restrictions on the
corporation that prohibit it from purchasing mutual funds in general
or particular types of mutual funds. This documentation will ensure
that the dealer is entitled to rely on the individuals so designated in
receiving instructions on the account in question. If the
corporation’s charter or by-laws contain this information, a certified
copy of this is acceptable. The trading resolution should be kept in
the client file. Often trading resolutions authorize persons who hold
specified titles to act on behalf of the corporation, in which case an
incumbency certificate will be required. The corporate trading
resolution must be renewed annually in Quebec. The KYC
information obtained for opening a corporate account relates to the
corporation, not to the individuals authorized to act on its behalf.
ESTATES AND TRUSTS

The mutual fund dealer should obtain a notarial copy of the letter of
probate/administration and include this in the file. M any dealers and
fund managers will waive this requirement if the value of the
account is modest. In these instances some dealers may also
require indemnities from the executor and beneficiaries to the
estate. For more information consult with the dealer’s compliance
department.
PARTNERSHIPS
All partners must sign and approve KYC information unless a
certified partnership resolution is provided confirming which
partners or employees of the partnership or other persons have
trading authority over the account. The partnership trading
resolution should be included in the client file.
GROUP PLANS
M any employees belong to group plans. Group plans are
sponsored by employers for the benefit of a group of employees. A
new client application form and KYC form for each employee in the
plan must be completed since each employee likely has a different
profile and investment objectives.
MINOR’S ACCOUNTS
The process for setting up accounts for minor children (age varies
among provinces) varies among mutual fund dealers. Some mutual
fund dealers do not accept accounts for minors, since minors can
repudiate mutual fund orders. Since mutual funds may fluctuate in
value, this could be a problem if the minor repudiates the purchase
of a mutual fund that has declined in value. This is why “in trust”
accounts are required at some mutual fund dealers. Another
method of dealing with minor accounts is to require the parent’s
guarantee on the account. In this instance, if the minor repudiates
the purchase, the dealer can demand that the parent cover any
shortfall.
If a mutual fund dealer opens accounts for minors, it is often
opened in the name of the parent or guardian in trust for the child
(for example, John Doe [parent/guardian] in trust for Jane Doe
[child]. Policies vary among dealers. The dealing representative
should obtain KYC information for both the parent and the child to
the extent possible.
All purchase and redemption orders for the account should be
either placed by the parent or confirmed by the parent verbally or in
writing. No formal trust deed is required as there is no document
(Declaration of Trust) that establishes an informal trust. If a formal
trust has been created, the account should be in the name of the
trust, not the beneficiary or the trustee.
INVESTMENT CLUBS
When opening an account in the name of an investment club, the
mutual fund dealer should take steps to make sure that the club
has been properly structured. It must meet the definition of an
investment club and thus be exempt from registration under
securities legislation. Investment clubs are specifically defined as
“private mutual funds” in some securities legislation. If an
investment club wishes to establish an account with your dealer,
contact your Compliance Department and discuss the structure and
rules of the club with authorized members of the club to ensure that
it is an investment club as defined in securities legislation.
EXAMPLE
Under the British Columbia Securities Act, an investment club
must fulfill the following criteria to qualify as a private mutual fund
and be exempt from registration: the club must have no more
than 50 shareholders; it must never have issued public debt; it
must not pay any member of the club for investment,
management or administration advice (except normal brokerage
fees); and all members must make pro rata contributions to
finance its operations.
A trading resolution should be obtained authorizing one or more

persons to trade on behalf of the investment club. A copy should
be retained in the file and the original forwarded to Head Office.
Here again, policies vary.
SCHOOL BOARDS, PUBLIC UTILITIES, LODGES,

SOCIETIES AND HOUSES OF WORSHIP
As with investment clubs, obtain a trading resolution authorizing
one or more individuals to act on behalf of the institution. A copy
should be retained in the file at the branch and the original
forwarded to the Head Office. (Each mutual fund dealer should
have an applicable policy.)
INTERMEDIARIES, TRANSFERS, AND

REFERRALS
Securities owned by clients of an intermediary (e.g., a mutual fund
dealer) are generally recorded either in the client’s name or in the
name of the intermediary. Securities that are recorded in the client’s
name are commonly referred to as “client-name securities”.
Securities that are recorded in the name of the intermediary are
commonly referred to as “nominee-name securities”.
A client name account is an account registered directly in the
name of the owner of the account with the mutual fund.
A nominee account (also known as “on-book” for brokers) is an
account registered in the name of a dealer or third-party
administrator on behalf of the owner of the mutual fund. A nominee
owner is a person or entity named to act on behalf of another
person or entity (e.g., beneficial owner), usually to facilitate the
processing of transactions.
Where nominee-name registration is used, dealers must have
appropriate controls and procedures in place to protect its clients
against fraud and the firm’s insolvency. Effective internal and
external oversight over operations is essential.
A mutual fund account may be transferred only by a mutual fund
dealer with the written authorization of the client, the nominee, or a
person duly authorized by the client to provide such authorization.
All transfers should be completed in a diligent and prompt manner
to ensure that the transfer takes place in an orderly and timely way.
A transfer cannot be delayed in an attempt to persuade the client
not to transfer the account or to determine the reason for the
transfer.
The M FDA defines a referral arrangement as an arrangement
where a representative or a member firm agrees to provide or
receive a referral fee to or from another person or company. A
referral fee refers to any benefit, whether direct or indirect, provided
for the referral of a client. The arrangement does not include
payment to a third-party service provider where the service
provider has no direct contact with clients and where the services
are not securities related.
Referral arrangements are permitted on the following terms (among
others) and in accordance with applicable M FDA rules:
• there is a written agreement governing the referral arrangement
prior to implementation
• all fees or other form of compensation paid as part of the
referral arrangement must be recorded on the member’s books
and records
• written disclosure of referral arrangements must be made to
clients prior to any transactions taking place or provides any
services. The disclosure document must include an explanation
or an example of how the referral fee is calculated, as well as
the name of the parties receiving and paying the fee
Prior to engaging in any activity that may result from a referral
arrangement representatives should consult with their dealer’s
policies and procedures as well as seeking guidance from the
Compliance Department.
WHAT ARE THE PROHIBITED SELLING

PRACTICES?
Prohibited selling practices refer to sales practices that are
clearly illegal or otherwise unacceptable to securities regulators.
Engaging in these and other types of overselling and unethical
behaviour could lead to a loss of registration and other potential
enforcement sanctions. The following practices are prohibited under
mutual fund regulations.
QUOTING A FUTURE PRICE

When an investor places an order to buy or sell a mutual fund, the
price per unit or share that she will be paying or receiving is not
known. This is because the purchase or sale price is based on the
end of day NAV which is determined by the closing or last quoted
price of all securities in the portfolio after the markets close at 4
p.m. Eastern time. Depending on the time of day in which the order
is entered, the NAVPS may be calculated at the closing price of the
current business day or at the closing price of the next business
day. M utual fund managers specify the time by which a trade must
be received by the fund to receive the NAVPS determined on the
current business day. Usually, orders submitted after 4 p.m.
Eastern time are entered at the next business day NAV. It is
unlawful for a dealing representative to backdate an order in an
attempt to buy shares or units at a previous day’s price.
OFFER TO REPURCHASE
A dealing representative may not make offers to repurchase
securities in an attempt to insulate investors from downturns in
price. Investors have the normal right of redemption should they
wish to sell their mutual fund investments.
SELLING WITHOUT BEING REGISTERED

As mentioned above, mutual fund dealing representatives must be
registered to sell mutual funds. This requires registration with the
securities administrator in each province and territory in which the
clients to whom they sell mutual funds reside. A dealing
representative must keep the securities administrator informed of
material changes in the material information provided on the dealing
representative’s registration application.
ADVERTISING THE REGISTRATION

Dealing representatives may not advertise or promote the fact that
they are registered with a securities administrator in most
provinces and territories, as this may imply that the securities
administrator has sanctioned or approved their conduct or the
quality of the funds they are offering.
USE OF TRADE NAMES BY DEALING

REPRESENTATIVES
A dealing representative may not conduct business using a
business or trade name or style name other than the one owned
by his or her mutual fund dealer or an affiliated corporation, unless:
• the mutual fund dealer has given prior written consent;
• all materials communicated to clients include the mutual fund
dealer’s legal name equally as prominently as the business or
trade or style name used by the dealing representative.
PROMISING A FUTURE PRICE

Dealing representatives may not make promises that the NAVPS
of a fund will achieve a certain level or increase by any amount.
SALES MADE FROM ONE PROVINCE INTO ANOTHER

PROVINCE, TERRITORY OR COUNTRY
While telecommunications have given access to the entire country,
the filling of orders from a client, even unsolicited, is not permitted
unless the dealing representative is registered in the client’s
province or territory. Selling mutual funds to clients in a province or
territory where the dealing representative is not registered, or to
residents of a foreign country, may result in the cancellation of the
mutual fund dealing representative’s registration or other
disciplinary action.
SALE OF SECURITIES AND OTHER PRODUCTS

It may be illegal for a mutual fund dealing representative to sell
products for which the dealing representative is not registered or
licensed. For example, it is not permissible for a dealing
representative to sell securities, other than mutual funds, in certain
provinces or territories unless registered in an appropriate category
to do so in that province or territory.
PROVISION OF NON-MONETARY BENEFITS

Receipt of non-monetary gifts or benefits by dealing
representatives from mutual fund managers and their affiliates is
forbidden unless they are of such minimal value or frequency that
the salesperson’s behaviour would not be influenced (such as
pens, t-shirts, hats and golf balls). This is not an exhaustive list. It
is the dealing representative’s responsibility to be aware of what is,
and is not, allowed. The Investment Funds Institute of Canada
(IFIC) puts out Sales Practices Bulletins, which interpret and give
examples of acceptable and unacceptable sales practices. M ost
financial organizations and mutual fund dealers require its dealing
representatives to sign a code of conduct that specifically states
that he or she is not allowed to accept non-monetary benefits from
clients or persons with whom she has other dealings that may give
rise to a conflict of interest.
RESTRICTION ON POWER OF ATTORNEY

The M FDA prohibits dealing representatives, officers and directors
of a mutual fund dealer from accepting a general power of attorney
or similar authorization from a client in their favour and relying on
such power of attorney or similar authorization to place trades to
purchase or sell securities on behalf of the client for the client’s
account with the mutual fund dealer. If they did so, they would be
engaged in the prohibited practice of discretionary trading. A
discretionary trade is defined as any purchase or sale where the
dealing representative determines the timing and/or price of a sale
or purchase.
There are a few exceptions to this general rule. In the case of
client name accounts, for example, a member or dealing
representative may accept a limited trading authorization from a
client for the express purpose of facilitating trade execution. The
limited trading authorization must be authorized by the M FDA and
must be completed and approved by the compliance officer or
branch manager and retained in the client’s file. Each purchase or
redemption made through a limited trading authorization must be
identified as such in all records.
WHAT ARE THE RULES FOR
COMMUNICATIONS WITH CLIENTS?
Rules applicable to communications with clients, including sales
communications, and the handling of client complaints, are set forth
in National Instrument 81-102 and M FDA Policy No. 3.
SALES COMMUNICATIONS
As mentioned earlier, National Instrument 81-102 sets out specific
requirements and prohibitions regarding sales communications. The
provisions of NI 81-102 apply whether the communication comes
from the dealing representative, the dealing representative’s dealer,
the fund’s promoter, manager, distributor, or anyone who provides a
service to the client with respect to the mutual fund. When in doubt,
the dealing representative should always consult with his or her
branch supervisor, manager, or compliance officer.
Approval is needed before any sales communications are sent out.
The provisions apply to any type of sales communications,
including advertising or any oral or written statements that the
dealing representative makes to a client or a potential client. Sales
communications can include, for example:
• 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;
• performance information—specific rules dictate how this
information must be calculated and presented;
• advertising that the fund is a no-load fund.
It is important that the sales communication does not mislead a
client. The communication cannot make any untrue statement or
omit any information that would make the communication
misleading, or present information in a way that distorts the
information. All information must be wholly consistent with the
information found in the fund’s fund facts document and simplified
prospectus.
HANDLING COMPLAINTS
A client who is not satisfied with a product or service has the right
to make a complaint and to ask to have the problem rectified. It is
important that client complaints regarding mutual funds be handled
efficiently and professionally. Failure to deal adequately with such
complaints can lead to problems with the securities administrators
and the SROs. Your dealer has procedures in place for handling
client complaints, which should be strictly observed.
M FDA Policy No. 3 specifies the minimum procedures for dealing
with written client complaints (including emails). All written client
complaints must be acknowledged in writing. The results of an
investigation into a client complaint must be conveyed in writing to
the client in due course and must be handled by a qualified
supervisor or member of the compliance staff. The registered
dealing representative involved and his or her supervisors should
be made aware of the complaint, and senior management should
be informed of complaints alleging serious misconduct and of all
legal actions arising from such complaints.
In Quebec, regulated persons must receive clients’ complaints,
impartially examine them and provide appropriate answers.
A complaint is the expression of one of the following three
elements:
• a reproach against a regulated person;
• the identification of real or potential harm that a consumer has
experienced or may experience;
• a request for remedial action.
A regulated person must examine every complaint, not just those
relating to a possible violation of the law. To be admissible, the
complainant must file a complaint in writing. If the complaint is
incomplete and the regulated person requires additional information,
then the complainant must provide this information in writing. The
AM F provides assistance to consumers through its Information
Centre as well as documentation to guide consumers in the drafting
of their complaints.
WHAT ARE YOUR OTHER LEGAL

RESPONSIBILITIES?
In addition to acting ethically and in compliance with industry and
agency rules—such as the rules for disclosure and suitability—
mutual fund sales representatives must also comply with other
legal requirements. Becoming familiar with the federal privacy law
and anti-money laundering and terrorist financing legislation is
important, because it will help you stay in compliance and better
serve your clients and your firm.
PRIVACY LAW
Clients are increasingly concerned about the privacy of the
personal information they provide to various private organizations,
governments and individuals, including mutual fund sales
representatives. In an age of instant telecommunication and
electronic technologies, personal and private information can be
disseminated widely and indiscriminately by the click of a mouse.
That’s why governments have become serious about providing
protection to individuals and have put in place laws designed to
safeguard the confidentiality of personal information and to regulate
its collection, use and disclosure.
In September 1998, the federal government announced a strategy
designed to position Canada as a world leader in the development
and use of electronic commerce. To achieve this ambitious goal,
the government adopted the Personal Information Protection
and Electronic Documents Act (PIPEDA) in April 2000. PIPEDA
incorporated and made into law ten principles set out by the
Canadian Standards Association (CSA) in 1996.
The Act provides protection for personal information and grants
legal status to electronic documents. For example, the Act requires
firms to:
• Obtain consent when they collect, use or disclose personal
information.
• Provide a product or service even if an individual refuses
consent to the collection, use or disclosure of personal
information, unless that information is essential to the
transaction.
• Collect information by fair and lawful means.
• Have personal information policies that are clear,
understandable and readily available.
An exception is that an advisor or sales representative may
disclose financial and other personal information without the client’s
consent when a government representative has legal authority to
obtain the information or when the disclosure is required to
administer a federal or provincial law.
For example, inquiries conducted by the Canada Revenue Agency
are often confidential. Therefore, the financial institution
representative who receives the request cannot inform the client
that an investigation is taking place. Thus, there are situations
when the law authorizes disclosure without knowledge or consent.
The financial institution or dealer you work with may have its own
process for validating “authorized” access to files. You should
review its policy on this matter.
The CSA standards on which PIPEDA is based were adapted for
banks and set out in the Canadian Bankers Association (CBA)
Privacy M odel Code in 1996. These standards relate to the
following conditions:
• accountability
• identifying the purposes for the collection of personal
information
• obtaining consent
• limiting collection
• limiting use, disclosure and retention
• ensuring accuracy
• providing adequate security
• making information management policies readily available
• the rights of individuals to:
◦ access their personal information
◦ challenge compliance with the rules
The federal law also established a Privacy Commissioner as an
oversight mechanism. Consumers have the right to file a complaint
about any aspect of compliance with PIPEDA. Clients are entitled
to file a complaint against a financial institution for its apparent
breach of compliance with the measures in the federal law for
protecting their personal information. To resolve complaints, clients
should initially be encouraged to use a financial institution’s (or
dealer’s) own internal redress body.
The Privacy Commissioner is empowered to:
• receive complaints
• conduct investigations
• attempt to resolve complaints
• audit the personal information management practices of an
organization
Unresolved disputes can be taken to the Federal Court, and the
Court may order the financial institution to correct its practices
and/or award damages to the complainant.
In addition to the above obligations, there are additional and
recently enacted requirements that pertain to disclosure and
notification requirements (both to impacted individuals as well as
the privacy commissioner) when there is a breach of these privacy
requirements resulting in an inappropriate release of private
information.
These obligations apply when a release of private information has
occurred resulting from a breach of security safeguards. If this is to
occur an evaluation must take place if such a breach is likely to
cause real risk of significant harm to the individual in question. If
this is the case, appropriate disclosure and notification is required
to both the Privacy Commissioner as well as the impacted
individuals.
There are additional record keeping obligations as well.
Registrants should carefully review their dealer’s privacy policy for
further information.
ELECTRONIC COMMERCE
Electronic commerce (e-commerce) refers to online business
activities such as purchasing, distributing, selling, and other
transactions. For financial institutions, however, e-commerce
involves more than simple buying and selling online. It means
conducting transactions involving the following instruments:
• automated banking machines
• credit and debit cards
• electronic data interchange (transmission of information
between financial institutions over private network)
• banking by phone and online banking
• faxes
The law extends to electronic documents and signatures. An
electronic document is data recorded or stored in a computer
system or other similar device that can be read or perceived by a
person or a computer system or other similar device. This includes
displays, printouts and other output of that data. For example, a fax
or an e-mail is an electronic document protected by the Privacy
Law. An electronic signature is a person’s signature in digital form
that is incorporated in, attached to, or associated with an electronic
document.
Canada’s financial institutions have always been committed to
keeping their customers’ personal information accurate, confidential,
secure and private. The guiding principles and most requirements
of the Act are the same as the voluntary privacy standards that
firms have followed for many years. Although customers will see
little change, the Act has significant implications for financial
institution representatives. You now have a legal responsibility to
ensure that these measures continue to apply to your everyday
work and client interactions.
ANTI-MONEY LAUNDERING AND TERRORIST

