We Make Money Easy Episode 9 – Investment Funds

Phil and Andre talk about ways to build your savings.

Download MP3

Show Notes:

The investment fund is the beginner’s leverage for the average retail investor that doesn’t have access to loads of capital.

There are three types of investment funds: Fixed trusts, closed-end funds, and the most common type, open end funds. These are usually known as mutual funds, and they own the market.

Fixed Trusts

Fixed trusts invest in debt securities – remember, we mentioned the kind where you’re lending your money to a company, or giving it to a manager who then lends it on your behalf. These include mortgage funds, bonds, and debentures. Fixed Trusts have a set lifespan, after which the fund is liquidated. So when the mortgage, bond, or debenture matures, you receive your original investment plus any remaining coupon payments. You can’t get out of a fixed trust early, but you can sell your rights to the trust to other investors at a price the market will bear. The trusts themselves aren’t managed, but portfolios of the trust can be

Closed-End Funds

Closed-End Funds have a fixed number of shares, they trade on a stock exchange, or Over The Counter. The price of shares in a closed-end fund is determined by the market, as with any stock An example of a closed-end fund is Warren Buffet’s Berkshire Hathaway, which trades on the NYSE. It’s controlled by Warren Buffett, and invests in shares of companies such as Coca-Cola.

Open-End Funds

Open-End Funds do not have a fixed number of shares. Shares are issued and redeemed so far as it furthers the goals of the fund company, and red The fund issues and redeems on demand at the Net Asset Value Per Share. If you hear the phrase “NAV” when professionals talk about mutual funds, this is what they mean. They’re referring to the value in much the same way you might talk about stock price. This is the most popular type of investment fund. Mutual funds can be purchased as a lump-sum, or over time on an ongoing basis. This tends to be the smartest method of buying funds in a way that fits your budget, since you’re spreading the risk of market timing over a longer span of time. Instead of worrying whether you bought in at the peak of the market, you’re smoothing out those peaks and valleys. This is called Dollar Cost Averaging, and lowers the average costs of units/shares.

Management fee

We discussed management fees in the investments episode, but we want to get into specifics, so you know what you’re paying for. The management fee is a fixed percentage of the fund assets. If there is a 2% management fee, which isn’t unheard of in the US, and is quite low in Canada, and the fund’s average net assets (amount of money in the fund over any span of time) is $100 million, then the manager earns $2 million.

The Management Expense Ratio includes that management fee along with other expenses to the fund such as legal costs, administration fees, etc. So if the MER on that same $100 million fund is 2.5%, then $2M went to the manager, $500k went to other expenses. Marketing costs, by the way, can’t be charged to the MER, so don’t worry whether you’re paying for Fidelity’s billboards and web ads.

Trailer fees are the fees paid out to the distributor of the fund. For example, the firm your advisor works for will be paid by the fund company based on the amount of outstanding units sold through that firm. The advisor then takes a portion of that fee, and that’s generally how mutual fund advisors are paid.

Gains/Losses

When you sell your fund units, the transaction is considered a disposition, meaning that you’ve triggered either a gain or a loss on the units you sold. Capital gains are preferentially taxed, since you took the risk in investing in these units. In Canada, only 50% of your gains are taxed. In the US, as with everything, it’s a bit more complicated. If you held your investment for less than a year, you’re taxed differently than if you’d held the investment for a year or longer. Short term gains are taxed just like employment income. Long term gains, beginning in 2013, are taxed at 20%. If you’re in the lower Federal tax bracket of 15%, your gains get taxed at 10%. Also starting in 2013, there’s a bit of a discount if you hold investments that meet certain criteria for more than 5 years. That is 18% for most of you, and 8% if you’re in that lower tax bracket of 15%.

If you didn’t catch all of that, don’t be afraid to write us and ask for clarification – we’ll be looking at this further when we get into the taxation episode.

So let’s say you bought a fund with a NAV of $10, and sold it a couple of years later for $15. You’ve generated $5 in capital gains. If you’re Canadian, then you report an additional $2.50 per share on the income. Let’s say you’re in the 22% bracket because you earn more than $43k per year. You’re paying $1.10. If you’re American and not in the 15% tax bracket, you’re paying $1 in taxes. If you’re Canadian, don’t feel so bad – that extra dime in taxes means you won’t go bankrupt from hospital fees if you get into a car accident.

On the other hand, let’s say your fund was a dud, and you sold it when it dropped by half its original unit value. So the $5 capital loss might seem like a total crapfest, but there’s at least a bright side. If you live in the US, you can use up to $3,000 of capital losses against your other income. If you’re married and you file separately, then it’s $1500. And if your losses are so great that the $3000 cap doesn’t let you account for all of it, then you can carry another $3000 of losses into the following year. You can keep doing this until your losses are used up.

In Canada, those losses can be carried back two years, and carried forward indefinitely. Of course, these are incredibly simplified summaries, and you should always consult an accountant before getting into financial areas outside of your realm of expertise. As always, we’re just here to give you a general lay of the land.

Subscribe to this Podcast on iTunes

HOW IT WORKS
HOW IT WORKS