unit 6: managing mutual funds

Canadian Investment Funds Course

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Unit 6: Managing Mutual Funds Welcome to Managing Mutual Funds. In this unit, you will be introduced to the portfolio manager and the various investment styles that he or she may employ. You will learn about financial statements and how they are used to make investment decisions. You will also learn how mutual fund performance is calculated and the factors that affect that performance, including risk. This unit takes approximately 1 hour and 45 minutes to complete. You will learn about the following topics:

• Role of the Portfolio Manager • Financial Statements • Analyzing Financial Statements • Mutual Fund Performance

To start with the first lesson, click Role of the Portfolio Manager on the table of contents.

Lesson 1: Role of the Portfolio Manager

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Lesson 1: Role of the Portfolio Manager Welcome to the Role of the Portfolio Manager lesson. In this lesson, you will learn about how portfolio managers perform their job. You will learn about the different investment styles and analytical techniques that they may employ. Since the portfolio manager is responsible for the management of your clients’ money, it is important to understand his or her role in the mutual fund. This lesson takes 25 minutes to complete. At the end of this lesson, you will able to do the following:

• describe the responsibilities of the portfolio manager • explain the different investment approaches • explain technical analysis • explain fundamental analysis


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The Role of the Portfolio Manager One of the advantages of mutual funds is that investors can take advantage of the services of professional money managers. Each mutual fund has specific investment objectives as laid out in the simplified prospectus. It is the responsibility of the portfolio manager(s) to ensure that those objectives are met. Who is the portfolio manager? Some mutual funds have a single manager while others use a team approach. In any case, the managers are well-trained and experienced professionals. The majority of managers hold the Chartered Financial Analyst® (CFA)® designation, which is bestowed by the Association of Investment Management and Research (AIMR)® of Charlottesville, Virginia. The Charter is granted to those who have completed an intensive course of study including three six-hour exams, as well as three years of relevant work experience. While all portfolio managers must follow the investment guidelines stated for their mutual fund in the simplified prospectus, they have some discretion in their investment decisions to increase returns. Fund managers are remunerated based on the amount of assets in the fund. Therefore, if the fund does well, it attracts more investment and the managers profit. The manager(s) of a mutual fund may be employees of the fund company or an outside entity that specializes in fund management. Some Canadian fund companies directly employ the managers of their Canadian funds, while using outside specialists for funds dealing with offshore investments, which require more specialized, hands-on treatment. For example, to manage a Japanese equity fund a mutual fund company might engage an investment management company based in Tokyo with specific expertise in the Japanese environment. Investment counsel firms Outside organizations that manage mutual fund assets are known as investment counsel firms, portfolio management companies, or portfolio advisors. In most provinces they must be registered with the appropriate securities commission. Registration is only granted to organizations that employ individuals who satisfy certain educational requirements and have at least five years of experience in performing research and financial analysis of investments. At least three of those years must be under the supervision of an advisor having the responsibility for an investment portfolio with a value of at least $1,000,000. Investment counsel firms may provide portfolio management services to just one mutual fund or mutual fund family, or may manage money for a number of clients, including funds from different fund families. These clients may also include individuals with substantial assets or companies with pension fund assets.


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The Responsibilities of the Portfolio Manager The goal of the fund manager is to attain the highest return possible while complying with the stated investment objectives and risk constraints of a particular fund. Obviously, those objectives and constraints will have a marked influence on the return of a particular fund. For example, the risk and return of a mortgage fund will likely be lower than the risk and return of an equity fund. Therefore, when looking at the relative return of various funds it is important to compare funds with the same risk and return objectives. The Investment Approach In many ways investing is an art, rather than a science. Although there are many accepted objective techniques for analyzing investments, each portfolio manager adopts his or her own specific approach to the situation. Here are the four basic investment styles:

• top-down • bottom-up • value • growth

Most portfolio managers employ a combination of these styles when making their investment selections. Top-down Approach With a top-down investment approach, the fund manager first analyzes the macroeconomic environment. Then he or she focuses on the industry, sector, or countries that look favourable considering the economic conditions. Finally, the manager selects companies that he or she feels has the most potential and meets the fund’s investment objectives. In essence, the top-down manager looks at the big picture to help guide his or her investment decisions.

Ted is the portfolio manager for the 21st Century Euro Fund manages a diversified portfolio of European stocks. A recent deposit of $1,000,000 gives Ted new funds to invest. With his top-down investment style, Ted begins by looking at the overall health of various countries in Europe, studying data such as gross national product (GNP), unemployment, and inflation. Ted decides that the German economy seems quite robust and has good prospects for growth. Having decided that Germany will be his target economy, Ted next looks at the various industry sectors in Germany. As a result of his research, Ted decides that the strongest economic sectors are banking and steel. Finally, Ted analyzes the various companies in the banking and steel sectors and decides that Commerz Bank and Deutsche Steel are the best prospects in their respective industry sectors. Ted invests $500,000 in the common shares of each of these companies.