FINANCING
Your legal responsibilities extend to reporting transactions or
dealings that may involve money laundering or terrorist financing.
Everyone involved in efforts against money laundering and terrorist
financing agrees that these crimes are increasingly dangerous and
difficult to detect and deter, and that they are global problems
requiring national and international solutions.
Money laundering (proceeds of crime) is about accepting cash (or
assets) obtained illegally and making it appear legitimate. It is a
criminal offence punishable under Canada’s Criminal Code.
Individuals launder money to disguise or conceal the nature or
ownership of the cash that was obtained through an illegal activity,
hence the idea of “dirty money.”
M oney launderers have long seen Canada as an ideal country to
practice their trade. A number of factors have encouraged this,
including:
• Canada’s stable banking system with confidentiality as one of
its hallmarks.
• A government and economy viewed as stable and a relatively
high standard of living in which to hide illegal wealth.
• A moderate and liberal justice system where penalties tend to
be far less severe than in other democratic nations.
• A large unguarded border with the United States; until
January 6, 2003, Canada lacked cross-border controls over the
movement of money.
Canadian financial institutions have traditionally acted against
money laundering and terrorist financing by reporting unusual
transactions voluntarily to the authorities. The latest efforts of the
federal government complement and enhance the measures
that have been taken.
Figure 17.3 provides a flow chart of the money laundering process.
The figure shows that there are three basic stages of money
laundering—placement, layering, and integration. As you move from
the bottom to the top of the figure, you can see how the proceeds
of crime get converted into clean (i.e., laundered) funds.
Figure 17.3 | The Money Laundering Process

Under current legislation, specified persons and entities are
required to:
• report suspicious and certain prescribed transactions
• implement a compliance regime
• verify client identification regarding specific transactions
(account opening)
• comply with new record-keeping requirements
• report any deposit transactions of $10,000 CDN or more made
in cash
REPORTING ENTITIES
Persons and entities required to report suspicious transactions and
certain prescribed transactions are:
• financial entities (e.g., banks, credit unions, caisses populaires,
trust and loan companies, and agents of the Crown that accept
deposit liabilities)
• life insurance companies, brokers and agents
• securities dealers, including portfolio managers and investment
counsellors
• persons engaged in the business of foreign exchange dealing;
• money services businesses
• Canada Post when it sells or redeems money orders
• accountants and accounting firms (when carrying out specific
activities for clients);
• gambling casinos
• legal counsel and legal firms (when carrying out specific
activities for clients)
• real estate brokers and sales representatives (when carrying
out specific activities for clients)
In Canada, “money services businesses” include any individual or
entity engaged in foreign exchange dealing, remitting or transmitting
funds by any means, and issuing or redeeming negotiable
instruments, such as money orders or traveller’s cheques.
Exhibit 17.1
Hawala and Hundi, are names for a money services business that
operates outside of traditional banking or financial channels. This
business was developed in India before the introduction of
western banking practices and is today a major remittance system
used around the world. Chop and Chitti are names for an
alternative remittance system that arose in China and is also used
around the world today. These systems are based on trust, family
relationships, and regional affiliations. Transfers commonly take
place among alternative dealer networks and often in the absence
of actual instruments. Thus, money can be transferred without
actually moving it. Alternative remittance systems have legitimate
uses but also are avenues for money laundering and terrorist
financing.
REPORTING TRANSACTIONS
Employees of the listed persons or entities, including mutual fund
sales representatives, also are required to report these
transactions within organizational guidelines. You must be able to
recognize transactions that could be linked to money laundering or
terrorist financing and report specific transactions according to your
employer’s internal policies and procedures, which in turn may be
reported to the Financial Transactions and Reports Analysis Centre
of Canada (FINTRAC) through your employer’s compliance unit.
For some individuals working in the financial services industry, the
practice of reporting suspicious transactions and terrorist financing
activities will be new. The challenge is to find a balance between
winning the business and recognizing these transactions.
WHAT IS TERRORIST FINANCING?

Terrorist financing (proceeds for crime) provides funds for terrorist
activity. A terrorist or terrorist group includes anyone (e.g., an
individual, group, trust, partnership, organization) that has any
purpose or engages in an activity to facilitate or carry out any
terrorist activity.
The main goal of terrorist activity is to use intimidation against a
specific population or to coerce a government to do something.
This can be accomplished by directly causing death or serious
harm, or causing substantial property damage that may cause
death, injury, or disruption of essential services. It can also be
accomplished indirectly through impacting a country’s economy
(e.g., with stock markets dropping out of fear of further violent
attacks, such as what happened after September 11, 2001).
Similar to a successful criminal organization, a successful terrorist
group must build and maintain an effective financial infrastructure.
To complete this task, the source of funding must be hidden. The
sums of money required for a terrorist attack are not always large
and the associated transactions are not necessarily complex.
The methods terrorists use to generate funds differ from those
employed by criminal organizations:
• Financial support may be obtained from certain countries,
organizations, or wealthy individuals; this is often referred to as
state-sponsored terrorism.
• M oney may be acquired through criminal revenue-generating
activities (e.g., kidnapping, extortion, fraud, smuggling, robbery,
drug trafficking).
• Financial support may be obtained from legal sources such as
donations or sales of publications; such funds may be more
difficult to detect or trace.
FINANCIAL ACTION TASK FORCE

The Financial Action Task Force (FATF) is an inter-governmental
body whose purpose is to develop and promote national and
international policies to combat money laundering and terrorist
financing. Financial institutions in FATF member countries have the
obligation to identify all clients, including any beneficial owners of
property, and keep appropriate records. They are also required to
report suspicious transactions to the competent national authorities
and to implement a comprehensive range of internal control
measures.
The FATF:
• M onitors members’ progress in implementing anti-money
laundering and terrorist financing measures.
• Reviews money laundering and terrorist financing techniques
and counter-measures.
• Promotes the adoption and implementation of anti-money
laundering and terrorist financing measures globally.
In performing these activities, FATF collaborates with other
international bodies involved in combating money laundering and
terrorist financing. In addition, FATF annually publishes a list of
countries currently identified as non-cooperating in the
development and implementation of money laundering and terrorist
financing controls. That list is reviewed annually to add new names
or delete names of countries that have met FATF standards.
The FATF reviews its mission every five years and has been in
existence since 1989. At the end of August 2021, the FATF
consisted of 39 members.
In this context, the Know Your Client rule takes on extra meaning.
M eeting your legal, ethical, and professional responsibilities in
knowing your client is more than good business. It is an essential
service you provide that benefits and protects the industry as well
as you, your clients and your firm.
EMPLOYEE RESPONSIBILITIES
Every person who is registered as a mutual fund

representative has certain regulatory responsibilities.
Do you know what those responsibilities are? Complete
the online learning activity to assess your knowledge.
SUMMARY
1. Describe the role, mandate, and scope of the securities
administrators in Canada.
◦ The provincial securities and territorial administrators are
regulatory bodies responsible for the administration of the
provincial and territorial securities legislation, regulations and
rules. The goal is the protection of investors who purchase
securities in the particular province or territory.
◦ The securities administrators are administrative bodies under
the authority of their respective provincial or territorial
government. The administrators have broad powers,
including investigation and prosecution, registration and
disclosure.
◦ The securities administrators periodically issue policy
statements. These statements clarify the position of the
securities administrators on various issues.
2. Describe the role and objectives of the M utual Fund Dealers
Association (M FDA) and the Autorité des marchés financiers
(AM F).
◦ The main objective of the M FDA is to protect Canadian
mutual fund investors and ensure that they have the same
level of protection regardless of the mutual fund dealer or
dealing representative they deal with.
◦ The M FDA has the power to enforce standards and conduct
investigations and is responsible for the enforcement of
rules and policies relating to its members, their employees
and agents.
◦ The AM F ensures compliance with the regulatory
requirements relating to access the distribution of financial
products and services. The AM F also issues an individual’s
or entity’s right to practice.
◦ A Branch Compliance Officer (BCO) must be appointed for
each registered branch with four or more mutual funds
dealing representatives. The BCO is responsible for
ensuring compliance with the regulatory requirements within
the branch by monitoring the conduct of the mutual fund
dealing representatives.
3. List and explain the registration requirements for becoming
registered as a mutual fund dealing representative.
◦ Before becoming eligible for registration, an applicant must
pass an examination recognized by the applicable provincial
or territorial securities commission.
◦ A mutual fund dealing representative (or his/her dealer) must
pay a registration fee on an annual basis. If not paid, the
registration expires.
◦ As soon as a dealing representative ceases to work for a
registered dealer, registration is automatically suspended.
Before a dealing representative’s registration can be
reinstated, notice in writing must be received by the
applicable securities commission from another registered
dealer of the employment or sponsorship of the dealing
representative by that other dealer.
◦ When transferring to another province or territory to work for
or be sponsored by the same mutual fund dealer, a notice
must be filed with the securities commission in the new
province or territory. Upon termination, registration is
suspended until reinstated upon employment with or
sponsorship by another dealer.
4. Describe the “know your client rules” within the context of
suitability, the circumstances in which suitability of a client
account must be re-assessed, know your product and opening
accounts for clients.
◦ Securities regulations require that dealers and their dealing
representatives know the personal and financial
circumstances, investment needs and objectives,
investment knowledge, time horizon and risk profile of their
clients by requiring the provision of “know your client”
information in all cases.
◦ This information must be obtained for all persons who have
trading authority for the account as well as other persons
with a financial interest in the account.
◦ Suitability of investments held in the client account must be
re-assessed whenever the client transfers their account to
the dealer, or whenever the dealer or mutual fund dealing
representative becomes aware of a material change in the
KYC information previously provided and/or anytime where
there has been a change in the mutual fund dealing
representative responsible for the client account.
◦ The suitability requirement applies to recommendations that
a dealing representative may make to a client and
unsolicited orders (i.e., orders for mutual funds that have not
been recommended by the dealing representative but
instead come from the clients).
◦ Especially important is information about individuals with a
financial interest in an account, information about changes in
the client’s circumstances, and requirements relating to anti-
money laundering and anti-terrorist financing laws.
5. List and explain account opening procedures, including the
relationship disclosure, the steps in completing the new
account application form (NAAF), differentiate among the types
of accounts and the circumstances in which Know Your Client
Information requires an update.
◦ Relationship disclosure information is all the information that
a reasonable client would consider important about their
relationship with the mutual fund dealer and the dealing
representative.
◦ The application form or account opening form, often referred
to as the new account application form (NAAF), is used to
open new accounts and may also be used to record
changes to the personal information in a client’s file.
◦ The NAAF must include the client’s full legal name,
permanent address, mailing address, social insurance
number (SIN), and date of birth.
◦ The NAAF also indicates the type of account. Types of
accounts include: joint accounts, tenants in common,
corporations, estates and trusts, partnerships, group plans,
minor’s accounts, investment clubs, school boards, public
utilities, lodges, societies and houses of worship.
◦ Know Your Client Information requires an update where
there has been a material change in the client information
previously provided. M aterial changes include, but are by no
means limited to, changes to the clients risk tolerance,
investment time horizon, investment objectives of the client
or a material change in the client assets or income.
6. List and distinguish among the prohibited mutual fund sales
practices.
◦ A number of sales practices are clearly illegal or
unacceptable. These include quoting a future price, offering
to repurchase a security, selling without being registered,
advertising one’s registration, sales made from one province
to residents of a province or territory in which the dealing
representative is not registered, sale of securities other than
mutual funds, and acceptance of non-monetary benefits from
fund managers.
7. Describe the rules applicable to sales and performance
communications with clients, including the procedures for
handling complaints.
◦ National Instrument 81-102 includes requirements and
prohibitions applicable to sales communications for mutual
funds. Of vital importance is that sales communications do
not mislead clients or potential clients. All information in a
sales communication must be consistent with the information
found in the fund’s fund facts document and simplified
prospectus.
◦ Approval is needed before any sales communications are
sent out. The provisions apply to any type of sales
communications, including advertising or any oral or written
statements that the dealing representative makes to a client
or a potential client.
◦ A client who is not satisfied with a product or service has
the right to make a complaint and ask to have the problem
rectified. Each mutual fund dealer is required to have
procedures in place for handling client complaints — these
should be strictly observed.
8. Summarize the importance of the federal privacy guidelines
and the anti-money laundering and anti-terrorist financing
legislation as part of the requirements of a mutual fund sales
representative.
◦ Governments have become serious about providing
protection to individuals and have put in place laws designed
to safeguard the confidentiality of personal information and
to regulate its collection, use and disclosure.
◦ The federal government adopted the Personal Information
Protection and Electronic Documents Act (PIPEDA) in
April 2000.
◦ The Act provides protection for personal information and
grants legal status to electronic documents.
◦ The Privacy Commissioner is empowered to receive
complaints, conduct investigations, attempt to resolve
complaints, and audit the personal information management
practices of an organization.
◦ M oney laundering (proceeds of crime) is about accepting
cash (or assets) obtained illegally and making it appear
legitimate. It is a criminal offence punishable under Canada’s
Criminal Code.
◦ There are three basic stages of money laundering—
placement, layering, and integration.
◦ Terrorist financing (proceeds for crime) provides funds for
terrorist activity. A terrorist or terrorist group includes anyone
(e.g., an individual, group, trust, partnership, organization)
that has any purpose or engages in an activity to facilitate or
carry out any terrorist activity.
◦ The Financial Action Task Force (FATF) is an inter-
governmental body whose purpose is to develop and
promote national and international policies to combat money
laundering and terrorist financing.
REVIEW QUESTIONS

Applying Ethical Standards
18
to What You Have Learned
CONTENT AREAS
What are Ethics and the Standard of Conduct?
How to Apply What You’ve Learned to Case Studies
LEARNING OBJECTIVES
1 | Summarize the roles of ethical decision-making and the

standard of conduct in building trust and confidence
within the securities industry and the values that sales
representatives should apply in their relationships with
clients.
2 | Apply what you have learned throughout this course to

various client scenarios.
KEY TERMS

confidentiality
duty of care
ethical decision-making
ethics
integrity
INTRODUCTION
The role of the mutual fund sales representative is to make sure
that clients buy only suitable investments given their personal and
financial circumstances, investment needs and objectives,
investment knowledge, risk profile, and investment time horizon.
There must be a good fit between the investments chosen by the
client and the characteristics of the client.
In order to make sure that the fit is good, the mutual fund sales
representative must know the client and the products. The better
you know both the client and the products, the better are the
chances for a good fit.
Tied into this approach is the important role ethics play in the
process of making decisions for clients. When dealing with the
public, you have a duty to act ethically, most importantly by placing
the needs and interests of the client above all else. Behaving
ethically is the cornerstone of maintaining and enhancing the
integrity of the industry.
WHAT ARE ETHICS AND THE STANDARD OF

CONDUCT?
A critical element in building a solid trusting relationship with a client
is behaving in an ethical manner. Ethics can be defined as a set of
moral values that guide behaviour. M oral values are enduring
beliefs that reflect standards of what is right and what is wrong.
ETHICAL DECISION-MAKING
Ethical decision-making is based on the principles of trust,
integrity, justice, fairness, honesty, responsibility, and reliability. The
securities industry cannot exist without the trust and confidence of
the public. Registrants in the securities industry play an important
role and must regularly generate trust and confidence in their
clients by adhering to high standards of ethical conduct in all of their
dealings.
Ethics is defined generally as a set of values and standards that
guide individual behaviour. A person’s values can change over
time, but the change is always driven by standards of right and
wrong, rather than by personal need. Commonly agreed-on ethical
values include accountability, fairness, honesty, loyalty, reliability,
and trustworthiness.
As a concept, ethics can be defined more specifically in the
following three ways:
• The rules or standards governing the behaviour of a particular
group or profession
• A set of moral principles or values
• The study of the general nature of morals and the moral
choices made by individuals
There is a key difference between ethical behaviour and mere
compliance with rules. Following rules does not involve judgment,
and compliance results only in conformity with externally
established standards. Some rules simply codify consensus
practices, such as the rule stating that stock trades settle two
business days after the trade date. Other rules approximate ethics
by incorporating ethical behaviour, such as the law against stealing.
Rules are designed to deal with the most significant or most
common situations. They cannot encompass every possible
situation that may occur in day-to-day business. People follow
rules because they must, not necessarily because they believe it
is morally correct. Ethical behaviour, in contrast, requires judgment
based on internally established moral values. Ethical decision-
making is a system that can be applied to any situation, even one
where no rule exists to govern behaviour.
Such a system might involve the following steps:
1. Recognize that a moral dilemma exists.
2. Assess your options in terms of moral criteria.
3. M ake a commitment to a morally appropriate strategy.
4. Have the courage to carry out the strategy.
THE STANDARD OF CONDUCT AND ETHICAL

GUIDELINES
As the national self-regulatory organization that oversees mutual
fund distribution, the M FDA regulates the actions and behaviour of
registered individuals. Along with strict compliance with its rules and
regulations, the M FDA requires that registered individuals observe
high standards of ethics and conduct when transacting their
business. This integration of ethics into industry rules essentially
applies to all of a registered individual’s actions and everyday
behaviour with clients.
DID YOU KNOW?
M FDA Rule 2.1.1 Standard of Conduct states:

Each M ember and each Approved Person of a M ember
shall:
a. deal fairly, honestly and in good faith with its clients;
b. observe high standards of ethics and conduct in the
transaction of business;
c. not engage in any business conduct or practice which
is unbecoming or detrimental to the public interest; and
d. be of such character and business repute and have
such experience and training as is consistent with the
standards described in this Rule 2.1.1, or as may be
prescribed by the Corporation.
The securities industry has no formal code of ethics. However,

industry rules and regulations imply a set of ethical standards. For
the purposes of this course, we have distilled these rules and
standards into the following five primary values that registered
individuals must observe:
Exhibit 18.1 | Five Primary Values — Summary
Primary Value Areas of Focus
Duty of Care • Know Your Client

• Due Diligence
• Unsolicited Orders
Integrity • Act in an honest, fair, and trustworthy

manner
• Priority of Client’s Interests
• Respect for Client’s Assets
• Complete and Accurate Information
Relayed to Client
• Disclosure
Professionalism • Client Business

• Client Orders
• Trades by Registered and Approved
Individuals
• Personal Business
• Personal Financial Dealings with Clients
• Other Personal Endeavours
Compliance • Compliance with the Securities Acts and

SRO Rules
Confidentiality • Client Information

• Use of Confidential Information
DUTY OF CARE
While duty of care encompasses a wide number of obligations
towards parties, the obligation to know the client is of paramount
importance in order to ensure the priority of clients’ interests.
Including this, the three major components of duty of care are:
Know Your The Know-Your-Client (KYC) rule is paramount for

Client the industry. As you have learned throughout this
course, you must learn the essential financial and
personal circumstances and the investment
objectives of each client. You must also know the
client’s level of investment knowledge, their risk
profile, and an understanding of their investment
time horizons. Client account documentation should
reflect all material information about the client’s
current status, and should be updated to reflect any
material changes to the client’s status in order to
assure suitability of investment recommendations.
Due You must make all recommendations based on a

Diligence careful analysis of both information about the client
and information related to the particular transaction.
You must know your products, including how they
are constructed, their features, costs, and a general
idea of how they are likely to perform in various
market conditions.
Unsolicited When you give advice to clients you must provide

Orders appropriate cautionary advice with respect to
unsolicited orders that appear unsuitable based on
client information. You must be aware of the
investment objectives and strategies behind each
order accepted on behalf of your clients, whether it
is solicited or not. You should take appropriate
safeguarding measures when clients insist on
proceeding with unsolicited, unsuitable orders.
You must make a concerted effort to know the client—to

understand the financial and personal circumstances and
aspirations of the client. You will make recommendations for the
client to invest funds in mutual funds that reflect, to the best of your
knowledge, these considerations. Having provided sound advice,
you will be above reproach for potentially unsuitable purchases and
sales of securities for a client if the client does not heed your
advice.
INTEGRITY
You must display absolute integrity since the client’s interests
must be the foremost consideration in all business dealings. This
requires that you observe the following:
Honest, Fair, and You must act in an honest, fair, and
Trustworthy trustworthy manner in all dealings with
clients, employers, colleagues, and the
public. You must avoid entering into
situations where your interests conflict
with those of your clients.
Priority of Client’s The client’s interest must be the

Interest foremost consideration in all business
dealings. In situations where you may
have an interest that competes with that
of the client, the client’s interest must be
given priority.
Respect for Client’s The client’s assets are the property

Assets solely of the client and are to be used
only for the client’s purposes. You cannot
utilize client funds or securities in
any way.
Complete and You must take reasonable steps to

Accurate Information ensure that all information given to the
Relayed to Client client regarding his or her existing
portfolio is complete and accurate. While
the onus is on your dealer to provide
each client with written confirmations of
all purchases and sales, you must
accurately represent the details of each
client’s investments to the client. You
must be familiar with the clients’
investment holdings and must not
misrepresent the facts to the client in
order to create a more favourable view of
the portfolio.
Disclosure You must disclose all real and potential

conflicts of interest in order to ensure fair,
objective dealings with clients.
As a mutual fund sales representative, clients need to know that

you are working to promote their best interests.
When clients trust you, they do not personally have to verify
everything that you tell them. For example, they do not have to
check the tax and estate implications of every investment
recommendation or ask for details about its risk or volatility. They
certainly do not waste time wondering if you have made a
recommendation that serves your interests rather than the client’s
own interest.
There are two parts to a trust relationship: trust in your competence
and integrity. Both are essential. Competence, without integrity,
leaves clients at the mercy of a self-serving professional. Integrity,
without competence, puts clients in the hands of a well-meaning
but inept professional.
In order to ensure that advisors are competent, they must meet
proficiency requirements for their registration category.
Exhibit 18.2 | Gaining a Client’s Trust
When Ottawa mutual fund sales representative Jo-Ann Carter

assumed the account of 65-year-old Ena Beyer, she knew she
had a challenge on her hands.
M rs. Beyer, a widow, held more than $350,000 in a non-registered
mutual fund account—and the entire amount was invested in a
combination of money market and mortgage mutual funds. After
the first meeting, it was evident that her new client’s investment
knowledge was very limited and that she relied almost entirely on
her son for financial advice.
Therein lay the problem. Her son, a systems-services
professional employed by a high-tech firm, had been generating
great returns for his own portfolio by investing in various Canadian
and U.S. technology stocks.
When M rs. Beyer passed over a sheet of paper listing some of
her son’s recommendations, Carter immediately shook her head.
The proposed list of holdings included an excessive amount in
equity mutual funds, especially aggressive high-growth situations,
and not nearly enough in dividend-paying blue-chip fixed-income
funds.
Convinced that the son’s proposed strategy was overly
aggressive for someone with M rs. Beyer’s client profile, Carter
recommended to her a much more conservative approach. M rs.
Beyer balked at the suggestions for change, siding with her son
over someone she was meeting only for the first time.
The easy way out for Carter would have been to go along with
what the son suggested and M rs. Beyer wanted. Carter could
easily have rationalized the choices, since one of M rs. Beyer’s
objectives was to pass on an inheritance to her son. By
questioning the son’s judgement, Carter risked losing an attractive
account.
But in good conscience, Carter could not go along with M rs.
Beyer’s requests without making further inquiries to determine
what in fact was in M rs. Beyer’s best interests. Carter asked her
to set up a meeting with her son so that the three of them could
discuss her situation together.
A few weeks later, the agreed-on meeting started poorly. M rs.
Beyer’s son, Roy, seemed skeptical of Carter’s abilities and was a
little suspicious about her intentions. Undeterred, Carter patiently
explained her responsibility as a mutual fund sales representative,
her concerns about his mother’s account and the reasons for her
recommendations.
After the first meeting, Roy said he was not yet convinced, but
would think about it. His mother concurred. “It took some time, but
after a couple more meetings, her son was impressed with my
recommendations,” says Carter. “In the end, we had totally
revamped the asset mix to ensure prudent allocation of his
mother’s investments.”
With M rs. Beyer more comfortable knowing her son was involved,
Carter also felt more assured that she would be able to get better
results for her client. “We now meet regularly and the trust that
has developed between the three of us is very strong.”
PROFESSIONALISM
It is generally accepted that professionals, by having specialized
knowledge, need to protect their clients, who usually do not have
the same degree of specialized knowledge, and must continually
strive to put the interests of their clients ahead of their own. You
must also make a continuous effort to maintain a high standard of
professional knowledge.
Client All methods of soliciting and conducting business

Business must be such as to merit public respect and
confidence.
• Client Orders: Every client order must be entered
only at the client’s direction unless the account
has been properly constituted as a discretionary
or managed account pursuant to the applicable
regulatory requirements.
• Trades by Registered and Approved Individuals: All
trades and all acts in furtherance of trades,
whether with existing or potential clients, must be
effected only by individuals who are registered
and approved in accordance with applicable
legislation and the rules of the SROs.
Personal All personal business affairs must be conducted in a

Business professional and responsible manner, so as to reflect
credit on the individual registrant, the securities firm,
and the profession.
• Personal Financial Dealings with Clients: You
should avoid personal financial dealings with
clients, including the lending of money to or the
borrowing of money from them, paying clients’
losses out of personal funds, and sharing a
financial interest in an account with a client. Any
personal financial or business dealings with any
clients must be conducted in such a way as to
avoid any real or apparent conflict of interest and
be disclosed to the firm, in order that the firm may
monitor the situation.
• Other Personal Endeavours: You must take care
to ensure that any other publicly-visible activity in
which you participate (such as politics, social
organizations or public speaking) is conducted
responsibly and moderately so as not to present
an unfavourable public image.
COMPLIANCE
You must ensure that your conduct is in accordance with the
applicable SRO rules and regulations.
• Compliance with the Securities Acts and SRO Rules: You
must ensure that your conduct is in accordance with the
Securities Administrators of the province or provinces in which
your registration is held. The requirements of all SROs of which
your dealer is a member must be observed. You cannot
knowingly participate in, nor assist in, any act in violation of any
applicable law, rule or regulation of any government,
governmental agency or regulatory organization governing your
professional, financial or business activities.
CONFIDENTIALITY
All information concerning the client’s transactions and his or her
accounts must be considered confidential and must not be
disclosed except with the client’s permission, for supervisory
purposes or by order of the proper authority.
Client You must maintain the confidentiality of identities

Information and the personal and financial circumstances of
your clients. You must refrain from discussing this
information with anyone outside your dealer, and
must also ensure that the dealer’s client lists and
other confidential records are not left out where
they can be taken or observed by visitors to the
office.
Use of Information regarding clients’ personal and financial

Confidential circumstances and trading activity must be kept
Information confidential and may not be used in any way to
effect trades in personal and/or proprietary
accounts or in the accounts of other clients.
Case Study | Keeping Karl’s Confidence: A Lesson In Proper

Conduct (for information purposes only)
Sonia, a mutual fund representative at a major Canadian

investment firm, has just concluded a meeting with her client Karl.
It was her last meeting of the day, and it was a difficult one. She
had met with Karl to discuss a major life change, where he advised
Sonia that he was getting divorced. It was a very emotional
meeting and required a number of important updates to Karl’s
investment needs and objectives, investment strategy and a
thorough analysis of the impact of the changes to his cash flow
and tax situations. After the meeting and a long day, Sonia leaves
the office looking forward to dinner with her husband, Phil, at a
local restaurant.
Over dinner, a tired Sonia relaxes with her husband and begins to
discuss her day with Phil. Trusting her husband’s opinion, she
talks about the meeting with Karl, but is careful not to use the
client’s name. However, as she becomes more comfortable, she
relays a great deal of the details of Karl’s situation, even letting
the client’s name slip a few times. Phil provides his helpful insights,
of which Sonia is very appreciative.
The following day, Sonia gets a call from Karl. He is very upset,
and complains to Sonia that a friend of his wife’s was sitting a few
tables over from Sonia and Phil at the restaurant. They overheard
Sonia’s conversation, and surmised from the details that they were
discussing Karl and his wife’s situation. They also learned about
Karl’s financial situation and conveyed all of this to his wife.
Karl tells Sonia that his trust has been violated and that he can no
longer rely on her discretion to maintain his privacy. He informs her
that he is terminating his relationship with her and her firm and
lodging a complaint with her employer.
FIVE PRIMARY ETHICAL VALUES
What are the five ethical values that are central to your role
as a mutual fund representative? Complete the online
HOW TO APPLY WHAT YOU’VE LEARNED TO

CASE STUDIES
The following two case studies give you an opportunity to apply
what you have learned throughout this course. As you work
through these cases, try to do your own analysis and come up with
recommendations before looking at the analysis presented. You
may break down the analysis for each case into the following
sections:
• Investment Needs and Objectives
• Personal Circumstances
• Financial Circumstances
• Investment Knowledge
• Risk Profile
• Time Horizon
• Asset Allocation
CASE 1: ROGER BLACK

Roger Black was waiting at the door when your office opened for
the day a few minutes ago. He did not seem particularly rushed. He
just walked over to the counter and asked if he could speak to
someone who could provide him with mutual fund information. The
receptionist directed him to you.
Roger explains that he wants to make his annual RRSP
contribution, and he is considering investing in one or more mutual
funds. You explain to him that you offer a number of different mutual
fund investments ranging from money market funds to international,
domestic and specialized equity funds.
He explains that he can contribute about $12,000 to an RRSP for
this taxation year, and he was thinking of putting it all into units of
the Canadian Growth Fund. He has already read parts of the fund
facts document and is here to place an order. Roger also mentions
that he has $160,000 in mutual funds within an RRSP with a
competing firm.
You explain that before you can accept an order, you must ask a
number of questions in order to judge the suitability of the
proposed investment. You ask if you can start filling out the mutual
funds application form. Roger agrees.
Based on the responses to the questions on the form, and to
additional questions you have asked, you find that Roger is 34
years old and a marketing professor at a local university. His annual
income consists of income from employment of about $70,000 and
a small amount from savings deposits and T-bills. He is single but
plans to marry in the near future. The couple will likely have two
professional salaries.
Roger brought along a breakdown of his investment portfolio. The
registered (RRSP) portion of the portfolio consists of the following:
Registered Portfolio Amount
International equity fund $21,000
Canadian bond fund $10,000
Canadian mortgage fund $8,000
Canadian balanced fund $5,000
Canadian money market fund $16,000
Canadian equity fund $100,000
Total $160,000
The non-registered portion consists of the following:
Non-Registered Portfolio Amount
Asia fund $6,000

Shares of a small French computer manufacturer $20,000
U.S. equity small cap fund $10,000
T-Bills $4,000
Total $40,000
In addition, he has about $15,000 in a maturing term deposit,

$12,000 of which will go toward his mutual fund RRSP purchase
this year.
Roger describes himself as “frugal.” He rents a one-bedroom
apartment and pays $600 per month. He has a car worth about
$10,000. Furnishings, two computers and appliances are worth
about $35,000. He has no outstanding loans, and credit card
balances are paid off in full every month. He estimates that he has
the capacity to save about $1,500 per month.
In response to a question about his level of risk tolerance, Roger
replies that he is willing to focus on the long term to a certain
extent, but that he tends to become anxious when markets are
really volatile. On balance, he considers himself moderately risk
tolerant.
Roger has life insurance offered through his university’s group
benefits program. He is covered for twice his annual salary.
Roger characterizes his investment knowledge as “fair to good.”
ANALYSIS — CASE 1: ROGER BLACK
1. INVESTMENT NEEDS AND OBJECTIVES

Roger is investing to add to his RRSP portfolio. On this basis, it is
fair to conclude that his investment horizon is long term. However,
note that he does not have a house, and virtually all of his assets
are financial in nature. According to his age (34), Roger could be in
the second life-cycle stage (family commitment years). However,
the fact that he is just planning to marry now suggests that he is
still in Stage 1.
This raises an important issue. Stage-1 investors may claim to be
making RRSP investments for the long-term, but may in fact be
only looking for the tax deduction. In reality, they might have given
little thought to retirement. In Roger’s case, marriage and family
responsibilities might lead to a decision to use part of his RRSP
portfolio for a down payment on a house. This would make his
RRSP investment horizon much shorter than the long-term
retirement horizon that his age might suggest.
2. PERSONAL CIRCUMSTANCES
Roger is single but planning to marry in the near future. This puts
him at the beginning of Stage 2, or perhaps at the end of Stage 1.
3. FINANCIAL CIRCUMSTANCES
NET WORTH
We calculate Roger’s current net worth at about $260,000. Of this
net worth, $215,000 is in financial assets. His current asset
allocation, considering both tax-deferred and non-tax-deferred
investments, is as follows:
Small cap equity 14% (computer stock, U.S. small

cap)
Equity 60% (equity funds, Asia fund, half

of balanced fund)
Fixed income 10% (bond fund, mortgage fund,

half of balanced fund)
Term deposit and money 16%

market funds
Total 100%
Note that we included half of the balanced fund as debt and half as
equity. This is just a guess for the sake of convenience. In reality,
Roger’s balanced fund might currently be 70% debt and
30% equity.
Based on the breakdown between equity, fixed income and near-
cash assets, this gives an asset allocation of 74% equities, 10%
fixed income and 16% near-cash.
There are two things to bear in mind as far as this allocation is
concerned. First, Roger has a high percentage (almost 75%) of
equities in his portfolio. Equity holdings can be volatile. Second,
26% appears to be a high amount of fixed income and cash (or
near-cash) to hold for the long term, but it can certainly be justified
if Roger feels that his change in family commitments might lead to a
need for liquidity in the near term.
Also of interest in this client’s portfolio is the allocation between
assets denominated in Canadian dollars versus other currencies.
The breakdown, before any additional RRSP investment, is 73%
Canadian and 27% foreign.
ANNUAL SALARY
Roger’s annual employment income appears to be very secure.
This is particularly true if he has tenure at his university. Roger
estimates that he can save $1,500 per month. This situation could
change with growing family commitments. Recall that Roger’s
fiancée will also be earning a professional salary. This type of
employment often provides good maternity benefits as well.
4. INVESTMENT KNOWLEDGE
Roger has provided an assessment of his level of investment
knowledge as “fair to good.” Based on the composition of his
investment portfolio, we would agree. The high equity component,
the fact that he holds individual stocks, and that there is an existing
asset allocation all support this view.
5. RISK PROFILE AND TIME HORIZON

