PROTECTION OF MUTUAL FUND INVESTMENTS

The first Canadian mutual fund was established more than 60 years ago. Today, fund companies manage in excess of $300 billion in assets, in more than 12 million fund holder accounts. One of the reasons for the continued popularity of this investment vehicle is the extensive regulatory framework in place to safeguard mutual fund investments. Some commonly asked questions about the safety of mutual fund investments are as follows:

How is my investment safeguarded?

In accordance with federal and provincial regulations, a mutual fund's assets belong to the fund and its investors, not to the trustee, who is responsible for administrative decisions, or the manager, who is responsible for investment decisions. In addition, securities regulations require that the assets of a mutual fund must be held by a custodian, which is either a Canadian chartered bank or trust company. The funds are therefore protected under banking and trust laws.

What happens if the mutual fund's trustee, manager, or custodian experiences financial difficulties?

Since the assets of the mutual fund are at all times segregated from those of the fund's trustee, manager and custodian, they are not, under any circumstances, available for any use or purpose other than the investment objectives of the mutual fund.

Why isn't my mutual fund investment covered by deposit insurance (CDIC)?

Deposit insurance applies to "deposits" and most guaranteed investment certificates of deposit taking institutions, such as banks and trust companies. Units or shares of mutual funds are "securities" that have fluctuating values, and therefore do not satisfy the definition of a "deposit" as required by CDIC.

What do others think about the level of safety in this type of investment?

Assets under administration by Canadian mutual funds continue to increase, demonstrating consumer confidence in this fast growing sector of the financial services industry.

In addition to the above-noted protections, certain provinces (British Columbia, Nova Scotia, Ontario and Quebec), operate contingency trust funds. These contingency funds, which would be utilized in the event of dishonest behaviour on the part of a salesperson or organization, have never been drawn upon since their inception in the 1960's.

Why do index funds and indexes differ?

The question is often asked: why do indexed funds not exactly replicate the performance of the indexes that they are based on and, why is it that indexed funds based on the same index often have different performances? There are many reasons why these anomalies arise; the four most important of which are discussed below:

The spread on Treasury Bills

The first reason for some of the discrepancy is the fact that indexed funds mimic the performance of an index by buying futures contracts on that index. The price of a futures contract is discounted by the rate-of-return of a risk-free debt security, or more plainly, a T-bill rate-of-return in that country. That is to say that if we are dealing with a futures contract on the S&P 500, the price of the futures contract will be discounted by the US Treasury bill rate. If one were to buy a futures contract on the S&P in the US, one would also earn the T-bill rate-of-return and the futures contract plus the T-bill would exactly replicate the performance of the S&P 500. Because some funds are Canadian based, they are buying Canadian T-bills. The spread between the Canadian T-bill rate and the US T-bill rate shows up as a difference in the performance between the Canadian based fund and the S&P 500 rate-of-return. Historically, Canadian T-bill funds have run 300-400 basis point above US T-bill rates. This condition in general would mean that a Canadian investment or futures contract would earn a higher rate-of-return than the S&P 500, all other things being equal. However, in the last couple of years, the T-bill spread has narrowed and in fact been inverted at times whereby the US T-bill rate is higher than the Canadian T-bill rate. This in turn means that the performance in Canada would lag that of the S&P.

The impact of the Management Expense Ratio

The second reason why a Canadian-based index fund would lag behind the actual index it is predicated on is the cost of the Management Expense Ratio (M.E.R.). Because the M.E.R. is real cost borne by the fund and not borne by the futures contract in a foreign country, the performance of a Canadian-based fund will lag the index by the M.E.R. When certain indexed funds were set up, the T-bill spread was more than enough to offset the M.E.R., the M.E.R. being in the neighborhood of 2.5% and the historical interest rate spread being 3-4%. As stated earlier, when the spread narrows, the M.E.R. becomes a more observable factor in the performance. If current interest rate trends continue and the interest rate spread increases in favour of Canada, once again the impact of the M.E.R. will be drastically reduced. 

The impact of foreign currency exposure on the fund

The third reason why the index fund itself will not exactly duplicate the performance of the index is the impact of foreign currency. As currencies fluctuate in value, which they do continually, the performance of a Canadian-based index fund will differ from that of the foreign currency based index. Certain funds hedge currency and are almost completely currency neutral, which means that in general, the fund will perform at the same level as that of the foreign index with some minor fluctuations in value. The more visible impact of foreign currency exposure is that when comparing two Canadian based funds, one with foreign currency exposure and one without, during periods where the Canadian dollar declines in value vis-à-vis a foreign currency, the fund with foreign currency exposure will outperform the currency-neutral fund. Conversely, in times when the Canadian dollar appreciates in value, the currency-neutral fund will outperform a fund that has currency exposure.

The issue of market timing and futures contracts

The fourth and final point of this discussion as to why the index fund will vary in performance is that of marketing timing. Futures contracts on foreign markets are of considerable size, for example a futures contract on the S&P is at least $650,000US. If the fund itself does not have $650,000 of new cash coming in every day, a futures contract cannot be purchased for that day. This means that the market's performance may be missed by the fund if a contract cannot be purchased. If in fact there is not sufficient monies coming in, this delay in purchasing the futures contract may go on for 2 or 3 days. So, in a time of rapidly rising markets, the fund may in fact have a portion of its monies sitting in cash and will miss the performance of those days in the market. Granted the impact of having a very minute portion of the fund being in cash on any given day is very small, if this happens over a prolonged period of time, if there is not sufficient new money coming into the fund, you will see a larger impact. 

Hopefully, this will give you a better understanding of why there are discrepancies between the index and the indexed fund. Obviously, these factors can all work together to create a large gap or they can have mitigating forces against each other so that the gap is quite small. At times, you may in fact see that the Canadian based index fund outperforms a foreign index. At other times, you will obviously notice that the Canadian sometimes lags, as has been the case recently.