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Top-down Approach and Asset Allocation In addition, a portfolio manager decides on the asset allocation and sector diversification of a portfolio before making the final investment selections. With asset allocation, a portfolio manager determines the weighting or percentages of cash, bonds, and stocks to be held in the portfolio. With sector diversification, a portfolio manager decides on the weighting or percentages of the various sectors or industries in the portfolio. Keep in mind that asset allocation and sector diversification depend on the investment objectives of the mutual fund. Bottom-up Approach The bottom-up approach is the opposite of top-down. This approach concentrates on a company's fundamentals rather than economic factors to choose securities. Bottom-up managers search for individual investments that represent good value, in other words, securities with attractive prices and/or income streams.

Jenny manages the European Value Fund with a bottom-up approach. She has $1,000,000 of new monies to invest and is looking for suitable investments. Jenny starts by looking for companies with good prospects. From her research, Jenny identifies two excellent prospects: Kredietbank, a Belgian financial company, and Peroni Company, an Italian brewing concern. Although the Belgian and Italian economies may not be the strongest in Europe, Jenny decides that the prospects for these companies are very good. Therefore, she invests $500,000 into each company. Value Investing Portfolio managers who employ a value investment style are interested in securities that they feel are undervalued. They begin by analyzing a company's fundamentals to determine what they believe a company is worth, known as its intrinsic value. To ascertain intrinsic value, portfolio managers use measures such as price earnings ratio (known as P/E ratio), which compares a company's current stock price to its earnings per share. Portfolio managers then compare the current stock price or P/E ratio to their intrinsic value to decide whether they will invest in the company. If the stock is trading at a discount, then they invest. If the stock is trading above the intrinsic value, then they wait until the price falls. Since value investing is a more conservative investment approach, many value managers do well in a bear market. Value managers tend to focus on long-term total return on equity.


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Sarita uses a value approach when managing her Canadian equity fund. She performs analysis on two property management companies she is interested in purchasing: Wexford Inc. and Waverly Corp. Sarita uses P/E ratios to determine intrinsic value. According to her calculations Wexford and Waverly should trade at 15 times earnings and 17 times earnings respectively. Currently, Wexford's P/E ratio is 25 times earnings while Waverly's P/E ratio is 10 times earnings. Sarita decides to invest in Waverly since its P/E (10 times earnings) is below her intrinsic value (P/E of 17 times earnings). She will wait to purchase Wexford because its P/E ratio (25 times earnings) is above what Sarita is prepared to pay (15 times earnings). Growth Investing Portfolio managers who use a growth investment style are interested in companies that tend to grow faster than other companies. During the 1990s, the growth investment style became very popular. Smaller companies in the high tech industry had a greater potential to grow than larger, more established companies. Consequently, there was a frenzy of interest in these growth stocks. Growth managers believe that growth in a company's earnings or revenues will directly correlate to an increase in the stock price. Hence, growth managers are not overly concerned about the price they pay for a stock as long as it has growth potential. One measure that growth managers use is earnings per share (known as EPS). The EPS reveals how much profit is being made for each share in the company. In general, the higher the EPS, the better. However, to be truly useful, a company's EPS should be compared to other companies in its industry.

Brad is a portfolio manager for an aggressive growth mutual fund who uses a growth investment style. He narrows down his selections to two stocks in the software industry: Tangent Software Inc. and Trenton eConsultants Co. After studying the earnings for each company, Brad decides that Tangent's earnings have the potential to grow 20% next year while Trenton's earnings are anticipated to only grow 10%. Therefore, Brad chooses to invest in Tangent since he believes that it has more growth potential than Trenton. Exercise: Investment Approach

Choosing Individual Securities With thousands of securities to choose from in Canada alone, investment selection is a demanding process. How do portfolio managers pick their investments?


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Portfolio managers use two basic methods to analyze securities:

• technical analysis • fundamental analysis

While most portfolio managers focus on fundamental analysis, they may also make use of technical analysis. Technical Analysis Technical analysis is a method of evaluating securities based on studying past trends in market activity, prices, and volume. Technical analysts look for patterns or indicators to predict future price movements. Technical analysts are often referred to as chartists since they rely heavily on charts of share-price behaviour and trading volume to make their extrapolations. A pure technical analyst is not concerned with information such as earnings, expenses, or assets, which are of interest to the fundamental analyst. Fundamental Analysis Among portfolio managers, fundamental analysis is the most popular approach to evaluating securities for investment selection. Fundamental analysis involves looking at the fundamentals of a company such as revenues, assets, profits, and competitive position. Fundamental analysts attempt to predict the future prospects of a company by becoming intimately acquainted with the details of the company. The most important sources of information for fundamental analysis are the company's financial statements. Financial statements contain clues to the current health of a company and its potential for growth. As well as making a detailed study of the financial statements, fundamental analysts speak to company officials and others connected to the business, such as customers and suppliers. These discussions help the portfolio managers to understand a company's strategic direction and mitigate expectations. Exercise: Role of the Portfolio Manager

