Do you know mutual funds?

In recent years, we’ve seen an explosion of highly specialized funds, investing in anything from Internet stocks to commodity futures. The result has been a dramatic change in the mutual funds landscape. It is almost unrecognizable compared to the  situation that existed even five years ago. Not only have many new funds been created, but whole new categories of funds.

To bring you up to speed on the new world of funds, I’d like to look at the new range of options available to investors. You may be surprised to find that some things you took for granted in fund investing are no longer valid.

Canadian Equity Funds:          
I’ll begin with Canadian equity funds. These invest primarily in Canadian stocks. However, many also hold U.S. and international securities, up to the foreign content limit.

There are five sub-categories within this broad grouping:

1. Broadly-based funds: Companies that trade publicly are divided into three types by money manags.

  • Small capitalization firms (‘small cap’) are at the bottom of the pyramid. These are junior companies. There is no hard-and-fast rule as to what constitutes a small cap company and a small cap U.S. firm might be a giant by Canadian standards.

  • Each fund company applies its own criterion in defining a small cap stock, but virtually everyone would agree that a company with a market capitalization (the value of all its publicly traded shares) under $50 million would fit.

    • Mid-capitalization firms (‘mid-cap’) are in the middle. These are typically companies that are on the rise and historically they tend to have strong growth rates.
    • Large-capitalization (‘large-cap’) firms are the giants of the industry-the big banks, Nortel, Alcan, Imperial Oil and the like.

    A broadly-based Canadian equity fund invests in all classes, so you’re buying the full range of the market.

    2. Large-cap funds: These focus only on the big firms. Again, the specific mandate is determined by the fund company but a true large-cap fund would rarely venture beyond the stocks listed on the S&P/TSE 60 Index. Large-cap stocks are generally felt to be more stable and, therefore, less risky. So these funds will tend to appeal to more conservative investors.
    3. Small-to-mid-cap funds: Funds of this type focus on the other end of the spectrum: the smaller companies. The risk is usually higher as a result, but the theory is that the greater profit potential offsets that risk. It’s not always the case, however.

    Over the decade, to the end of October 2000, the average Canadian large-cap fund outperformed the average small-to-mid-cap fund by more than a full percentage point.

    4.  Dividend funds: In theory, the main objective of these funds is to deliver a regular income stream that will benefit from the dividend tax credit. In practice, many of these funds are simply blue-chip stock funds that invest heavily in bank stocks, utilities, and the like.

    There are a few true dividend funds around. You can identify them by taking a close look at their portfolios. If they hold a high percentage of preferred shares, they fit the classic definition of a dividend fund. Otherwise, treat them as a type of large-cap fund.

    5. Labour-sponsored venture capital funds: The original attraction of these funds was the generous tax credits offered by the federal government and some provincial governments. These were given to compensate for the high-risk nature of the funds, which invest in start-up companies.

    The idea is to encourage the development of larger pools of venture capital in Canada, as a way of creating jobs and business expansion. Initially, returns on most of these funds were weak. However in recent years, many of them have scored big gains as a result of early-stage investments in successful technology companies.

    As a result, investors have enjoyed both tax deductions and profits. As well, owning units in these funds creates extra foreign content room in RRSPs. 
    Adapted from the forthcoming book Six Steps to $1 Million, by Gordon Pape, to be published by Prentice Hall Canada.