After discussions with Roger and his completion of an investor
questionnaire, it is clear that he falls in the moderate risk tolerance
and risk capacity category. We are assuming in this instance that
his investment horizon is long term.
6. ASSET ALLOCATION
Roger has stated an interest in a Canadian growth fund. We will
assume that this fund holds 80% of its assets in equities, and
these equities are of small- and medium-capitalization firms.
For a moderate risk profile investor, one who does not like a lot of
volatility; this might result in too high a weight given to the small-
cap equity component of the portfolio. If Roger invests the whole
$12,000 in the growth fund, this will raise the small-cap component
to 20% of the portfolio (or one-fifth).
An alternative investment is a Canadian equity fund. This would
raise the equity component to about 66%. This is perhaps
desirable in Roger’s case.
There is something else that should be brought to Roger’s
attention. It appears that he saves money on a monthly basis and
then makes his RRSP contribution at year-end. If he made RRSP
investments on a monthly basis instead, he would benefit from
dollar cost averaging and, at the same time, avoid the additional tax
burden resulting from the interest earned on his term deposits.
CASE 2: JANET CHEN

Janet Chen has made an appointment to see you. You have been
in touch with her, off and on, for about a year and a half, but she is
not really a client because she has not invested any money using
your services. She is the type of person who wants to know all of
the details but seems to have a lot of trouble making a decision.
You have found her frustrating to deal with.
You have never known Janet to smile, but today she is beaming.
The reason, you discover, is that about one month ago she won
$80,000 (tax-free) in a provincial lottery. She wishes to consult with
you about how to invest her windfall.
You direct Janet into an office and begin by asking if she has
thought about what she would like to do with the money. She
replies that she wants to pay off the remaining mortgage on the
house, but other than that, she wants to invest it for the longer
term. She explains that there is no pension plan where she works.
As a result, she is concerned about her retirement. She has read a
lot about mutual funds lately and she knows that your dealer offers
a number of them. She is not sure if they are suitable for her and
would like your advice.
You begin by explaining that mutual funds are generally riskier than
the savings deposits she has made in the past. You explain that
the values of most types of mutual funds fluctuate from day to day
and mutual fund investments are not covered by deposit insurance.
However, over the longer term, the greater risk should translate
into greater returns. But, there is no guarantee that this higher
return will materialize.
She says that she understands what you have explained and
would like to know if she is a candidate for any of the funds you
offer. You explain that you need to consider a number of factors
before you can make any recommendations and that a good place
to begin is with the account application form.
From the details provided in the account application form, from
other discussions you have had with her today, and from notes you
made in previous contacts with her, you have the following
information: Janet is 43. She and her husband have two children
aged 19 and 15. Janet is the manager of a women’s apparel store.
She has held that job for six years and currently earns $58,000 per
year. Prior to assuming the manager’s position, she was assistant
manager; in fact, she started at the same store 20 years ago as a
sales assistant and has worked her way up.
Her husband’s income has not been very stable over the last few
years. He was injured on a construction job and for the last year
has been receiving workers’ compensation benefits of $1,400 per
month. Prior to his injury his employment was not very stable. He
changed jobs often and was unemployed for a good part of every
year. At 49, it is difficult for him to find steady work. You recall from
previous discussions with Janet that it embarrasses her to discuss
this aspect of the family’s situation.
Janet, her husband and their younger child live in a small house.
The older child is away for most of the year at university in another
province. Janet estimates the value of the house at $220,000.
There is a mortgage of $20,000, which Janet intends to pay off with
part of the lottery winnings. There are no other outstanding loans
or liabilities. Janet has run the household with a good control on
spending, given the family’s tenuous financial situation.
When asked about her investments, she answers that all of her
$19,000 RRSP holdings are in a one-year RRSP GIC. She has
about $3,000 in a chequing/savings account held at a bank. Since
she has not always contributed the maximum allowable amount to
an RRSP, for this taxation year she may contribute up to $15,000.
She has a life insurance policy with a $10,000 death benefit.
Janet’s husband has no RRSP, other savings or life insurance.
When asked about living expenses, Janet says that she manages
adequately with her salary, plus whatever her husband brings in.
Her mother-in-law thinks that some of the windfall should go into a
savings vehicle to fund the children’s university education, but
Janet believes that her kids should pay for most of their education.
She is willing to help out but only in a minor way.
ANALYSIS — CASE 2: JANET CHEN
1. INVESTMENT NEEDS AND OBJECTIVES

Janet and her husband are old enough to be in Stage 3 of the life
cycle (the mature earning years), but because of her husband’s job
difficulties, they might never leave Stage 2. Janet’s income is not
high enough to warrant having tax minimization as a key objective.
However, like many Stage-3 investors, Janet is concerned about
her financial position in retirement.
Note that the windfall does not necessarily result in a change in her
objectives, possibly because it is not a huge amount like $2 million
or $5 million.
2. PERSONAL CIRCUMSTANCES
Janet is a Stage-3 client from the perspective of family
responsibilities. One child is already out of the house and the other
should be in a few years. Whatever financial demands the children
currently make, they will decline as time goes on. Her husband’s
employment picture is a problem for this family, since they could
save much more with an additional steady and solid income. The
windfall will help to a certain extent, since it replaces savings that
would have otherwise been accumulated by the household.
Janet seems not too confident about her ability to make good
investment choices. It is important to understand if Janet’s lack of
confidence is a result of a lack of knowledge about investments
generally, or because of a high level of risk aversion. You can
inform and educate, but you cannot make a psychologically risk-
averse person more risk tolerant.
3. FINANCIAL CIRCUMSTANCES
NET WORTH
Janet and her husband have a net worth, including the $80,000
windfall, of $332,000. To arrive at this number, we add to the
$80,000 windfall the value of the house ($220,000), assume about
$30,000 of other assets including a car and furnishings, and include
RRSP funds of $19,000 and $3,000 cash. We subtract the $20,000
outstanding balance on the mortgage. Of this net worth, $230,000
is in fixed assets (i.e., the house, furnishings and car). The
remainder is made up of the windfall, RRSP funds and cash. The
asset allocation is currently 100% cash or near-cash assets.
ANNUAL SALARY
As indicated above, the current annual income made up of Janet’s
salary and her husband’s compensation benefits is adequate. We
could assume that Janet’s salary is secure given her long
association with the company. But the retail clothing industry is
fickle. Also, Janet provides the principal source of the family’s
income. The loss of this income would put the family in a very
difficult position.
4. INVESTMENT KNOWLEDGE
Janet’s level of investment knowledge is low.
5. RISK PROFILE AND TIME HORIZON

We know from her current asset allocation (ignoring the windfall)
that Janet has not sought out riskier investments in the past. There
is little to indicate whether this is from a lack of investment
knowledge, a lack of savings to invest, or high risk aversion. In
cases like this, the mutual fund sales representative must make the
client aware of the nature of investment risk. The key concern here
is Janet’s salary as the principal income source. This leads us to
some concern for liquidity than would normally be the case for
families with either two income sources or one very secure and
substantial source. If Janet’s husband found full-time, permanent
employment, liquidity would be less of a concern.
After completing an investor questionnaire, you note that Janet
scored higher on the risk tolerance questions than you expected,
based on your conversations with her and given her investment
history. However, she scores lower on risk capacity. This makes
sense, given a variety of questionnaire factors including her age,
her annual salary, her type of employment, and her family’s overall
financial situation. Since she scored lower on risk capacity
compared to risk tolerance, her lower risk capacity contributes to
your determination that she falls into the conservative investor
profile.
In terms of time horizon, Janet has her mind set on long term
savings.
6. ASSET ALLOCATION
Given the single income source and limited savings, plus doubts
about the client’s ability to psychologically tolerate investment risk
and her responses to risk capacity questions, we would tend to
weight the allocation toward more liquid investments.
One allocation that might work here would be to leave the RRSP
funds in GICs. Of the $60,000 remaining windfall (after $20,000
goes to pay off the mortgage), $10,000 could go into a Canadian
M oney M arket fund, $10,000 could go into a Canadian Dividend
and Income Equity fund, $20,000 into a Canadian Short Term Fixed
Income fund, and $20,000 into a Canadian Long Term Fixed Income
fund.
This would give an asset allocation of 39% cash or near-cash, 49%
fixed income and 12% equity. Since Janet can contribute $15,000
to an RRSP this year, it would be best to hold $15,000 of the
$20,000 bond fund within the plan. The highest interest income is
likely to come from the bond fund, and since interest income is fully
taxable, it should be sheltered from current taxation as much as
possible.
This allocation is conservative. If Janet feels that she can tolerate
more risk based on your explanation, you might suggest a small
cap or growth equity fund component (5%). A conservative
international equity fund might be helpful for additional
diversification. The key for Janet is the need for relatively high
liquidity.
Janet is an excellent candidate for an asset allocation service that
constructs an optimized portfolio of mutual funds based on
responses to the questionnaire and then periodically rebalances
the portfolio. M any dealers offer this service and some require that
when mutual fund sales representatives give advice, they restrict
that advice to the recommendations provided by the asset
allocation program.
PUTTING IT ALL TOGETHER
Can you analyze two additional case studies online and

answer the multiple choice quiz questions that accompany
the cases? Complete the online learning activity to assess
your knowledge.
SUMMARY
1. Summarize the roles of ethical decision-making and the
standard of conduct in building trust and confidence within the
securities industry.
◦ The five primary ethical values are:
Duty of care (know your client, due diligence, unsolicited
« orders).
« Integrity (acting with trustworthiness, honesty and fairness
with a focus on priority of client interests, protection of
client assets, complete and accurate information,
disclosure).
« Professionalism (client business, personal business,
continuous education).
« Compliance (compliance with securities acts and SRO
rules, inside information).
« Confidentiality (client information, use of confidential
information).
2. Apply what you have learned throughout this course to various
client scenarios.
REVIEW QUESTIONS

Glossary
A
account closing fees
A charge lev ied by some mutual funds when clients close their accounts.
accredited investor
An individual or institutional inv estor who meets certain minimum requirement relating to
income, net worth, or investment knowledge. Also referred to as a sophisticated inv estor.
accumulation plan
A plan offered by a mutual fund company that enables investors to make automatic
periodic purchases of units of a particular mutual fund.
acquisition fee
See Front-end Load.
active portfolio management

An investment management sty le employed by managers who believ e that financial
markets present occasional inefficiencies which can be exploited to earn excess returns.
Proponents of this approach will try to add v alue through strategies such as market timing
and individual security selection.
adjusted cost base

The deemed cost of an asset representing the sum of the amount originally paid plus any
additional costs, such as brokerage fees and commissions.
administrative bodies
Provincial and territorial securities administrators such as securities commissions or other
regulatory bodies that operate within the provincial and territorial governments. Powers
and operations include registration, disclosure, and inv estigation and prosecution.
alpha
A statistical measure of the v alue a fund manager adds to the performance of the fund
managed. If alpha is positiv e, the manager has added value to the portfolio. If the alpha
is negativ e, the manager has underperformed the market.
alternative managed products

Professionally managed portfolios of basic asset classes and/or commodities and
include segregated funds, hedge funds, commodity pools, exchange-traded funds,
income, trusts, closed-end funds and principal protected notes (PPN).
amortization
Gradually writing off the v alue of an intangible asset over a period of time. Commonly
applied to items such as goodwill, improv ements to leased premises, or expenses of a
new stock or bond issue.
amortization period
The period during which the entire principal amount of a mortgage loan is to be repaid to
the mortgagee.
amortized cost
This cost reflects the fact that mortgages might have entered the portfolio when the
market rate for them was different from their fixed rate.
Annual Information Form (AIF)

A document that contains information not included in a simplified prospectus or annual
financial statements.
annuitant
The person on whose life insurance benefits are based.
annuity
A sum of money inv ested with a life insurance company that is paid out to the investor
based on a predetermined formula. The annual pay outs are composed of both the initial
amount invested and returns generated.
appraisal firms
Firms that engage in the business of collecting mutual fund performance information and
report this information on a regular basis.
arbitrage transactions
The simultaneous purchase and sale of securities traded on different exchanges.
arithmetic mean
A somewhat inaccurate method of calculating av erage annual return. It inv olves adding
up the annual returns and div iding by the number of years.
arrears
Interest or dividends that were not paid when due but are still owed. For example,
dividends owed but not paid to cumulativ e preferred shareholders accumulate in a
separate account (arrears). W hen pay ments resume, div idends in arrears must be paid
to the preferred shareholders before the common shareholders.
ask price
The lowest price at which a seller will accept for the financial instrument being quoted.
asset allocation
The weight of the various components (cash, debt, equity, and money market securities)
of an inv estor’s portfolio.
assets
All things of v alue that are owned by a firm or indiv idual.
assets under management (AUM)

The assets managed by an inv estment firm.
auction market
Market in which securities are bought and sold by brokers acting as agents for their
clients, in contrast to a dealer market where trades are conducted over-the-counter. For
example, the Toronto Stock Exchange is an auction market.
audit
A professional rev iew and examination of a company ’s financial statements required
under corporate law for the purpose of ensuring that the statements are fair, consistent
and conform with International Financial Reporting Standards (IFRS).
auditor’s report
An independent report on the accuracy and validity of a company ’s financial statements.
Autorité des marchés financiers (AMF)

The body that administers the regulatory framework surrounding Québec’s financial
sector: securities sector, the distribution of financial products and serv ices sector, the
financial institutions sector and the compensation sector.
availability bias
A method that allows people to estimate the probability of an outcome based on how
prevalent or familiar that outcome appears in their liv es.
average
A statistical tool used to measure the direction of the market. The most common av erage
is the Dow Jones Industrial Av erage.
average annual return
The av erage of the simple annual returns earned on an inv estment ov er a given number
of years.
B
back-end load
A ty pe of sales fee that is paid by the inv estor when the funds are redeemed or sold. This
fee is calculated on either the initial purchase v alue or the current price which includes any
increase in v alue.
balance of payments
Accounts maintained by a country to record international activ ities, such as foreign trade
and international borrowing and lending. Balance of pay ments accounts actually
comprise two separate accounts: the Current account and the Capital account.
balanced mutual funds

Hold a diversified portfolio of different ty pes of securities: bonds, stocks, and money
market securities. Often, the fund manager will v ary the proportions depending on market
conditions.
bank rate
The minimum rate at which the Bank of Canada will lend money on a short-term basis to
the chartered banks and other members of Pay ments Canada in its role as lender of last
resort.
bankers’ acceptance
A commercial draft (i.e., a written instruction to make pay ment) drawn by a borrower for
payment on a specified date. A BA is guaranteed at maturity by the borrower’s bank. As
with T-bills, BAs are sold at a discount and mature at their face v alue, with the difference
representing the return to the inv estor. BAs may be sold before maturity at prev ailing
market rates, generally offering a higher yield than Canada T-bills.
basis point
A unit equal to 1/100 of 1%.
bear market
A sustained decline in equity prices. Bear markets are usually associated with a downturn
(recession or contraction) in the business cy cle.
bearer bond
A bond that is not registered in the name of a particular investor and can be negotiated
by any holder.
behavioural biases
Systematic errors in financial judgment or imperfections in the perception of economic
reality.
behavioural finance
A field of study that combines psy chology and economics to explain why and how
investors act and how that behaviour affects financial markets.
benchmark
An index or fund that enables y ou to compare the success of a fund or portfolio manager.
benchmark index
An index that reflects a mutual fund’s investment universe and can be used as a standard
against which performance can be measured.
beneficiary
The person who will receiv e the benefits pay able under the contract upon death of the
annuitant.
best practical allocation

An asset allocation where the risk and return lev els are adjusted based upon a client’s
behavioural tendencies. A best practical allocation may slightly underperform ov er the
long term, but is an allocation that the client can comfortably adhere to ov er the long run.
beta
The standard measure of market risk. It shows how much a security or a portfolio
fluctuates when the market as a whole fluctuates.
biases
Personal beliefs that may lead to irrational or emotional choices and decisions.
bid price
The highest price at which a buy er will pay for the financial instrument being quoted.
board of directors
Those that hold the ultimate responsibility for a mutual fund’s activ ities, ensuring that
the investments are in keeping with the fund’s inv estment objectives.
bond
A bond is a debt security that may be issued by either a gov ernment or a corporation.
The issuer of a bond promises to pay a stipulated rate of interest (coupon rate) and to
pay back the principal or par v alue at maturity.
bond fund
A fixed-income fund that inv ests principally in government and corporate bonds.
Branch Compliance Officer (BCO)

The person responsible for ensuring compliance with the regulatory requirements within
the branch by monitoring the conduct of the mutual fund salespeople.
bull market
A general and prolonged rising trend in security prices. Bull markets are usually
associated with an expansionary phase of the business cy cle. As a memory aid, it is said
that a bull walks with his head up while a bear walks with his head down.
business cycle
The series of short-term fluctuations of national income ov er definite periods.
C
call
A call feature allows the issuing corporation to redeem, or pay back, the bondholders
before the stated maturity date. Also known as a redemption.
call option
Giv es its owner the option of buy ing shares at the fixed exercise price prior to the call’s
expiration date.
call premium
Is measured by the difference between a security ’s par v alue and the price the issuer
must pay to call it for retirement.
Canada Education Savings Grants (CESG)

An incentive program for those inv esting in a Registered Education Sav ings Plan (RESP)
whereby the federal government will make a matching grant of a maximum of $500 to
$600 per y ear of the first $2,500 contributed each y ear to the RESP of a child under age
18.
Canada Pension Plan (CPP)

A gov ernment sponsored pension plan to which all employ ed residents in Canada
(except Québec) contribute. Contribution to the plans is automatic. Starting from age 65,
pensioners receiv e a modest monthly amount.
Canadian Investment Funds Standards Committee (CIFSC)
The body that oversees mutual fund classification. The CIFSC tracks investment funds on
a security-by -security holdings basis.
capital
Has two distinct but related meanings. To an economist, it means machinery, factories
and inventory required to produce other products. To an inv estor, it may mean the total of
financial assets invested in securities, a home and other fixed assets, plus cash.
capital and financial account