Lesson 2: Financial Statements

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Lesson 2: Financial Statements Welcome to the Financial Statements lesson. In this lesson you will learn about the different financial statements issued by publicly traded companies. You will learn how to interpret the information that is presented on these documents. It is important for you to understand the purpose of these statements since portfolio managers make investment decisions based on these disclosures. This lesson takes 30 minutes to complete. At the end of this lesson, you will able to do the following:

• understand the purpose of each financial statement • describe the components of a balance sheet • describe the components of an income statement • describe the components of a retained earnings statement • describe the components of a cash flow statement


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Understanding Financial Statements Companies that make their securities available to the public are required to publish audited financial statements. These statements are the primary source of information for a fundamental analyst. Securities law outlines the minimum amount of information that must be included in the company's annual report, (which included the audited financial statements), and interim financial statements. Some companies go beyond these minimum requirements and disclose more details. Financial statements must be reviewed by an independent auditor or auditing firm to confirm that the statements have been prepared in accordance with Generally Accepted Accounting Principles (GAAP) and that they fairly depict a company's financial position. As the name suggests, annual reports are published once a year. The date of the report depends on the company's fiscal year, which may or may not coincide with the calendar year. Interim reports are usually published quarterly or semi-annually. Four Financial Statements At a minimum, every annual report must contain four basic financial statements:

• balance sheet • income statement • retained earnings statement • cash flow statement or statement of changes in financial position

In the next pages, we will discuss each financial statement. Balance Sheet The balance sheet is often defined as a snapshot of a company's financial position at a specific point in time. It is sometimes referred to as statement of financial position or statement of assets and liabilities. There are two sides to a balance sheet:

• assets on the left side • liabilities and shareholders' equity on the right side

A company's assets include what it owns and what it is owed. A company's liabilities are what it owes to its creditors. Shareholders' equity represents the shareholders' financial interest, or equity, in the company. Since both sides must balance, the following equation must always hold true:

Assets = Liabilities + Shareholders' Equity Any increase or decrease in the total on one side of the balance sheet must be matched by a corresponding change on the other side.


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For example, if a company issues $500,000 of new bonds, it includes this amount in its liabilities. However, it receives $500,000 in cash, which is added to its assets. Therefore, the two sides always balance.

Assets Liabilities $500,000 $500,000 Shareholder's Equity $0

Note: In most cases the assets and liabilities are recorded on the balance sheet at their historical value rather than market value. (An exception is a mutual fund where the assets or investments are recorded at market value.) Assets The assets of a company are typically divided into two parts:

• current assets • fixed assets

A company may also have the following appear on its balance sheet:

• amortization • intangible assets

Current Assets Current assets Current assets are assets that are likely to be used immediately or in the near future to satisfy the company's financial obligations. Cash: This represents currency the company has in its bank accounts and on its premises. These funds are generally used to meet upcoming financial obligations, such as paying suppliers. Sources of cash could be customer receipts, proceeds of bank loans, or infusions from shareholders. Marketable securities: These securities can be quickly converted into cash. They may include stocks, bonds, and short-term financial instruments, such as Treasury bills. Accounts receivable: These are amounts owed to the company by customers for goods that have been shipped or services that have been performed. To be included in accounts receivable, an amount must be accurate and the company must be relatively certain that it will be paid. When payment is received, the accounts receivable total is reduced and cash is increased by the same amount. Inventories: This amount represents the value of available goods ready to be sold to customers and any raw materials or unfinished goods. Inventories are generally valued at cost, or current market value if it is lower. Prepaid or deferred expenses: These represent expenditures that have yet to be recognized as expenses. For example, a company may pay $10,000 for insurance that


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covers the next 5 years. Each year the company will recognize a $2,000 expense, which will reduce the outstanding balance on the balance sheet. Fixed Assets and Intangible Assets Fixed assets Fixed Assets are intended for long-term use (typically greater than one year). They include items such as buildings, property, and equipment. They represent resources that are used to produce revenue for the firm. These assets are generally recorded at their original cost. Amortization or depreciation Amortization, also called depreciation or depletion in certain cases, represents the deterioration of assets when used to produce revenue. On the balance sheet, amortization reduces the value of these assets. Amortization also appears on the income statement as an expense. It shows amortization over one year, whereas, the figure on the balance sheet represents accumulated amortization over several years. Intangible assets Intangible assets have no physical presence but still represent value to a firm. Examples of intangible assets are copyrights, patents, and other legal rights and licenses that have value. These assets are amortized. Goodwill is a common intangible asset. Goodwill arises when one company purchases another company. The purchasing company may be willing to pay more than the tangible assets of the target company if there is a strong brand name or loyal customer base. Liabilities Liabilities are financial obligations of the firm. Like assets they are divided into two categories:

• current liabilities • long-term liabilities

Current liabilities Current liabilities are financial obligations that are typically due within a year. Accounts payable: When a company purchases materials or services on credit the amount appears in accounts payable. When the company pays for the services or materials, both accounts payable (liability) and cash (asset) are reduced by the same amount, thereby keeping the balance sheet in balance. Accrued expenses: These amounts represent goods or services that the business has received but payment is outstanding. For example, utility companies supplying electricity, water, and natural gas often bill their customers after the fact. Therefore, companies receive the goods before they have to pay for them.


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Tax payable: Although taxes may not be due until a later date, for accounting purposes the tax expense is recognized throughout the year. The taxes payable account stores the amount owing until it can be remitted to the government. Short-term debt: When a company borrows funds for a short period of time, typically for less than a year, it is recorded on the balance sheet as short-term debt. It may also appear as notes payable or short-term notes payable.

Long-term liabilities Typically, long-term debt has a term to maturity greater than one year. It can include bonds, mortgages, and long-term loans. For accounting purposes, when a company pays interest on its outstanding debt, it is recorded as an expense on the income statement.

Shareholders' Equity Shareholders' equity represents the owners' financial interest in the company. In other words, what is left after the liabilities of the company are subtracted from its assets. The shareholders' equity section generally consists of the following:

• capital stock • retained earnings

Some companies also include contributed surplus.

Capital stock Capital stock is the amount of capital contributed to the company by its shareholders or owners. It includes capital originally invested, plus any subsequent investments. Capital stock is also referred to as share capital or equity capital. This section describes the types of stock outstanding, which are generally common and/or preferred shares. Please note that the amounts shown on the balance sheet are the amounts received upon issuance of the shares. The current market value of the shares is irrelevant to the company's balance sheet. Any increase or decrease in the value of the shares on the secondary market affects the shareholders not the company. Retained earnings If a company earns a profit, it can distribute the profit to its shareholders in the form of dividends, reinvest the money in its own business, or a combination of both. The reinvested portion is recorded as retained earnings on the balance sheet. This amount is an accumulated total of all earnings reinvested in the company over the years.


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If a company realizes a loss, then the retained earnings are reduced by that amount. In other words, retained earnings reflect cumulative profits, less dividends distributed, and less cumulative losses. Contributed surplus A company includes a contributed surplus on its balance sheet if it receives funds from sources other than earnings. This situation may occur when a company sells shares for more than its par value. For example, a company may sell 100,000 shares with a par value of $10 for $13 each. In this case, the contributed surplus would amount to $300,000 ($1,300,000 proceeds less total par value of $1,000,000). Exercise: Balance Sheet

Income Statement The income statement shows the income and expenses of a business over a period of time. It is also known as the statement of earnings, statement of operations, or the profit and loss statement. If revenues are greater than expenses, the company shows a profit. If revenues are less than expenses, the company shows a loss. There are six main sections on an income statement:

• operating income • operating expenses • operating profit (or loss) • other income (or losses) • income taxes • net profit (or loss)

Operating income These figures show the revenue generated from sales of the company's products. The gross sales number is recorded minus any adjustments for returned merchandise, bad debts, rebates to customers, and other discounts. Operating expenses These are the expenses incurred by the company in the process of conducting business. Cost of goods sold: Expenses incurred to produce the company's products, such as cost of raw materials, direct labour, electricity, and supplies are included in this category. Selling, general and administrative expenses: These are the indirect costs incurred by the company such as salaries, advertising, and office supplies.


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Depreciation and amortization: When an asset is purchased, it may be used for many years. Over the lifetime of the asset, a portion of the cost is expensed as depreciation each year. Similar to physical assets, non-tangible assets are amortized over a period of time. Depreciation and amortization are non-cash items. Operating profit (or loss) This figure is arrived at by subtracting operating expenses from operating income. This figure shows how much money was made (or lost) from the company's normal business operations. Other income (or losses) Aside from operations, a company may earn income from other sources, such as investments. These items are usually listed under other income. For example, if a company invests in interest-bearing instruments it will receive interest income. From this amount, any interest paid on outstanding company bonds may be deducted. Income taxes Corporate income taxes are based on the pre-tax profit of a company. The pre-tax profit is calculated by taking a company's operating profit, adding other income, and subtracting interest it pays on bonds. Taxes must be deducted before profits can be reinvested in the company or distributed to shareholders. Net profit (or loss) This figure, referred to as the bottom line, represents the overall success of the business. It is calculated by subtracting the income tax expense from pre-tax income. Any net profit (or loss) is then added to (or subtracted from) retained earnings on the retained earnings statement. Retained Earnings Statement The retained earnings statement details how net profits are distributed to shareholders and/or retained in the company. The retained earnings statement serves as the link between the income statement and the balance sheet. This statement takes the previous retained earnings balance, adds the net profit from the income statement, subtracts dividends distributed to shareholders to determine the retained earnings at the end of the period. This new retained earnings figure then appears in the balance sheet as the accumulated total of retained earnings.


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Cash Flow Statement Formerly referred to as the statement of changes in financial position, the cash flow statement summarizes the actual flow of cash from the company's activities during the year. By examining the changes in a company's cash flow over time, you can assess the following:

• the company's ability to generate cash when needed • whether the company has the cash to meet its financial obligations • whether the company has enough cash to pay dividends or to reinvest

The cash flow statement is divided into three sections:

• operating activities • financing activities • investing activities

Operating activities Cash inflows and outflows incurred from a company's operating activities are included in this portion of the cash flow statement. Many of these items are from the income statement. However, items such as depreciation and amortization are excluded because they do not involve movement of cash. This section may also include adjustments for revenues and expenditures that have yet to be paid or received. Generally, these are items in accounts receivable and accounts payable.

Financing activities This section details the items that relate to the financing of the business, such as raising money through stock or bond issues. Any repayment of outstanding debt or dividend distribution is also recorded under financing activities.

Investing activities Items such as cash expenditures for the purchase of assets or cash receipts through the sale of assets are found in this section. Income from investments, such as interest of dividends, will also be included here. Notes to Financial Statements Investors should be aware of one other important element of financial statements. These are known as notes to financial statements, and they are often included to clarify financial statements or to provide additional information.


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Because these notes contain information that may be important for an accurate comprehension of financial statements, they should be carefully studied. Here is a partial list of what topics might appear in notes to financial statements:

• consolidation of financial statements. This occurs when the financial statements of a parent company and its subsidiaries are combined. As a result, transactions between the parent company and its subsidiaries are eliminated.

• share capital • long-term debt • fixed assets • depreciation • deferred income taxes • lease obligations • the method of converting transactions in foreign currencies to Canadian dollars • investment holdings • legal actions in progress against the company

Exercise: Financial Statements


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Lesson 3: Analyzing Financial Statements Welcome to the Analyzing Financial Statements lesson. In this lesson, you will learn about how portfolio managers use the information disclosed on a company’s financial statements to perform their analysis. This lesson gives you a good understanding of the key financial ratios used to gauge a company’s attractiveness as an investment. This lesson takes 30 minutes to complete. At the end of this lesson, you will able to do the following:

• calculate key financial ratios • identify the most common liquidity, profitability, debt and equity, and market

ratios • explain what these liquidity, profitability, debt and equity, and market ratios

measure • describe earnings before interest, taxes, depreciation, and amortization

Lesson 3: Analyzing Financial Statements

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Analyzing Financial Statements Most portfolio managers use the information provided in the financial statements to help them make investment decisions. They perform detailed analysis of the information by using mathematical tools known as financial ratios. What is a financial ratio? A ratio is a measure of the relative size of one number compared to another. For example, if you compare the height of a 100 metre high building with that of a 50 metre building, the ratio is 2 to 1, which is commonly written as 2:1.

Portfolio managers use financial ratios to compare a company's financial information to a benchmark or to other companies in the same industry. Since ratios are relative numbers, portfolio managers may directly compare two companies of very different size. Furthermore, ratios for a specific company can be compared year to year to determine differences and trends. We will examine the major financial ratios in this course. Note that there are many financial ratios and means for interpreting these ratios, which are beyond the scope of this course. We have also deliberately avoided suggesting normal or adequate ratio levels since these are very subjective measures. However, we will give you an overview of the purposes served by many financial ratios and how they are calculated. There are four main types of financial ratios:

• liquidity ratios • profitability ratios • debt and equity ratios • market ratios

Click the icon for a summary of all the ratios.

Liquidity Ratios Liquidity ratios show how quickly current assets and current liabilities are cycled through a business. They provide an indication of whether a company can satisfy its current financial obligations. Information for calculating these ratios is found on the balance sheet. Working capital ratio (or current ratio) The working capital ratio, also known as the current ratio, is the ratio of current assets to current liabilities.


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A working capital ratio greater than 1 represents a good indication that there are sufficient resources available to satisfy current financial obligations. In contrast, a low working capital ratio (less than 1) may indicate that a company may have to borrow to cover its current liabilities. Quick ratio (or acid test) The quick ratio is a variation on the working capital ratio. Whereas the working capital ratio includes all current assets, the quick ratio excludes inventories from its calculation. Inventories are excluded because they may not be easily converted to cash.