One of the two accounts of the balance of pay ments that records the flow of pay ments
between countries to finance the acquisition of assets such as stocks, bonds and real
estate.
capital gain
W hen an investor sells an asset for more than its purchase price, a capital gain is
realized. Only 50% of capital gains is taxable; 50% remains tax free.
capital growth
An investment with this return objectiv e will hav e an appreciable lev el of risk and will be
expected to increase in v alue ov er the long term. See also Capital Gains.
capital loss
Selling a security for less than its purchase price. Capital losses can only be applied
against capital gains. Surplus losses can be carried forward indefinitely and used against
future capital gains. Only 50% of the loss can be used to offset any taxable capital loss.
career average plan

Pension is calculated as a percentage of an employ ee’s earnings over the course of her
career (while in the plan). Employees may contribute a fixed percentage of their salary
(such as 5%) to this ty pe of plan. Employ er contributions required to fund the defined
benefit v ary according to factors such as inv estment y ield, mortality and employ ee
turnover.
carry forward
In the case of RRSPs, it refers to unused contribution room that can be used to reduce
taxable income in future periods. In general, unused contributions can be carried forward
indefinitely.
cash account
An account in which no borrowing is permitted.
cash flow
The amount of money coming in from all sources of income and the amount of money
going out to pay bills.
cash flow from operations/total debt ratio

A ratio that gauges a company ’s ability to repay the funds it has borrowed. Cash
flow/total debt ratio = cash flow / total debt.
cash management
A central bank process of controlling the national money supply through the buy ing or
selling of bonds in the market.
Chambre de la sécurité financière

The Chambre is responsible for setting and monitoring continuing education requirements
and for enforcing a code of ethics in the prov ince of Quebec.
client name account

The opposite of a nominee account. A client name account is an account registered
directly in the name of the client of the account with the mutual fund.
client service
This inv olves fully understanding and satisfy ing the unique needs of each client.
closed mortgage
Can often be repaid prior to the end of the term, but a penalty will apply.
closed-end discretionary funds

Funds that hav e the flexibility to buy back their outstanding shares periodically.
closed-end fund
Shares of these funds are bought and sold on the open market. A fixed number of shares
are issued and their v alue depends on market demand and on the v alue of the securities
held by the fund.
code of ethics
A code that establishes norms based upon the principles of trust, integrity, justice,
fairness, honesty, responsibility and reliability.
cognitive bias
Basic statistical, information processing or memory errors that are common to all human
beings. They can be thought of also as “blind spots” or distortions in the human mind.
coincident indicators
Economic indicators that behave similarly and simultaneously with the economy.
Coincident indicators help economists to determine which phase of the business cy cle an
economy is currently in. Examples include gross domestic product (GDP), personal
income, and retail sales.
collateral
Secures a bond by a pledge of an asset in the case of default.
commercial paper
A short-term debt security whose issuer promises to pay the maturity v alue by a stated
date. Commercial paper is issued by v ery creditworthy companies and is therefore quite
liquid.
common shares (common stock)

A common share is said to represent residual ownership of the issuing company and is
therefore entitled to a vote at shareholder meetings. It does not hav e a stated maturity
date and is only paid dividends once preferred shareholders have been paid.
comparison universe
A collection of portfolios that form the basis for comparison.
compliance
Following the rules, whether those rules are legal requirements or dealer policies.
compounding
The effect of reinv esting (rather than spending) the returns on an inv estment, so that
investors earn a “return on a return”.
concentration risk
ETFs are not subject to indiv idual stock or sector exposure limits that normally are part of
a mutual fund’s inv estment objective. If particular sectors hav e had extraordinarily large
gains, then it is possible for the ETF to be highly concentrated in a single stock (in excess
of 10%) or sector (in excess of 40%).
confidentiality
All information concerning the client’s transactions and his or her accounts must be
considered confidential and must not be disclosed except with the client’s permission, for
superv isory purposes or by order of the proper authority.
consumer price index (CPI)

A measure of the av erage of the prices paid for a basket of goods and serv ices
compared to a base year.
contract holder
The owner of a segregated fund contract.
contraction
The phase of the economic cy cle that follows the peak. During a contraction, economic
activity declines.
contractionary
A monetary policy that seeks to reduce the size of the money supply.
contribution in kind
Transferring securities into an RRSP. The general rules are that when an asset is
transferred there is a deemed disposition. Any capital gain would be reported and taxes
paid. Any capital losses that result cannot be claimed.
contribution room
If you do not contribute the maximum allowable amount to y our RRSP in any giv en year,
you can carry forward the unused contribution indefinitely to future y ears. The contribution
room is the annual unused contribution carried forward.
conventional mortgage
W hen the amount of the mortgage loan does not exceed 80% of the appraised v alue of
the pledged property.
convertible bond
Can be conv erted to a given number of common shares, generally of the same
company. Conversion is usually permitted during periods determined by the issuer or the
issuer can force conv ersion if market conditions warrant it.
corporate bonds
Are issued by corporations mainly to finance the acquisition of equipment. They are
subject to interest rate risk but, unlike gov ernment bonds, are also subject to default risk.
Often, specific assets are pledged as collateral to guarantee repay ment of the debt.
correlation
A statistical measure of the degree to which the returns on a security are associated with
the returns on another security.
cost-push inflation
A ty pe of inflation that develops due to an increase in the costs of production. For
example, an increase in the price of oil may contribute to higher input costs for a
company and could lead to higher inflation.
coupon
The promise made by the bond to make semi-annual pay ments to the bondholder.
coupon rate
The periodic (almost alway s semi-annual) interest pay ment that the issuer of a bond has
promised to pay the bondholder.
credit rating
The grading of a company based on the company ’s ability to pay back credit. A high
credit rating means that the company is v ery likely to pay back loans and is not a default
risk.
cumulative
A preferred stock hav ing a prov ision that if one or more of its div idends are not paid, the
unpaid dividends accumulate in arrears and must be paid before any div idends may be
paid on the company’s common shares.
currency
The money used as a form of pay ment by a country.
currency forward contract

A contract between two parties that locks in the exchange rate for the purchase or sale of
a currency on a future date.
current account
One of the two accounts of the balance of pay ments that records the net trade of goods
and services, net pay ments of interest abroad and net transfers between countries.
current assets
Are assets that are expected to be conv erted to cash within one y ear. Cash or cash
equivalents are also considered current assets.
current income
Earned from fixed-income funds that make regular interest or div idend pay ments to the
holder. Generally, an investor seeking current income has the intention of liv ing off the
proceeds.
current liabilities
Are liabilities that are expected to be settled within one year.
current ratio
A liquidity ratio that is calculated by div iding a firm’s current assets by its current liabilities.
current yield
Is computed by dividing the coupon or dividend pay ment for one year by the current
market price of the security. The current y ield is used to compare the short-term return on
different securities. For a money market mutual fund, it is the last sev en days’ annualized
yield; it does not assume compounding of returns.
custodian
Handles the disbursement and receipt of funds as well as the safekeeping of the
securities. This function is performed by a trust company or bank.
cyclical unemployment
The type of unemploy ment that rises when the economy weakens and falls when it
recov ers.
D
dealer market
A market in which securities are bought and sold ov er-the-counter in which dealers acts
as principals when buying and selling securities for clients. Also referred to as the unlisted
market.
death benefits
In a segregated fund, the contract holder’s beneficiary or estate is guaranteed to receiv e
payouts amounting to at least the original premiums inv ested by the contract holder,
excluding sales commissions and certain other fees. The amount of the death benefit is
equal to the difference, if any, between the net asset v alue of the fund and the original
amounts invested.
debentures
Are bonds that have no assets pledged as collateral in the case of default.
debt instruments
Money borrowed from lenders for a v ariety of purposes. The borrower ty pically pay s
interest for the use of the money and is obligated to repay it at a set date.
debt security
A debt security, such as a bond, ev idences a loan which has been made by the inv estor
to the issuer. The issuer of a debt security essentially borrows money from the inv estor
and thereby incurs a debt.
debt/equity ratio
A financial leverage ratio that determines the relationship of debt to equity.
declaration of trust
A legal document establishing the fund’s structure, indicating its principal inv estment
objectiv es, inv estment policy, any restrictions on the fund’s inv estments, who the fund’s
trustee, manager and custodian will be, and the classes or series of units the fund may
have, among other things.
deemed disposition
Under certain circumstances, taxation rules state that a transfer of property has occurred,
ev en without a purchase or sale, e.g., there is a deemed disposition on death or
emigration from Canada.
default risk
This is the risk that a mortgage, bond, or preferred share will not make its anticipated
interest or dividend pay ment, or principal will not be repaid at maturity (in the case of
mortgages and bonds).
deferred sales charge

See Back-End Load.
defined benefit plan

A ty pe of employer-sponsored pension plan that allows the employ ee to determine the
amount of the ev entual pension benefits with relative accuracy. Generally, the benefits
are a given percentage of the employ ee’s salary and are often based on the number of
years of serv ice.
defined contribution (money purchase) plan

A ty pe of employer-sponsored pension plan that does not allow the employee to
determine the amount of the ev entual pension benefits in adv ance. The benefits receiv ed
depend on how successfully the contributions hav e been inv ested ov er the y ears. The
employ ee and the employ er both contribute to the plan.
deflation
A decrease in the general price level of goods and serv ices in a country. Deflation occurs
when the inflation rate falls below 0%.
demand
The tendency of consumers to buy more of a good when its price decreases and less
when its price increases.
demand-pull inflation
Inflation that occurs when demand in an economy outpaces supply.
deposit-taking institution
Companies, such as banks and trust companies, that pool the deposits of thousands of
savers and then inv est those funds in different ty pes of investments.
depreciation
The amount by which the v alue of fixed assets is periodically decreased to reflect the
effects of regular wear and tear.
derivatives (derivative securities)

A security whose value is determined by the v alue of some other security or asset. An
example of a derivative would be an option or a future.
direct distribution
A mutual fund company that has its own centralized order-taking department and sales
staff is said to engage in direct distribution.
directional strategies
Hedge fund strategies that bet on anticipated mov ements in the market prices of equities,
debt securities, foreign currencies, and commodities.
disclosure
Includes insider reports, regular corporate financial reports, timely disclosure of material
changes in the affairs of a company and examination of all prospectuses to ensure that
there is full, true, and plain disclosure. Proper disclosure allows inv estors to make
informed choices.
discount
Occurs when the price of a mutual fund is below its net asset v alue.
discouraged workers
Individuals that are av ailable and willing to work but cannot find jobs and hav e not made
specific efforts to find a job within the prev ious month.
discretionary funds
Sav ings that are not needed for day -to-day liv ing.
discretionary income
The amount of money coming in from employment and other sources minus the amount
of money going out to pay bills.
discretionary trading
Any purchase or sale where the sales representativ e determines the timing and/or price
of a sale or purchase.
disinflation
A decline in the rate at which prices rise – i.e., a decrease in the rate of inflation. Prices
are still rising, but at a slower rate.
diversification
The process of reducing investment risk by inv esting in different ty pes of securities
issued by companies activ e in different industries. Ideally, these securities will not all
have the same response to economic and other ev ents — as some decrease, others will
hopefully increase.
dividend fund
A ty pe of fixed-income fund that holds div idend pay ing common shares and possibly
preferred shares. Dividend funds are distinguished from preferred div idend funds by the
fact that they tend to hold mostly common shares.
dividend income
The dividends received from an inv estment in common and preferred shares.
dividend tax credit (DTC)

Refers to the preferential tax treatment granted to dividend income (common and
preferred) receiv ed from taxable Canadian corporations. The dividend is grossed up by
38% and the tax credit of 15.02% is calculated based on this amount.
dividend yield
Div idends earned during ownership of shares.
dollar cost averaging

Involv es periodically (e.g., monthly) purchasing a fixed dollar amount of mutual fund units.
As the unit price fluctuates, so will the number of units purchased. By inv esting regular
dollar amounts in an increasing market, the av erage cost per unit tends to be lower ov er
the long run.
drawdowns
A transfer of deposits from the chartered banks to the Bank of Canada.
dual employment
Persons that are dually registered as mutual fund sales representativ es and life
insurance agents.
duration
A measure of a bond or a bond portfolio’s sensitiv ity to changes in interest rates. The
higher (lower) the duration, the greater (smaller) the change in the value of a bond in
response to a given change in interest rates.
duty of care
A legal obligation imposed on mutual funds representativ es requiring that they adhere to
a standard of care while performing any acts that could foreseeably harm others.
E
earned income
For an indiv idual, it includes all income from employ ment but it excludes income from
investments and any pension or unemploy ment benefits receiv ed.
earnings per common share (EPS)

A shareholder ratio that is calculated by div iding net income by the number of common
shares outstanding. Shareholders like to see consistent increases in EPS ov er time.
economic indicators
These are a group of statistics that prov ide information about the direction and lev el of
activity of the economy.
economics
A social science that is concerned with an understanding of production, distribution, and
consumption of goods and serv ices.
effective yield
In the case of money market mutual funds, this calculation makes the assumption that the
yield generated over the last seven days will remain constant for one y ear into the future.
It assumes weekly compounding of returns at that rate.
efficient
If markets are efficient, the prices of securities reflect all the information that exists about
them.
efficient market
The prices of stocks or securities reflect all of the information that may exist about those
stocks or securities.
electronic commerce (e-commerce)

Business activ ities, such as purchasing, distribution, sales, and other transactions, that
take place by means of advanced communications and computer technologies.
electronic document
Data recorded or stored in a computer sy stem or other similar dev ice and that can be
read or perceived by a person or a computer sy stem or other similar dev ice. This
includes displays, printouts, and other output of that data.
electronic signature
A signature in digital form that is incorporated in, attached to, or associated with an
electronic document.
emotional bias
The opposite illogical or distorted reasoning. An emotion is a mental state that arises
spontaneously, rather than through conscious effort. Emotions are phy sical expressions,
often inv oluntary, related to feelings, perceptions or beliefs about elements, objects, or
relations between them, in reality or in the imagination.
Endowment bias
People who are subject to endowment bias place more v alue on an asset they hold
property rights to than on an asset they do not hold property rights to.
enforcement
Securities Administrator enforcement may include inv estigating and prosecuting
offenders who violate securities regulations. Securities administrators hav e the authority
to subpoena witnesses, seize documents for examination and operate as administrativ e
tribunals. The securities administrators may also prosecute a v iolator in the courts, which
may result in imprisonment and/or substantial fines.
equilibrium price
The price at which the quantity demanded equals the quantity supplied.
equities (equity instruments)

An investment instrument that prov ides an ownership stake in a company.
equity growth fund

This type of fund seeks out smaller firms that are expected to pay little or no div idends
and to produce significant capital gains as their share prices increase. As a result, equity
growth mutual funds tend to hav e a lot of v olatility and are suitable for inv estors with
higher risk tolerance.
equity index fund

Has the primary goal of earning capital gains by constructing a portfolio designed to
mimic a particular stock market index — often the S&P/TSX Composite Index in Canada.
equity mutual fund

Seeks to earn some combination of current div idend income and capital gains. It
generally inv ests in common shares of larger firms with strong div idend records and
limited capital gains potential.
ethical conduct
The conduct of complying not only with the letter of the law but also with the spirit of the
law.
ethical decision-making
Decision-making based on the principles of trust, integrity, justice, fairness, honesty,
responsibility, and reliability.
ethical responsibility
The responsibility of the inv estment guide to ensure that the client’s needs are respected
and placed before the guide’s own needs (e.g., attaining a sales target) and those of the
employ er.
ethics
The moral principles that go bey ond prescribed behaviour and addresses situations
where rules are unclear or contradictory.
event-driven strategies
Hedge fund strategies that seek to profit from unique ev ents such as mergers,
acquisitions, stock splits and stock buybacks.
excess returns
The possibility of returns abov e those needed to compensate for the risk of an
investment. Undervalued stocks offer the possibility of excess returns.
exchange rate
The price at which one currency exchanges for another.
exchange rate risk

The risk that an unexpected change in exchange rates will alter the v alue of foreign
assets or cash payments expected from a foreign source. This ty pe of risk applies to
global mutual funds. See also Foreign Exchange Risk.
exchange-traded funds (ETFs)

Baskets of securities traded like indiv idual stocks on an exchange. ETFs are similar to
index mutual funds in that they will primarily inv est in the equities of companies that
compose the target index, but the way in which an ETF is structured allows it to be far
more tax efficient than an index mutual fund.
expansion
The phase of the economic cy cle that follows the trough. During an expansion, economic
activity increases.
expansionary
A monetary policy that seeks to increase the size of the money supply.
explicit costs
Costs that are directly borne by the inv estor. They fall into three categories: management
fees, operating expenses, and sales charges.
extra dividend
A div idend paid in addition to the regular div idend.
F
fairness
All relevant information that might hav e an impact on an inv estor’s decision to buy or to
sell must be fully disclosed.
final average plan

Bases the pension on an employ ee’s length of serv ice and av erage earnings ov er a
stated period of time. Often this is the average of the best fiv e consecutiv e y ears of
earnings in the last 10 y ears of employ ment, or the av erage of the best three consecutiv e
years of earnings over the last fiv e years of employ ment.
final good
A finished product that is purchased by the ultimate end-user.
Financial Action Task Force (FATF)

An inter-gov ernmental body whose purpose is to dev elop and promote national and
international policies to combat money laundering and terrorist financing.
financial circumstances
Include the size of the client’s inv estment portfolio, employment and inv estment income,
whether the source of employment income is secure, and the lev el of periodic expenses
incurred.
financial goals and objectives

A client’s reasons for selecting a giv en investment. May be expressed in terms of the
types of desired returns (e.g., growth, interest income) or in terms of desired inv estment
characteristics such as safety or liquidity.
financial intermediaries
Suppliers and users of capital access the markets through the chartered banks, trust
companies, life insurance companies, and investment dealers. These financial
intermediaries can be either deposit-taking or non-deposit-taking institutions.
financial market
The mechanism through which suppliers and users of capital are matched.
financial planner
A professional holding a recognized designation (CFP, ChP or PFP) who assists clients in
establishing and reaching financial goals by analy sing current finances and making
recommendations on reaching financial goals. The Mutual Funds Sales Representativ e is
not expected to play the role of financial planner.
financial planning pyramid