The quick ratio is generally a better test for liquidity since it is a more conservative measure than the working capital ratio. A quick ratio greater than 1 indicates high liquidity in a company. Book value per common share (BVPS) This ratio indicates the value of each common share, relative to the value of the company's net assets as shown on the balance sheet. Book value per common share indicates what each common share would be worth if the company were to liquidate all its assets at the carrying value, discharge all its liabilities, and wind up its business.

Please note that the book value of common shares may differ from the price on the stock exchanges. The market value of the shares reflect the future earning potential of the firm, while the assets on the balance sheet reflect historical values and depreciation. Exercise: Liquidity Ratios


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Profitability Ratios Profitability ratios provide a measure of the company's operating performance and efficiency of financial management. These ratios relate a company's profits to other factors, such as sales or the amount of capital invested. The data used to calculate profitability ratios is found primarily on the income statement. Please note that net profit is also referred to as net income or net earnings. Net profit margin This ratio gives an indication of how much of a company's revenue is retained as profit.

Like most ratios, the net profit margin should be compared with industry standards, as well as with profit margins from previous years for the same company. A reduction in this ratio may indicate issues, such as increased borrowing expenses, higher taxes, or higher extraordinary expenses. Gross profit margin This indicator represents a company's ability to generate a profit. It measures the profit margin on products after the cost of goods sold is taken into account.

A drop in gross profit margin can indicate problems, such as rising inventory expenses, increasing competition from other companies, or a poor pricing policy. Operating profit margin This ratio measures the operating profit per dollar of sales. It focuses on the company's core business activities and excludes profits from other sources, such as investments.

If a company's operating profit margin decreases from year to year, while its gross profit margin remains unchanged or grows, it may indicate rising operating expenses — such as salaries, cost of supplies and depreciation costs — without a corresponding increase in sales.


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Return on investment (ROI) This ratio relates the company's net profits to the total capital invested in the company. It is a measure of how efficiently that capital is being used.

The higher the ROI, the better a company's capital is managed, because it takes less investment to generate the same level of income. A variation on the return on investment is return on common equity. It shows how efficiently the money raised from the sale of common shares is working to earn income.

Earnings per common share (EPS) Although technically not a ratio, earnings per common share measures a company's profitability in relation to its share structure. It is the dollar amount of company earnings for each common share outstanding. EPS shows how successful a company is at producing earnings for individual shareholders.

If there is a positive trend in this measure over time, the company becomes more attractive to investors since it is perceived to be making money for its shareholders. If investors anticipate the trend to continue, they would be willing to pay more for the stock, causing the market price to increase. Exercise: Profitability Ratios

Debt and Equity Ratios Portfolio managers use debt and equity ratios to gauge how heavily a company relies on borrowed money to conduct its business. Bondholders are interested in this ratio, because they need to know if a company is able to fulfill its financial obligations. For shareholders, these ratios provide clues to whether a company has profits to distribute as dividends.


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Debt-equity ratio This ratio shows the proportion between a company's debt and its equity.

Generally, a higher debt-equity ratio represents greater risk. A company with too much debt may have difficulty making interest payments, borrowing additional funds, or borrowing at a favourable interest rate. However, if used wisely, greater debt can increase productivity and profits. Portfolio managers can use this ratio to compare a company's debt burden to others in its industry or to see if a company has increased or decreased its debt load over the years. Interest coverage Also known as times interest earned, this ratio measures a company's ability to pay the interest on its debt.

Financially healthy companies should have a comfortable financial cushion beyond what is required to meet debt payments. Preferred dividend coverage Similar to the interest coverage measurement, the preferred dividend coverage shows the margin of safety for coverage of preferred share dividends.

A comfortable margin is assurance that the preferred dividends will be paid. Exercise: Debt and Equity Ratios


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Market Ratios Market ratios are calculations that relate the financial condition of a company to the price of its shares on the open market. For portfolio managers, these ratios can indicate whether the current price of a company's stock represents good value. Price earnings ratio (P/E) Also known as the price earnings multiple or P/E ratio, this ratio relates the current market price of a company's shares to its earnings per share.

P/E ratios compare the price investors have to pay for a dollar of earnings per share in one company versus another company in the same industry. Traditionally, industries with high capital expenditures or research costs, such as high-technology or biotechnology firms, will have on average higher P/E ratios. Portfolio managers use this measurement to assess the quality of a company's shares. In addition to using current earnings information, portfolio managers will calculate the P/E ratio based on estimated future earnings. This makes the P/E ratio a more efficient forecasting tool, provided the earnings estimates are realistic. Dividend yield The dividend yield represents the return on the investment based on the annual dividend payment and the current market price.

Portfolio managers seeking income producing investments use this ratio to gauge the amount of income generated by a stock, relative to other shares. For the portfolio manager seeking capital gains, the dividend yield may indicate whether shares are overvalued or undervalued. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Although earnings before interest, taxes, depreciation, and amortization (EBITDA) is not a financial ratio, many portfolio managers use this measure when analyzing a company's cash flow. Following is the formula for EBITDA:


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EBITDA looks at the cash flow of a company. By excluding interest, taxes, depreciation, and amortization from a company's expenses, portfolio managers have a clearer picture of the money a company brings in. However, there are a few cautions with EBIDTA:

• Since so many expenses are excluded from the measure, it may mask a problem with the company.