A v isual aid that can be used to help build a financial plan and prioritize decision making
around asset choices.
financial statement analysis

The process of examining and working with the firm’s financial accounting information in
order to assess value and financial soundness.
first-order risks
Risks associated with the direction of interest rates, equities, currencies and commodities.
Broadly speaking, it refers to market-induced risk, or sy stematic risk.
fiscal policy
A deliberate action by a gov ernment (federal, provincial or territorial) to influence the
economy through changes either in spending or in taxation initiativ es.
fiscal year
A company ’s accounting y ear. Due to the nature of particular businesses, some
companies do not use the calendar y ear for their bookkeeping. A ty pical example is the
department store that finds December 31 too early a date to close its books after the
Christmas rush and so ends its fiscal year on January 31.
fixed assets
Are those assets that are expected to last longer than one y ear.
fixed-dollar (constant) withdrawal plan

A ty pe of sy stematic withdrawal plan that allows inv estors to receiv e a periodic fixed
amount of money through the redemption of units of their mutual fund.
fixed-income funds
Consist of fixed-income securities. Fixed-income funds share the goal of generating
current income.
fixed-income securities
Are securities that generate predetermined periodic interest or div idend income. They
include gov ernment and corporate bonds, mortgages, and preferred shares.
fixed-period withdrawal plan

A systematic withdrawal plan that allows the mutual fund inv estor to receiv e money such
that ov er a specified period the mutual fund will be completely paid out.
flat benefit plan

An employee’s monthly pension is a specified number of dollars for each y ear of serv ice.
forecast
To estimate the cash flow to be earned during the year as well as the price y ou think that
you could sell a security for at the end of the y ear.
foreign exchange risk

The risk that an unexpected change in exchange rates will alter the v alue of foreign
assets or cash payments expected from a foreign source. This ty pe of risk applies to
global mutual funds.
foreign investors
Retail or institutional inv estors who reside outside of a country, but inv est in that country.
frequent trader
Individuals who buy and sell mutual fund units activ ely, sometimes holding positions for
as little as one day.
frequent trading charge

Is assessed by some mutual funds to discourage investors from redeeming their units
shortly after purchase or from switching between funds.
frictional unemployment
The result of the labour turnover in a normal, healthy economy, where people enter and
leav e the workforce and jobs are created and terminated.
front-end load
A sales fee that the investor pay s when the fund is purchased. This fee is generally not
charged by banks or trust companies and is based on the dollar v alue inv ested.
fund distributors
Represents the link between a mutual fund and the inv esting public. A fund’s distributor is
often its inv estment company.
fund facts
A short mutual fund document designed to giv e inv estors key information that is relev ant
to their investment decisions, including facts about the fund itself, performance history,
investments, and the costs of inv esting in the fund.
fund manager
Provides day-to-day superv ision of the fund’s investment portfolio.
fund of funds
The investor owns units of a pool of mutual funds.
fund sponsor
The mutual fund investment firm.
fund wrap
A program that prov ides a series of portfolios with multiple mutual funds to reflect pre-
selected asset allocation models. It can be a fund of funds or a portfolio allocation
service.
fundamental analysis
Security analysis that attempts to determine the true or intrinsic v alue of a security by
examining the fundamentals such as sales, earnings, economic changes, competitiv e
forces, and management.
futures contract
A transferable agreement to deliv er or take deliv ery of a fixed quantity of an asset for a
specific price by a specific future date.
G
geometric mean
A calculation that determines the av erage compound return ov er sev eral time periods.
glide path
A formula that defines the change in the asset allocation mix of a target date fund ov er
time, based on the number of y ears remaining to the target date. The closer the target
date, the more conserv ativ e the asset mix.
global equity funds

A ty pe of global mutual fund that earns div idends and capital gains.
global mutual funds

These funds offer international div ersification by investing in the economies of specific
countries or regions anywhere in the world, including Canada.
government bond
A debt security that is issued by the federal, provincial, and municipal governments in
order to finance public spending. These bonds trade OTC, they hav e a wide range of
maturities, and they are considered to hav e little or no default risk.
gross domestic product (GDP)

The market v alue, in current dollars, of all goods and serv ices produced within a country
in one y ear. GDP includes the value of all goods and serv ices produced by Canadian
citizens and foreigners liv ing in Canada and does not include the v alue of goods and
services produced by Canadian citizens and businesses abroad.
gross profit
The excess of sales revenues ov er the costs that were incurred to produce or acquire
the goods that were sold.
gross profit margin ratio

An operating performance ratio that shows the company’s rate of profit after allowing for
cost of goods sold.
growth at a reasonable price (GARP)

A v alue approach to buy ing earnings growth. GARP managers, like growth managers,
seek companies with projections of growing earnings and high and increasing ROEs
(return on equity ) relativ e to the industry av erage. Unlike growth managers, GARP
managers av oid stocks with high P/Es (price/earnings ratios) and P/Bs (price-to-book
ratios).
growth investing
A form of equity investing that is more concerned about the future prospects of a firm than
its present price.
Guaranteed Investment Certificate (GIC)

A deposit instrument most commonly av ailable from trust companies, requiring a
minimum investment at a predetermined rate of interest for a stated term. Generally
nonredeemable prior to maturity but there can be exceptions.
guaranteed minimum withdrawal benefit plan

A GMW B plan is similar to a variable annuity. W ith a GMW B, the client purchases the
plan, and the GMW B option giv es the planholder the right to withdraw a certain fixed
percentage (7% is typical) of the initial deposit every y ear until the entire principal is
returned, no matter how the fund performs.
H
hard retraction
W ith a hard retraction feature, the company must pay any redemption v alue in cash.
hedge funds
Lightly regulated pools of capital run by managers that hav e great flexibility in apply ing
their inv estment strategies.
hedging
The process of reducing the risk of loss from fluctuations in market prices — effectiv ely
locking in the v alue of a portfolio. Derivativ e securities can be used for this purpose.
high-water mark
A fund manager is paid an incentiv e fee only on net new profits. In essence, a high-water
mark sets a bar (based on the fund’s previous high v alue) above which the manager
earns incentive fees.
hindsight bias
Refers to the belief that the outcome of an ev ent was predictable, even if it was not.
Therefore, people tend to ov erestimate the accuracy of their own predictions.
holding period return

A transactional rate of return measure that takes into account all cash flows and increases
or decreases in a security’s value for any time frame. Time frames can be greater or less
than a year.
holdings-based style analysis

Examines each stock in the portfolio and maps it to a style at a specific point in time.
household budget
Outlines the indiv idual or family income and expenditures on a periodic basis with the
intention of determining how much money will be available for sav ings and inv estment.
hurdle rate
The rate that a hedge fund must earn before its manager receives an incentive fee.
Hurdle rates are usually based on short-term interest rates to reflect the opportunity cost
of holding risk-free assets such as T-bills.
I
implicit costs
Trading costs, which are measured by brokerage fees and turnov er.
incentive fees
Fees that are usually calculated after the deduction of management fees and expenses
and not on the gross return earned by the manager.
independent review committee

Under National Instrument 81-107, mutual funds must have an independent rev iew
committee which is required to either approv e or consider conflicts of interest that are
identified by the manager of the fund.
inflation
A generalized, sustained trend of rising prices.
inflation rate
The rate of change in prices.
initial public offering (IPO)

An issuing by a company that has never issued shares before. It requires an estimate of
an appropriate offering price for the shares.
insider
An individual with inside information of material significance about his company that has
not y et been made public.
insider trading
The act of trading in securities based on undisclosed material non-public information.
instalment debenture
A bond or debenture issue in which a predetermined amount of principal matures each
year.
institutional investor
A legal entity that represents the collectiv e financial interests of a large group. A mutual
fund, insurance company, pension fund and corporate treasury are just a few examples.
integrity
Acting in an honest, fair, and trustworthy way.
interest coverage ratio

A financial leverage ratio that reveals the ability of a company to pay the interest charges
on its debt and indicates how well these charges are cov ered, based upon earnings
av ailable to pay them.
interest income
Income earned on fixed-income securities.
interest rate anticipation

A fixed-income inv estment philosophy that inv olves mov ing between long-term
government bonds and v ery short-term T-bills based on a forecast of interest rates ov er
a certain time horizon. Price sensitiv ity to interest rate mov ements increases as the term
to maturity increases and the coupon decreases.
interest rate risk

The basic feature of interest rate risk is that as interest rates rise (fall), the v alue of all
fixed-income securities will decrease (increase).
interest rates
For consumers, interest rates represent the gain from deferring consumption from today
to tomorrow via sav ing. For businesses, interest rates represent the cost of borrowing
money.
international funds
Mutual funds that inv est any where in the world except in Canada.
interval funds
See Closed-End Discretionary Funds.
inventory turnover ratio

An operating performance ratio that measures the number of times a company ’s
inventory is turned ov er in a year. It may also be expressed as a number of day s
required to achiev e turnover.
investigation and prosecution

V iolations are carefully scrutinized and offenders may be prosecuted; the commission
has the authority to subpoena witnesses, seize documents for examination and assume
many functions of an administrativ e tribunal. The securities commission may also
prosecute an action against a violator. This may result in the levy of a substantial fine
and/or imprisonment.
investment company
The firm that receives the management fees from each of the mutual funds under its
control. The inv estment company is responsible for hiring inv estment managers and for
organizing the distribution of the funds.
investment dealer
May act on the clients’ behalf as agent in the transfer of instruments between different
investors, and may also act as principal. Inv estment dealers are also referred to as
brokerage firms or securities houses.
investment fund
Offers inv estors an interest in a pool of securities. Mutual funds are a type of investment
fund.
investment horizon
The length of time within which an inv estor expects a giv en inv estment to satisfy his
investment or return objectiv es.
Investment Industry Regulatory Organization of Canada (IIROC)

The Canadian investment industry ’s national self-regulatory organization. IIROC carries
out its regulatory responsibilities through setting and enforcing rules regarding the
proficiency, business and financial conduct of dealer firms and their registered
employ ees and through setting and enforcing market integrity rules regarding trading
activity on Canadian equity marketplaces.
investment knowledge
How familiar an inv estor is with the risk and return characteristics of securities.
investment manager
(also known as a portfolio manager) Is responsible for constructing and managing the
investment portfolios that make up the v arious mutual funds managed by an inv estment
company.
investment policy statement

The statement that guides the ov erall asset management of the mutual fund portfolio.
investment portfolio
The fundamental characteristic is that it is a div ersified collection of securities. Those
securities may include stocks, bonds, money market securities, and ev en derivatives.
iShares CDN S&P/TSX 60 Index Fund

Units are traded on the Toronto Stock Exchange and are bought and sold
through stockbrokers. The S&P/TSX 60 is composed of 60 of the largest Canadian firms.
J
January Effect
Stocks in general, and small stocks in particular, that mov e abnormally higher during the
month of January.
K
Know Your Client
The mutual fund adv isor must use due diligence to learn the essential facts relev ant to
ev ery client and every order. Information concerning the client’s personal and financial
circumstances, inv estment needs and objectiv es, investment knowledge, risk profile, and
investment time horizon, is required in order to make an appropriate inv estment
recommendation.
Know Your Product

Understand the characteristics (e.g. risk lev el, fees, ty pe of income generated, and tax
consequences) of all the funds offered for sale.
L
labour force
The sum of the population aged 15 y ears and ov er who are either employed or
unemployed.
lagging indicators
An economic indicator that measures that change after an economy has passed through
a phase in the business cy cle.
leading indicators
An economic indicator that helps to determine which phase of the business cy cle is likely
to occur in the future.
legal responsibility
The responsibility of the inv estment guide to ensure that each client buy s only suitable
investments. All provincial securities acts make this legal responsibility clear.
leverage
The use of borrowed funds to inv est.
liabilities
The obligation to prov ide goods, serv ices, or cash at some time in the future. Simply
stated: what is owed by a firm or an indiv idual.
life annuity
An annuity whose pay ments are guaranteed as long as the inv estor liv es.
life-cycle hypothesis
The basis of the hypothesis is that as people age, their objectives, financial and personal
circumstances, and risk tolerance change as well. Though the hy pothesis is not infallible, it
can facilitate the task of “knowing y our client.”
Life Income Fund (LIF)

A termination option available to holders of locked-in pension funds such as a LIRA. A LIF
is similar to a RRIF but it has both a minimum and a maximum annual withdrawal
requirement. Funds from a standard RRSP are not transferable to a LIF.
life insurance
A contract between an insured holder and an insurer, where the insurer promises to pay a
designated beneficiary a sum of money in exchange for a premium, upon the death of the
insured person.
life withdrawal plan

Similar to the fixed-period plan, except the period selected is the expected remaining
lifetime of the inv estor.
limit order
An order to buy or sell a security at a specific price or better.
limited partnership
A ty pe of partnership whereby a limited partner cannot participate in the daily business
activity and liability is limited to the partner’s investment.
liquidity
Refers to the readiness with which an asset can be sold without requiring the seller to
make a large price concession.
liquidity ratio
A financial ratio that attempts to determine a firm’s ability to meet its short-term liabilities
from its current assets. See Current Ratio.
load
Sales commission charged to individual inv estor. See Back-End Load and Front-End
Load.
Locked-In Retirement Account (LIRA)

W hen a registered pension plan is terminated prior to retirement (e.g. when an indiv idual
changes employ ers), plan funds may be transferred to a LIRA. The funds cannot be
withdrawn before the holder reaches a designated age.
lock-limit up
W hen a commodity contract has reached it’s permitted daily price limit on the upside, the
commodity is said to trade lock-limit up. W hen lock-limit up (or lock-limit down on the
downside), trading can only take place at the lock-limit up price or lower on that day.
Locked-In RRSP
The holder of a locked-in plan cannot withdraw any of the money until the holder reaches
a particular age depending upon the prov ince of residence.
long position
Signifies ownership of securities. “I am long 100 BCE common” means that the speaker
owns 100 common shares of BCE Inc.
long-term liabilities
Are liabilities that are not likely to be paid off within one year.
loss aversion
A stronger impulse to avoid losses than to acquire gains.
M
macroeconomics
The field of assessing the performance, structure, and behav iour of the economy as a
whole.
managed futures
Involv es the active trading of deriv atives products and strategies on phy sical
commodities, financial assets and currencies.
managed products
Professionally managed portfolios of basic asset classes and/or commodities.
Components of managed products could include segregated funds, hedge funds,
commodity pools, closed-end funds and principal protected notes (PPN).
management expense ratio (MER)

A calculation that is required under National Instrument 81-102. It allows inv estors to
compare the lev el of management fees and expenses from one fund to another. It
includes both management fees as well as fund expenses.
management fees
These fees are charged by all mutual funds and are deducted from the fund itself to pay
the fund managers or inv estment adv isory serv ices.
margin
The amount that an investor is required to leav e on deposit when using borrowed funds to
purchase securities. The margin is usually a fixed percentage of the v alue of the
securities.
margin account
An account that uses money borrowed from a stockbroker to buy securities.
marginal tax rate

Refers to the rate of tax to be paid on the next dollar of income earned from any source.
market
Any arrangement whereby products and serv ices are bought and sold, either directly or
through intermediaries.
market efficiency
This hypothesis argues that all av ailable information about the markets is reflected in
market prices, which is to say that it is impossible to earn excess returns by simply using
publicly available information.
market order
An order to buy or sell a security at the current market price.
market ratios
See Value Ratios.
market review
A section of mutual fund financial statements where the fund manager explains what has
happened to rates, and therefore the performance, of the fund over the recent past, and
why. The fund manager also prov ides a forecast or outlook for the fund over the next few
months.
market risk
Refers to the risk of fluctuations in the market as a whole — if the stock market is in a
slump, this will influence a fund that inv ests in stocks. Ev en a highly div ersified mutual fund
has market risk.
market sentiment
The ov erall attitude of inv estors toward a particular stock or the stock market in general.
market timing
The act of shifting from one class of security to another (e.g. from bonds to stocks) based
on expectations of where the economy or the markets may be heading.
marketable government bond
Bonds for which there is a ready market (i.e., clients will buy them because the prices and
features are attractive).
material fact
A fact that, if correctly stated, would likely lead inv estors to change their purchase
decision.
maturity date
The date at which the bondholder expects to get the par v alue of the bond back.
maturity guarantee
The minimum dollar value of the contract after the guarantee period, usually 10 y ears.
This amount is also known as the annuity benefit.
mean
A central value of a set of numbers. Or, the sum of the v alues div ided by the number of
values. Also known as the av erage.
microeconomics
Refers to how the individual is affected by changes in prices or income lev els.
minimum investment
An investor exemption from receiv ing a prospectus based on a prescribed minimum
investment. NI 45-106 sets the minimum across Canada at $150,000.
momentum investing
A form of equity investing where proponents believe that strong gains in earnings or stock
price will translate into stronger gains in earnings or stock price.
monetary aggregates
An aggregate that measures the quantity of money held by a country ’s households,
firms, and governments. It includes various forms of money or pay ment instruments
grouped according to their degree of liquidity.
monetary policy
The regulation, by a Gov ernment, of the money supply and av ailable credit for the
purpose of promoting sustained economic growth and price stability.
money laundering
The fact of accepting cash (or assets) obtained illegally and making it appear legitimate.
It is a criminal offence punishable under Canada’s Criminal Code.
money market funds

These are considered to be the lowest risk of all mutual fund investments. The fund
invests in money market securities, such as T-Bills and commercial paper.
money purchase plan

A ty pe of Registered Pension Plan; also called a Defined Contribution Plan. In this ty pe of
plan, the annual pay out is based on the contributions to the plan and the amounts those
contributions hav e earned ov er the y ears preceding retirement. In other words, the
benefits are not known but the contributions are.
money supply
The total amount of money av ailable in an economy at a specific time.
mortgage
Essentially includes an obligation by the mortgagor to pay stipulated amounts on a debt
that is secured by a pledge of property.
mortgage fund
Consists of a div ersified portfolio of residential and some commercial mortgages. Some
mortgage funds limit mortgages held to those insured under the National Housing Act
(NHA). Default risk is lowered still by the fact that mortgages that are in default will often
be purchased by the investment company ’s parent firm (i.e. the bank that booked the
mortgage).
mutual fund
An unlimited number of units are issued by the fund and they are bought and sold directly
by the fund itself. The value of a unit is not determined by market demand but by the net
asset value of the securities in the fund’s portfolio.