• Revenues are reported but the corresponding costs (depreciation) associated with them are not.

• Different companies may choose to include or exclude different expenses from the EBITDA, making comparison between companies difficult.

Exercise: Market Ratios


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Lesson 4: Mutual Fund Performance Welcome to the Mutual Fund Performance lesson. In this lesson you will learn about the types of investment risk, the key risk measurements, and how to track and understand mutual fund performance. Since there is a correlation between mutual fund performance and investment risk, it is important for you to comprehend and be able to explain this concept to your clients. Furthermore, you will need to understand how a client’s investment returns are calculated. This lesson takes 20 minutes to complete. At the end of this lesson, you will able to do the following:

• describe the different types of risk • understand the concept of standard deviation and beta • understand the concept of duration • demonstrate the effects of mutual fund distributions • demonstrate how non-money market fund returns are calculated • demonstrate how money market fund returns are calculated • understand what factors affect fund performance

Lesson 4: Mutual Fund Performance

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The Risk of Investing in Financial Assets Risk is a fact of life when investing in financial assets. As a mutual fund salesperson, you must be able to explain to your clients the various types of risks involved in your recommendations. These include the following: Market risk: The possibility that your investment may lose value because an entire

financial market drops in value.

Business risk:

The possibility that the issuer of the financial instrument may perform poorly.

Interest rate risk:

Risk associated with variations in interest rates. For example, when interest rates increase, bond prices drop and vice versa. Interest rates also affect stock prices since high interest rates make stock investing less attractive, while low interest rates tend to increase demand for stocks.

Liquidity risk:

The possibility that your investments are difficult to sell. There may be few buyers in the market or you have restrictions on when you can liquidate. For example, real estate tends to be less liquid than Canada Savings Bonds or Treasury bills.

Currency risk:

Involves fluctuations in the value of foreign currencies. For example, if you hold a U.S. investment and the Canadian dollar appreciates, then the value of your investment denominated in Canadian dollars drops.

Inflation risk:

Reduces the financial return on investments. The main impact of inflation is a reduction in the purchasing power of money.

Measuring Risk One measure often used to quantify investment risk is the notion of volatility. If the price of a financial asset fluctuates greatly, it is most likely to be high risk. Two common tools used to measure the volatility of mutual funds are:

• standard deviation • beta

Standard deviation Standard deviation indicates how much a mutual fund's performance fluctuates around its average return over a specified period of time. For example, consider a fund with a 10% annual average return and standard deviation of 5 (percentage points). This fund's rates of return typically range between 5% and 15%. Another fund with the same return of 10%, but a standard deviation of 2, could be expected to have rates of return that range from 8% to 12%. The second fund is generally considered to be less volatile, and therefore, less risky for investors than the first fund. A graphical representation of this measure is the familiar bell curve. The height and width of this curve reflects the amount of variation in an investment's return.


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Beta Unlike standard deviation, beta is a relative measure that compares how an investment reacts to movements in a specific index, such as the S&P/TSX Composite Index. The index is given a beta value of 1, and with the use of statistical methods, a fund's beta value is estimated. This table summarizes the relationship between the funds beta and the index.

If a fund's beta is then the unit price fluctuates

equal to 1 in step with the index

less than 1 less than the index

greater than 1 more than the index

If a stock's beta is 0.5, its price is expected to rise or fall by half as much as the overall market's rise or fall. If the average market price rises (or falls) by 10%, this stock's price is expected to rise (or fall) by 5%.

For a stock with a beta of 2, its price is expected to rise or fall by twice as much as the overall market. Duration Duration is commonly used to measure the volatility of fixed income investments. It is the number of years, calculated as the weighted average time to receive the present value of the interest and principal. Essentially, duration tells bond investors how long it will take to receive their interest and principal. The longer it takes to receive their payments, the greater their risk to changes in the price of their bond. For example, if two bonds have the same coupon, but different terms, the bond with the longer term will have a longer duration and will be more volatile. A bond's coupon rate will also have an affect on duration. For example, if two bonds have the same term, but different coupons, the bond with the lower coupon will have a longer duration and will be more volatile.


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Exercise: Measuring Volatility

Tracking Mutual Fund Performance There are many sources of performance data for mutual funds. Many newspapers and financial Web sites publish daily fund prices. Most of these sources also provide comparison data and comprehensive reports on a monthly, quarterly or annual basis. Mutual fund information can be found on a fund company's Web site and here at the IFIC Web site. Daily fund tables Although the amount of information varies by provider, at a minimum, interested investors can find the following data:

• the most recent NAVPS of a fund • the date of the NAVPS • the change in the NAVPS from the previously published value • whether a recent distribution has been made • whether the fund company is a member of The Investment Funds Institute of

Canada Since money market funds are set at a fixed NAVPS, current and effective yield are displayed in lieu of the price. Dividend tables The daily fund tables indicate if a distribution has been made, but the details of the distribution usually appear on a separate dividend table. The dividend table indicates the amount of distribution made and the type (dividend, interest, and/or capital gain). Effects of Distributions The NAVPS of a fund will always drop by the amount of a distribution. However, it is very important to appreciate that a client's overall net worth (excluding taxes) does not change; the makeup of that wealth has simply been adjusted.

On Jan 1, Keith purchases 1,000 units of XYZ fund for $10 per unit for a total investment of $10,000. The NAVPS at the end of the year is $12 so the value of Keith's investment grew to $12,000. On December 31 of the same year, the fund manager makes a distribution of $2 per unit and Keith receives a distribution of $2,000, calculated as (distribution amount per unit x number of units owned) or ($2 X 1,000 units). Immediately, the NAVPS of the fund drops to $10. Keith now has 1,000 units at $10 per unit or $10,000 plus $2,000 in distributions. His overall wealth is $12,000, the same as before the distribution.


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If Keith elects to reinvest his $2,000 distribution, he will then purchase 200 more units, calculated as (amount reinvested ÷ new NAVPS) or ($2,000 ÷ $10). In this case, he will have 1,200 units at $10 per unit. His overall worth is still $12,000. Understanding Fund Performance Mutual fund investors are extremely interested in fund performance, both as a measure of their current investment values and as a yardstick in comparing potential new investments. A fund's performance over any time period is the result of a number of factors. These include the following:

• the performance of the financial markets in which the fund invests • the investment skill of the individual fund manager or portfolio management

team • the flow of cash in and out of a fund as a result of net sales and net redemptions

It is important to understand that a fund's past performance is no guarantee of future performance. It is also important to understand the source of returns. A high 10-year return for a fund could be greatly influenced by one year of superb performance. A top-performing fund may lag behind its competitors if the manager is taking profits and accumulating cash in anticipation of a drop in the market. Or, a fund manager's investment style may be out of favour with the current environment but favourable when the market turns around. Standard performance data There are many ways of calculating performance. Without a common methodology, comparing the performance of different funds can be very misleading. The securities regulators have defined how fund performance shall be measured and what comparisons may be made. Standard performance data was developed so investors can make meaningful comparisons between funds. For non-money market funds, standard performance data is calculated using the formula for compounded annual rate of return, also known as annual internal rate of return (IRR). These calculations assume that any distributions from the fund are immediately reinvested back into the fund. For money market funds, current yield and effective yield are used to show performance.


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Rates of Return for Non-Money Market Funds To calculate the compounded annual rate of return for a mutual fund, the following formula is used:

Chris purchased 100 units of ABC fund on January 1, 2004 at $10 per unit for a total investment of $1,000. On January 1, 2007 his units are worth $13 for a total investment value of $1,300. What is the annual compound rate of return?

Please note that you are not expected to calculate the annual compound rate of return but you should understand the conceptual underpinnings. Rates of Return for Money Market Funds Performance for money market funds are displayed in two ways:

• current yield • effective yield

Current yield Current yield reflects the income earned on a money market fund for the most recent seven days expressed as a simple annualized percentage.

ABC money market fund holds assets of $10,000,000. In the last seven days the fund earned $9,595. This represents a percentage return of 0.0960%, calculated as ($9,595 ÷ $10,000,000 x 100). To get the simple annual return we multiply the percentage by the number of weeks in a year (365 ÷ 7 = 52.14). This results in an annualized simple return of 5.0054%, calculated as (52.14 x 0.0960%). Effective yield Unlike current yield, effective yield calculates the return on a money market fund by incorporating the compounding effect.

Using the same example, the fund made a return of 0.0960% in the past seven days. To calculate the effective yield we assume that we will take the amount in the fund after seven days and reinvest this 52.14 times at 0.0960%. In this case, the effective yield is 5.1303%.


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The effective yield for a money market fund will always be higher than the current yield due to the effect of compounding. Exercise: Mutual Fund Performance

Review Let's look at the concepts covered in this unit:

• Role of Portfolio Manager • Financial Statements • Analyzing Financial Statements • Mutual Fund Performance

You now have a good understanding of how mutual funds are managed. At this point in the course you can interpret companies' financial statements, as well as identify the common financial ratios that fund managers use to compare investment products. You are also able to explain the types of investment risk, the key risk measurements, and the mutual fund performance measurements to clients. Click Assessment on the table of contents to test your understanding. Assessment Now that you have completed Unit 6: Managing Mutual Funds, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.

unit 6: managing mutual funds

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