The Self-Regulatory Organization (SRO) that regulates the distribution (dealer) side of the
mutual fund industry in Canada.
mutual fund sales representative

Individuals who are licenced to sell and prov ide adv ice on mutual funds products to their
clients in the province or territory where they hav e been licenced.
N
A law adopted by the Canadian Securities Administrators (CSA) and followed throughout
the country. It specifies the required structure and content of the mutual fund simplified
prospectus.
A law adopted by the Canadian Securities Administrators (CSA) and followed throughout
the country. It is a wide-ranging set of rules that deals with all aspects of the creation and
management of mutual funds.
National Registration Database

Database for registration of applications for mutual fund salespeople.
natural resource funds

A ty pe of specialized fund that inv ests in the securities of companies engaged in natural
resource industries. Examples of such industries include mining, oil and gas, and forest
products.
natural unemployment rate

Also called the full employment unemployment rate. At this lev el of unemployment, the
economy is thought to be operating at close to its full potential or capacity.
net asset value per unit (NAVPU) or net asset value per share (NAVPS)
It is the net assets of the fund div ided by the number of units outstanding.
net profit margin

A profitability ratio that indicates how efficiently the company is managed after taking into
account both expenses and taxes.
net worth
W hatever an indiv idual has accumulated to date is his net worth. It is the difference
between the total assets and the total liabilities of an indiv idual — what is owned less
what is owed.
New Account Application Form (NAAF)

A form that is filled out by the client at the opening of an account. It giv es relev ant
information to make suitable investment recommendations. The NAAF must be
completed and approved before any trades are put through on an account.
no-load funds
This type of fund charges no sales fee and is predominately offered by subsidiaries of
financial institutions.
nominal GDP
The dollar value of all goods and serv ices produced in a giv en y ear at prices that
prevailed in that same year.
nominal interest rate

The quoted or stated rate on an investment or a loan. This rate allows for comparisons
but does not take into account the effects of inflation.
nominal return
The return on an inv estment that has not been adjusted for inflation. In the case of a bond
it is simply the coupon rate.
nominee account
An account registered in the name of a dealer or third-party administrator on behalf of the
beneficial owner of the mutual fund.
nominee owner
A person or firm (bank, investment dealer, CDS) in whose name securities are registered.
The shareholder, however, retains the true ownership of the securities.
non-conventional mortgage
A mortgage that exceeds 80% of the appraised value of the property. This ty pe of
mortgage requires mortgage insurance under the “National Housing Act”.
non-cumulative
A preferred div idend that does not accrue or accumulate if unpaid.
non-deposit-taking institution
Companies, such as life insurance companies, that do not take deposits. They acquire
capital by pooling the premiums from policies they issue to indiv iduals and then invest
those premiums in capital market securities. In this way, they prov ide sufficient funds to
satisfy the claims of policy holders.
O
odd lot
A transaction in less than a board lot.
offering memorandum
A document that prov ides detailed disclosure, similar to a prospectus, but that is not
rev iewed by any regulatory agency and that does not prov ide inv estors with the same
legal remedies.
Old Age Security (OAS)

Pension is pay able at age 65 to all Canadian citizens and legal residents including landed
immigrants and those with visitors’ permits.
open mortgage
A ty pe of mortgage that, at any time before the end of the term, can be repaid by the
mortgagor (the borrower) without penalty.
open-end mutual fund (open-end fund)

See Mutual Fund.
open-end trust
The trust structure enables the fund to av oid taxation. Any interest, div idends or capital
gains income, net of fees and expenses, is passed on directly to the unit holders. The
fund does not incur tax liability.
open-market operations
Method through which the Bank of Canada influences interest rates by trading securities
with participants in the money market.
operating expenses
In the case of a mutual fund, it refers to expenses that arise from the day-to-day activ ities
of the fund. Examples include brokerage fees, securities filing fees, audit fees and
administrativ e expenses.
operating performance ratios

Ratios that illustrate how well management is making use of the company ’s resources.
These ratios include profitability and efficiency measures.
option contract
A derivative security which giv es the holder the right, but not the obligation, to buy or sell
the underly ing asset within a fixed period for a fixed price.
option premium
This is the price an inv estor pay s for an option.
organized exchange
The location (either phy sical or electronic) where buyers and sellers of securities are
sy stematically matched.
output gap
The difference between real GDP (actual production) and potential GDP (what the
economy is capable of producing). Economists use the output gap as an indicator to
measure inflationary pressures.
overconfidence
Unwarranted faith in one’s intuitiv e reasoning, judgments, and cognitiv e abilities.
over-contribution
An investment into an RRSP that exceeds the allowed amount of contribution. The ov er-
contribution is not tax deductible, and the indiv idual may be subject to a penalty if the
ov er-contribution exceeds a cumulative lifetime ov er-contribution limit of $2000.
overnight rate
The interest rate that is set in a marketplace called the ov ernight market where major
Canadian financial institutions lend each other money on an ov ernight basis.
over-the-counter (OTC)
The OTC market has no phy sical location as such. It is really a large computer network
through which investment dealers negotiate transactions among themselv es. Most bonds
trade OTC but the shares of some small and large companies can also be traded OTC.
P
par value
This is the face v alue or the stated v alue of a bond or a preferred share. Securities may
trade abov e, below, or at their par v alue.
pari passu
A legal term meaning that all securities within a series hav e equal rank or claim on
earnings and assets. Usually refers to equally ranking issues of a company ’s preferred
shares.
participation rate
The share of the working-age population in the labour force. The participation rate shows
the willingness of people to enter the workforce and take jobs.
passive portfolio management

An investment management sty le employed by managers who believ e that financial
markets are efficient (that is, all av ailable information is reflected in the price of a security )
and therefore present no opportunity to earn significant excess returns. Proponents of this
approach will seek to match the performance of a market segment or index by mimicking
its risk and return characteristics. Unlike activ e managers, passiv e managers do not try to
add v alue through strategies such as market timing and indiv idual security selection.
Payments Canada
An organization that establishes, operates, and maintains sy stems for the clearing and
settlement of payments among member financial institutions on behalf of their clients—
individuals, businesses, and gov ernments.
peer group
A group of managed products (particularly mutual funds) with a similar inv estment
mandate.
perfect negative correlation

The patterns of returns of different classes of securities are mirror images of each other,
with the peaks of one security corresponding with the troughs of the other.
perfect positive correlation

The patterns of returns of different classes of securities match each other, with the peaks
of one security corresponding with the peaks of the other.
performance assessment
The process of comparing a mutual fund manager’s results with those of an established
and reliable benchmark to determine if there has been a comparativ ely “good” return on
investment.
performance averaging formulas

The method by which a PPN’s final pay off is based not on the v alue of the underly ing
asset at maturity, but on some average performance of the underly ing asset ov er the life
of the note.
performance participation cap

A principal protected note with a performance participation cap promises to pay the
return earned by some particular asset up to a maximum amount.
performance universe
A large number of other mutual funds with similar characteristics against which a mutual
fund can be compared.
personal circumstances
These include clients’ age, whether they are single or married, how many children they
have, and what kind of lifesty le they wish to maintain. They hav e a major impact on the
ability of the investor to bear risk and on the financial goals selected.
personal data
The personal information of a person that may include age, marital status, number of
dependants, risk tolerance and health and employ ment status.
Personal Information Protection and Electronic Documents Act (PIPEDA)

The Act that provides protection for personal information and grants legal status to
electronic documents.
Phillips curve
A graph showing the relationship between inflation and unemploy ment. The theory states
that unemployment can be reduced in the short run by increasing the price lev el (inflation)
at a faster rate. Conversely, inflation can be lowered at the cost of possibly increased
unemployment and slower economic growth.
policy statements
Clarify the position of the securities commissions on v arious issues. They may be issued
as national policies and instruments, prov incial policies, or uniform policies, e.g. NI 81-101.
Pooled Registered Pension Plan (PRPP)

A ty pe of retirement savings plan offered by the federal gov ernment. The plan is
designed to address the gap in employ er pension plan cov erage by providing
Canadians with an accessible, large-scale, low-cost pension plan.
portfolio allocation service

A ty pe of fund wrap where the client owns units of sev eral mutual funds in the proportions
established through the allocation service.
portfolio asset allocation

This refers to the selection of the classes of securities to be held the proportions of
equities, debt securities, and money market securities.
portfolio funds
Mutual funds that inv est in other funds instead of buy ing securities directly.
portfolio investment objectives

Are most often presented in terms of the ty pes of return that the portfolio should generate
and, indirectly, the lev el of risk that will be assumed in order to earn those returns.
portfolio manager
A professional inv estor who selects the securities that belong to the portfolio.
potential GDP
The goods and serv ices an economy is capable of producing when its existing inputs of
labour, capital, and technology are fully employed at their normal levels of use.
pre-authorized contribution plan (PAC)

Automatic purchase plans or contributions, where investors can purchase units in regular
installments throughout the y ear.
pre-authorized investment plan

See Voluntary Accumulation Plan.
precious metals funds

Specialized mutual funds that focus on securities related to precious metals, such as gold
and silv er.
preferred dividend funds

A ty pe of fixed income fund that holds primarily div idend pay ing preferred shares and
possibly common shares. Preferred div idend funds are distinguished from div idend funds
by the fact that they tend to hold mostly preferred shares.
preferred shares
Preferred shareholders will receiv e a fixed div idend before common shareholders. They
are granted voting rights only under special circumstances, and will receive a
predetermined dollar amount (par v alue) should the company dissolv e.
premium
The price of a fund is abov e the net asset v alue.
price-earnings ratio (P/E)

A shareholder ratio that shows how much inv estors are willing to pay for the current
earnings of a firm and what they believ e the firm’s growth prospects are. It is calculated
by dividing the current price per common share by the current EPS.
primary market
This is the market for newly issued and underwritten securities that have nev er been
offered to the public.
principal protected note (PPN)

A debt instrument. It has a maturity date upon which the issuer agrees to repay inv estors
their principal. In addition to the principal, PPNs prov ide interest paid either at maturity or
as regular pay ments linked to the positiv e performance of the underly ing PPN asset. The
underlying assets can be common stocks, mutual funds, stock indices, commodities, or
hedge funds.
Privacy Commissioner
The federal law establishes a Priv acy Commissioner as an ov ersight mechanism.
Consumers have the right to file a complaint about any aspect of compliance with
PIPEDA. Clients are entitled to file a complaint against a financial institution’s apparent
breach of compliance with the measures adopted in the federal law for the protection of
their personal information. The Commissioner is empowered to receiv e complaints;
conduct inv estigations; attempt to resolv e complaints; and audit the personal information
management practices of an organization.
private placement
The underwriting of a security and its sale to a few buy ers, usually institutional, in large
amounts.
probate
A prov incial fee charged for authenticating a will. The fee charged is usually based on the
value of the assets in an estate rather than the effort to process the will.
professional management
The fundamental serv ice offered by mutual funds. It is the role of highly qualified portfolio
managers to select investments that are likely to generate returns that reach certain
performance targets.
professional responsibility
The responsibility of the inv estment guide to provide the best client serv ice possible and
to refuse to sell a product that is felt to be unsuitable.
profit
That part of a company ’s rev enue remaining after all expenses and taxes hav e been
paid and out of which div idends may be paid.
prohibited practices
Practices that are illegal or otherwise unacceptable to securities regulators.
prospectus
A legal document which must accompany all new security issues. It primarily outlines the
financial condition of the issuer, the use to which the funds raised will be put, and the risk
associated with the securities.
purchase price per unit

The total cost per unit an investor pay s including any acquisition fees. It is calculated by
dividing the NAV PU by 1 minus the acquisition fee percentage.
purchasing power
It is the ability of a dollar to buy goods and serv ices. As purchasing power decreases, an
individual is able to purchase fewer goods and serv ices for the same amount of money.
Q
quartile (quartile rankings)
A ranking system that shows how well an indiv idual security or mutual fund has performed
compared to its peers. A first quartile ranking implies that the fund’s performance is in the
top 25%, or equivalently, that it outperformed 75% of its peers. A second quartile ranking
implies that the fund’s return is between 25% and 50% of the top performing funds. Funds
within these two quartiles are deemed to be outperforming their peers. The bottom
quartile, then, would include funds that are under-performing relativ e to their peers. It has
been found to be highly unlikely that a fund will consistently remain in the top quartile ov er
extended time periods.
Québec Pension Plan (QPP)

A mandatory contributory pension plan designed to prov ide monthly retirement, disability,
and surv iv or benefits for all Quebec residents. Employers and employees make equal
contributions.
quick ratio
A more stringent measure of liquidity compared with the current ratio. Calculated as
current assets less inventory div ided by current liabilities. By excluding inv entory, the
ratio focuses on the company’s more liquid assets.
R
ratio analysis
A method of using v arious ratios to ev aluate financial statements.
ratio withdrawal plan

A systematic withdrawal plan that allows mutual fund inv estors to regularly receive a
fixed percentage of the fund value. If the ratio exceeds the total of income and capital
appreciation, capital erosion will result.
real GDP
The dollar value of all goods and serv ices produced in a giv en y ear v alued at prices that
prevailed in some base y ear.
real estate market

This is the market for commercial or residential properties.
real interest rate

The nominal rate of interest minus the percentage change in the Consumer Price Index
(i.e., the rate of inflation).
real rate of return

This refers to the return on an inv estment ov er a giv en period after adjusting for inflation
for the same period.
record keeping
The act of keeping and maintaining accurate financial records.
redemption
A feature that allows the issuing corporation to redeem, or pay back, the bondholders
before the stated maturity date. Also known as a call feature.
redemption fee
See Back-End Load.
referral arrangement
An arrangement where a member is paid (or pays) a fee, including fees based on
commissions (or sharing a commission), for the referral of a client to or from another
person.
Registered Education Saving Plan (RESP)

A ty pe of tax deferred sav ings plan that allows usually parents or grandparents to sav e
for a child’s education. Unlike RRSP contributions, annual RESP contributions are not tax
deductible.
Registered Pension Plan (RPP)

A trust registered with Canada Rev enue Agency and established by an employ er to
provide pension benefits for employ ees when they retire. Both employer and employ ee
may contribute to the plan and contributions are tax-deductible.
Registered Retirement Income Fund (RRIF)

An RRSP termination option that allows the inv estor to retain the same inv estments as
were held in the RRSP. A RRIF requires minimum annual withdrawals which must begin by
the end of the second calendar y ear following the plan’s initiation. Like RRSPs, RRIFs are
transferable between financial institutions and an inv estor may hav e more than one.
Registered Retirement Savings Plan (RRSP)

Allows contributors to sav e some of their annual earned income, up to allowable limits,
while deferring income taxes on the contributions. Any earnings held within the plan are
sheltered from taxes but, upon withdrawal, are taxed as regular income regardless of
their source (e.g., dividends, capital gains or interest).
registrar
Usually a trust company appointed by a company to monitor the issuing of common or
preferred shares. W hen a transaction occurs, the registrar receives both the old
cancelled certificate and the new certificate from the transfer agent and records and signs
the new certificate. The registrar is, in effect, an auditor checking on the accuracy of the
work of the transfer agent, although in most cases the registrar and transfer agent are the
same trust company.
registration
Every one who sells securities, or counsels and adv ises inv estors, must be registered
with the appropriate prov incial or territorial securities administrator. This is to monitor the
competence and ethical behav ior of people involv ed in the selling of securities.
regret aversion
People who are subject to regret av ersion bias av oid making decisions because they
fear, in hindsight, that whatev er they decide to do will result in a bad decision.
regular dividend
A term that indicates the amount a company usually pays on an annual basis.
regulators
It is the role of regulators to define the limits of activity for the participants in the financial
sy stem and to ensure that financial market transactions are fair and in compliance with
regulations.
regulatory bodies
Provincial and territorial securities administrators that are responsible for
the administration of the prov incial securities acts.
relative value strategies

Hedge fund strategies that attempt to profit by exploiting inefficiencies or differences in
the pricing of related stocks, bonds, or derivativ es in different markets.
Representativeness bias
An internal system for classify ing objects and thoughts.
reset option
Allows the contract holder to protect profits inside the segregated fund.
retail investors
Individual inv estors who buy and sell securities for their own personal accounts, and not
for another company or organization. They generally buy in smaller quantities than larger
institutional investors.
retained earnings
Net income that is not paid out in the form of dividends but kept by the firm usually to
finance growth.
retract
A feature which can be included in a new debt or preferred issue, granting the holder the
option under specified conditions to redeem the security on a stated date – prior to
maturity in the case of a bond.
return
The return or y ield on a security includes any change in the v alue of the security ov er the
holding period plus any cash flows (e.g. interest, div idends) receiv ed, all div ided by the
original price.
return on common equity (ROE) ratio

An operating performance ratio that indicates management’s effectiveness in maintaining
or increasing profitability in relation to the company ’s common equity capital.
returns-based style analysis

Comparing the fund’s returns (usually 36 to 60 months of data) to the returns of a number
of selected passiv e sty le indices.
reward-to-risk ratio
Provides an indication of how successful a fund is at earning a return giv en the lev el of
risk it assumes to earn that return. It is calculated by div iding the fund’s return by its
standard dev iation of returns.
right of redemption
A mutual fund’s shareholders have a continuing right to withdraw their investment in the
fund simply by submitting their shares to the fund itself and receiving in return the dollar
amount of their net asset v alue. This characteristic is the hallmark of mutual funds.
Pay ment for the securities that hav e been redeemed must be made by the fund within
three business days from the determination of the net asset v alue.
risk
See Volatility .
risk analysis ratios

Ratios that show how well the company can deal with its debt obligations.
risk averse
Descriptive term used for an inv estor unable or unwilling to accept the probability or
chance of losing capital.
risk capacity
A client’s ability to endure a potential financial loss.
risk profile
A description of the ty pe of risk associated with a particular inv estment. Also refers to a
combination of a client’s risk tolerance and risk capacity.
risk tolerance
The financial and psychological readiness of an individual to bear the day to day
fluctuations in the value of their inv estments. People who are unable to tolerate risk are
said to be risk averse. Those who like to take risks are risk tolerant.
risk-adjusted rate of return

The rate of return that is adjusted for risk to be able to compare the performance of two
securities on the same basis.
S
sacrifice ratio
Describes the extent to which Gross Domestic Product must be reduced with increased
unemployment to achiev e a 1% decrease in the inflation rate.
safety of capital
An investment that is not likely to erode the capital of the investor will prov ide safety of
capital. A money market mutual fund, for example, will satisfy this investment objectiv e.
sales charges
A ty pe of explicit cost paid to mutual fund sales representativ es and financial adv isors
who recommend a company ’s funds to their clients.
sales commission
See Load.
savings
The amount of money not needed for current expenditures.
seasonal unemployment
Occurs as a result of industries where workers are not needed in certain parts of the y ear
due to the seasonal nature of the industry.
secondary market
This is the market for securities that hav e prev iously been sold by the issuer. W hen an
investor purchases a security through a broker, this is said to be a secondary market
transaction.
second-order risks
Risks that are not related to the market, but to other aspects of trading, such as dealing,
implementing arbitrage structures, or pricing illiquid or infrequently v alued securities.
Second-order risks include liquidity, lev erage, deal-break, default, counterparty, trading,
concentration, pricing model, security -specific and trading model risks.
sector rotation
A ty pe of equity investing philosophy that is based on the belief that different industries
will perform well during certain stages of the economic cy cle.
sector trading
A fixed-income philosophy for bonds that inv olv es v ary ing the weights of different ty pes
of bonds held within a portfolio.
sector weighting
The selection of the specific industries from which stocks in a portfolio will be chosen.
secured bond
Bonds that include a promise to turn ov er an asset to the bondholders for liquidation if the
corporation fails to make its coupon payments or pay the par v alue at maturity.
securities
Paper certificates or electronic records that ev idence ownership of equity (stocks) or debt
obligations (bonds).
securities administrator
A general term referring to the prov incial regulatory authority (e.g., Securities
Commission or Provincial Registrar) responsible for administering a prov incial Securities
Act.
securities commission
See Securities Administrator.
security
Paper certificates or electronic records that ev idence ownership of equity (stocks) or debt
obligations (bonds).
security analysis
Refers to the evaluation of risk and return characteristics of securities.
security selection
A fixed-income philosophy for bonds that inv olv es fundamental and credit analy sis and
quantitative v aluation techniques at the indiv idual security lev el.
segregated fund
Essentially, the life insurance industry ’s equiv alent of a mutual fund. These pooled
investments are sometimes called v ariable deferred annuities and, like mutual funds,
investors purchase an interest in these funds based on their net asset v alue. Unlike
mutual funds, the v alue of these investments is often guaranteed.
Associations that regulate the companies and the employ ees within a specific industry.
For example, the Mutual Fund Dealers Association (MFDA) is the mutual fund industry ’s
SRO for the distribution side of the mutual fund industry.
serial bond
A bond or debenture issue in which a predetermined amount of principal matures each
year.
service fee
See Trailer Fee.
set-up fee
A one-time fee that is charged by some mutual funds the first time an investor purchases
units.
seven-day yield
Calculated by dividing the ending net asset v alue by the fund’s initial net asset v alue and
then subtracting 1.
shareholder
A person who purchases a stock is a shareholder of the company that issued the stock.
shareholders’ equity
Also known as net worth, this is what is left when liabilities are subtracted from assets.
Sharpe ratio
Similar to the reward-to-risk ratio, but it subtracts the T-bill rate from the return before
calculating the ratio.
shelf registration
Registration of only a simplified prospectus for new issues.
short selling
This occurs when an inv estor sells a security that he does not own. This transaction is
undertaken in order to benefit from a fall in the price of the security.
short-term bond fund

A ty pe of fixed-income fund that combines the characteristics of a bond fund and a
money market fund. This fund inv ests primarily in gov ernment bonds with maturities of up
to five years (though mostly less than three y ears) and money market securities.
simple rate of return
It is the return earned by an inv estment ov er a giv en period without considering
the effects of compounding. Simple rates are useful for looking at the consistency
of returns.
simplified prospectus
For mutual funds, provides all of the information required under National Instrument 81-101
(risk factors of the fund, method of distribution, fees, inv estment objectiv es etc.).
small cap funds

Small capitalization funds, which means that the market v alue of the equity of the firm is
relativ ely low, probably because the firm is small.
soft landing
A business cycle phase when economic growth slows sharply but does not turn negativ e,
while inflation falls or remains low.
soft retraction
A ty pe of retractable preferred share where the redemption v alue may be paid in cash or
in common shares, generally at the election of the issuer.
sophisticated investor
See Accredited Investor.
source of capital
The only source of capital is sav ings. Capital comes from retail, institutional, and foreign
investors.
specialty mutual funds

A category of funds that specialize in a particular industry (sector fund) or a distinctive
type of security. These funds offer a lower level of div ersification than other mutual funds
and may therefore be somewhat riskier.
speculator
An investor who seeks out higher risk funds and investments that offer the possibility of
high returns.
spousal RRSP
This type of plan allows a couple to div ide the ultimate retirement income between them.
See Registered Retirement Sav ings Plan (RRSP).
stability
The opposite of volatility. Stability refers to the amount of change in an inv estment ov er
time. A stable investment is a safe inv estment.
standard deviation
A common measure of v olatility in inv estment returns. It shows how spread out the
returns are with respect to the av erage (mean) return. The higher the standard deviation,
the riskier the inv estment.
standard equity funds

A mutual fund composed of Canadian common stocks that seeks to earn some
combination of div idend income and capital gains.
standard trading unit

A fixed number of shares that constitute a trading unit. The common size is 100 shares,
but it may be as large as 1000 shares depending on the stock exchange and the stock
price.
standards of conduct
The code of conduct that mutual fund sales representativ es should apply in their
relationships with clients.
statement of changes in equity

A financial statement that shows the total comprehensiv e income kept in the business
year after y ear.
statement of comprehensive income

A financial statement which shows a company ’s rev enues and expenditures resulting in
either a profit or a loss during a financial period.
statement of financial position

A financial statement showing a company ’s assets, liabilities and equity on a giv en date.
statement of investment objectives

Mutual funds must set inv estment objectiv es and clearly state the ty pes of investments
that the fund will make in order to attain them.
status quo
The predisposition of people, when faced with a wide v ariety of options, to choose to
keep things the same.
stock
Also called a share or equity. A stock represents an ownership interest in corporations.
Ty pically, stocks do not hav e a stated maturity date and therefore fit within the definition of
a longer-term security.
stock exchange
A marketplace where buy ers and sellers of securities meet to trade and where prices
are established according to supply and demand.
strategic asset allocation

An investor’s mix of specific mutual funds or asset classes consistent with the investor’s
characteristics. The mix is determined mathematically based on capital market
expectations.
structural unemployment
A form of unemploy ment resulting from a mismatch between demand in the labour market
and the skills and locations of the workers seeking employment.
style analysis
The study of style drift (change in a manager’s inv estment style over a period of time) in
a fund’s holdings or returns ov er time.
style drift
Changes in a manager’s inv estment style ov er a period of time.
suitability
A registrant’s major concern in making inv estment recommendations. All information
about a client and a security must be analy zed to determine if an inv estment is suitable
for the client in accounts where a suitability exemption does not apply.
supply
The quantity of a good or serv ice that producers are willing to supply at a particular price
during a giv en time period.
survivorship bias
A form of bias that affects comparison univ erses. As defunct portfolios drop out, they are
excluded from rankings in subsequent quarters; therefore, a performance univ erse is a
univ erse of survivors.
System for Electronic Document Analysis and Retrieval (SEDAR)

A web site containing all Canadian mutual fund documents including the simplified
prospectus, annual reports, and annual information forms.
systematic risk
The risk associated with mutual fund shares or units that can suffer in falling markets
where unit values are subject to market swings.
systematic withdrawal plan

Allows a mutual fund inv estor to automatically redeem units on a regular basis. This ty pe
of plan is of benefit to inv estors who require cash pay outs on which to live or to
supplement their income.
T
T3 Form
Referred to as a Statement of Trust Income Allocations and Designations. W hen a mutual
fund is held outside a registered plan, unitholders of an unincorporated fund is sent a T3
form by the respective fund.
T5 Form
Referred to as a Statement of Investment Income. W hen a mutual fund is held outside a
registered plan, shareholders are sent a T3 form by the respective fund.
target-date funds
A mutual fund that adjusts its asset mix to mov e from riskier to more conserv ativ e as the
maturity date of the fund approaches.
Tax-Free Savings Account (TFSA)

A Government sponsored sav ing plan where inv estment income earned in the TFSA is
tax free.
technical analysis
Security analysis that is based on the premise that the only things that affects stock
prices are supply and demand. This type of analy sis may also inv olv e looking for buy or
sell signals by examining price mov ements or v olume mov ements in stock charts.
term
The period during which a particular rate of interest on a mortgage stay s in effect.
term to maturity
The time between the issuance of a fixed income security and its maturity date, at which
the issuer will pay back the principal.
termination
Leav ing the employ er and transferring internally within the company to another prov ince.
terrorist financing
Terrorist financing (proceeds for crime) provides funds for terrorist activ ity.
time-weighted maturity
See Duration.
time weighted return (TWR)
Also known as the geometric mean return, it involv es adding 1 to each of the observ ed
annual returns, finding the nth root of their product (where n is the number of annual
returns), and finally subtracting 1.
total assets
Includes the estimated market v alue of real estate, the value of all inv estments, and the
value of all other assets held by the client.
total liabilities
Calculated by adding up the outstanding amount on mortgages and loans, as well as
unpaid bills.
tracking error
The degree to which ETFs fails to mirror the index returns.
trading costs
The amount of brokerage fees and commissions paid to buy and sell securities within a
mutual fund.
trailer fee
Is paid by mutual funds to compensate distributors for prov iding ongoing services to the
mutual fund’s clients. These fees are not borne by the fund’s investors but by
the investment company that manages the fund.
trailing commission
See Trailer Fee.
transfer agent
Is responsible for maintaining records of who owns the mutual fund’s units. This function is
usually performed by a trust company.
transfer fee
Is charged when a mutual fund inv estor wishes to switch inv estments out of one fund and
into another fund with the same mutual fund company.
Treasury bill (T-bill)

A T-Bill is a short-term debt security issued by the gov ernment. T-Bills do not pay interest,
instead they are sold at a discount and are redeemed for their par v alue at maturity.
trend ratios
Constructed by selecting a base period (usually treating the ratio for that period as 100)
and then div iding the base period into subsequent periods. Trend ratios are useful for
spotting trends and making comparisons between companies.
trust deed
This is the formal document that outlines the agreement between the bond issuer and the
bondholders. It outlines such things as the coupon rate, if interest is paid semi-annually
and when, and any other terms and conditions between both parties.
trustee
For bondholders, usually a trust company appointed by the company to protect the
security behind the bonds and to make certain that all cov enants of the trust deed relating
to the bonds are honoured. For a segregated fund, the trustee administers the assets of a
mutual fund on behalf of the inv estors.
trustee fee
Is charged to inv estors who hold mutual fund inv estments as stand-alone RRSP, RRIF,
and RESP investments.
trustworthiness
The trait of deserv ing trust and confidence.
turnover rate
The proportion of a total fund’s assets traded in a y ear.
U
underwriting
Occurs when a new issue is purchased by an investment dealer and the dealer bears the
risk that the issue will be sold at the desired price. In a best efforts underwriting, the dealer
does not assume the risk of guaranteeing that all or any part of an issue will be sold.
unemployment rate
A measure of the prevalence of unemploy ment. It is calculated as a percentage by
dividing the number of unemploy ed indiv iduals by all indiv iduals currently in the labor
force.
unique risk
The risk that a particular firm or industry will do poorly, regardless of the performance of
the market as a whole. This type of risk can be eliminated through div ersification.
unsolicited orders
Orders for mutual funds that hav e not been recommended by the salesperson but
instead come from the clients.
users of capital
Individuals, companies, and gov ernments that lev y money by borrowing or issuing
shares (companies only) for a number of reasons.
V
value investing
An equity inv estment philosophy that promotes a conservative approach to money
management. Value inv estors want to buy a firm for less than what the assets in place
are worth.
value ratios
Ratios that show the inv estor what the company ’s shares are worth, or the return on
owning them.
variability
The amount of change in returns of an inv estment ov er a period of time.
variable annuity
An annuity where pay ments to the annuitant will fluctuate in keeping with the changes in
the v alue of the mutual fund from which pay ments are made.
variance
Measures the extent to which the possible returns on a security differ from the expected
return.
vested
The accumulated contributions in an employ er-sponsored pension plan belong to the
employ ee.
volatility
Volatility measures the periodic change in returns in relation to the average or mean
return — the greater the change, the more v olatile the inv estment. A v olatile investment is
a risky investment.
voluntary accumulation plan

Allows the mutual fund inv estor to specify the amount and timing of the regular
investments they are willing to make.
W
wealth
This is measured by the v alue of an inv estor’s sav ings, inv estments, and assets. W hen
their v alue grows at a rate that exceeds the inflation rate, wealth increases.
whipsaws
Rapid intraday or interday price swings in the market that may result in many short-term
trading losses.
working capital
A company ’s total current assets minus its current liabilities.
working capital ratio

See Current Ratio.
Y
yield
See Current Yield and Effectiv e Yield.
yield curve
A graph showing the relationship between yields of bonds of the same quality but
different maturities. A normal y ield curv e is upward sloping depicting the fact that short-
term money usually has a lower y ield than longer-term funds. W hen short-term funds are
more expensiv e than longer term funds the y ield curv e is said to be inv erted.
yield to maturity
Shows the return expected ov er the life of a bond assuming the periodic coupon
payments are reinvested at the yield to maturity. It takes into account the current market
price of a bond, the time remaining to maturity, the par v alue, and the coupon rate.

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THE CANADIAN SECURITIES INSTITUTE

The Canadian Securities Institute (CSI) has been setting the

• CSI is a thought leader offering real world training that sets

TELL US HOW WE’RE DOING

At CSI, we make every effort to ensure that what you learn is

A Note About References to Third Party Materials:

Notices Regarding This Publication:

© 2021 Canadian Securities Institute

Identiﬁers: ISBN 978-1-77176-487-2 (print)

First printing: 1997

Copyright © 2021 by Canadian Securities Institute

SECTION 1: INTRODUCTION TO THE MUTUAL FUND

SECTION 2: THE KNOW YOUR CLIENT

SECTION 3: UNDERSTANDING INVESTMENT

SECTION 4: UNDERSTANDING MUTUAL FUNDS AND

SECTION 5: EVALUATING MUTUAL FUNDS

SECTION 6: ETHICS, COMPLIANCE AND MUTUAL

HOW TO USE THIS TEXT

THE CANADIAN SECURITIES INSTITUTE

2 Overview of the Canadian Financial Marketplace

4 Getting to Know the Client

6 Tax and Retirement Planning

7 Types of Investment Products and How They Are Traded

8 Constructing Investment Portfolios

9 Understanding Financial Statements

10 The Modern Mutual Fund

11 Conservative Mutual Fund Products

12 Riskier Mutual Fund Products

13 Alternative Managed Products

14 Understanding Mutual Fund Performance

16 Mutual Fund Fees and Services

17 Mutual Fund Dealer Regulation

18 Applying Ethical Standards to What You Have Learned

SECTION 1 | INTRODUCTION TO THE MUTUAL FUND

1 The Role of the Mutual Fund Sales

HOW HAS THE MUTUAL FUND INDUSTRY

WHAT IS THE ROLE OF A MUTUAL FUND SALES

MUTUAL FUND SALES IN PRACTICE

2 Overview of the Canadian Financial

WHAT IS INVESTMENT CAPITAL?

SECTION 2 | THE KNOW YOUR CLIENT

4 Getting to Know the Client

WHY ARE CLIENT COMMUNICATION AND

WHAT IS THE FINANCIAL PLANNING

WHAT ARE THE STEPS IN THE FINANCIAL

6 Tax and Retirement Planning

HOW DOES THE CANADIAN TAXATION SYSTEM

SECTION 3 | UNDERSTANDING INVESTMENT

7 Types of Investment Products and

8 Constructing Investment Portfolios

WHAT IS RISK AND RETURN?

9 Understanding Financial Statements

WHAT ARE THE FINANCIAL STATEMENTS?

WHAT IS THE STATEMENT OF FINANCIAL

APPENDIX A: XYZ INC. FINANCIAL STATEMENTS

SECTION 4 | UNDERSTANDING MUTUAL FUNDS AND

10 The Modern Mutual Fund

WHAT IS A MUTUAL FUND?

11 Conservative Mutual Fund Products