CFP® Study Tip

Many of the questions on the FPE1® and FPE2® examinations are based on investment suitability. These questions bring you back to the basics.

This e-newsletter deals with determining client investment objectives and risk tolerance. It also covers some basic types of mutual funds. The e-newsletter concludes with a short case study to test you on the basics. A few concepts will be described in the next e-newsletter when providing the solutions for the case study.

Investment Objectives

2. Mortgage Fund

Invests primarily in residential mortgages. Mortgages pay a blend of interest and principal payments, usually on a monthly basis. The mortgages may be guaranteed by the Government of Canada under the National Housing Act (NHA). The Canada Mortgage and Housing Corporation (CMHC) administers this act.

Fund Objectives
The objective is to provide attractive income with a high degree of safety through holding NHA guaranteed mortgages.

Who would it appeal to?
It would appeal to the investor who wants relatively high current income and is willing to accept a moderate degree of risk through owning mortgages.

3. Bond Fund

Invests in government and/or corporate bonds and debentures.

Fund Objectives
The objective is to provide attractive income to the investor as well as safety through owning government and/or corporate debt securities. This fund has moderate capital appreciation potential.

Who would it appeal to?
It would appeal to the investor who wants relatively high current income and is willing to accept a moderate degree of risk (higher than mortgage funds). The fund has moderate growth potential—slightly higher than mortgage funds.

4. Balanced Fund

Invests in a cross-section of securities, including bonds, debentures, preferred shares and common shares.

Fund Objectives
The objective is to provide a combination of safety (stability) and income through holding bonds and dividend paying stocks, and growth potential through holding common shares. The percentage holding of each of the securities in the balanced fund will vary, depending on the investment strategy of the fund. The weighting, however, remains relatively fixed.

Who would it appeal to?
It would appeal to the investor who wants a combination of safety of capital, income and capital appreciation. Because of the fund’s diversity, the balanced fund does not generate as much income as a fixed income fund or the growth potential of an equity fund. A similar type of fund to a balanced fund is an Asset Allocation Fund. Here, the manager actively allocates money to various asset categories based on market conditions.

5. Dividend Fund

Invests in a diversified portfolio of dividend paying preferred shares and common shares (primarily preferreds). Dividends received by investors, from taxable Canadian corporations, are not fully taxable and receive the dividend tax credit.

Fund Objectives
The objective is to provide attractive income on an after-tax basis to investors. The fund also offers moderate growth potential through holding common shares.

Who would it appeal to?
It would appeal to the investor who is concerned with tax reduction and wants a steady income return on an after-tax basis. The investor would also want the potential for moderate growth in the fund.

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6. Equity Fund

This fund invests in common shares. There is a huge assortment of equity funds available, which range from the very conservative blue chip funds (invest in large well-seasoned companies) to the speculative or venture funds (invest in high risk situations). There are also Global Funds, which invest internationally, and Index Funds, which invest in shares that comprise a stock market index. An example of an index fund is a S&P/TSX 60 Index Fund, which invests in shares of the 60 companies that comprise the index. The purpose of this fund is to attempt to duplicate the return of the index.

Fund Objectives
Equity funds vary as to the level of diversification and risk involved. However, these funds have growth or capital appreciation as their major investment objective. Some funds generate dividend income for their investors as a secondary objective. For Global Funds, international diversification is obtained and there is the possibility of obtaining foreign exchange gains. Conversely there is the possibility of foreign exchange losses. In the US there is a distinction between Global Funds, which invest in US and foreign shares, and International Funds, which invest in foreign shares only.

Who would it appeal to?
It would appeal to the investor who wants to obtain capital gains from his or her investments. Historically, over long periods, returns on common shares have outperformed fixed income securities (such as mortgages, bonds and GICs). However, on a year-to-year basis, common share returns are volatile and may show positive or negative returns.

7. Real Estate Fund

Invests in a diversified portfolio of commercial real estate holdings. A real estate fund differs from most other mutual funds in the following ways:

• It values the fund infrequently (e.g., monthly). This varies with most funds that calculate the net asset value per share on a daily basis.
• It lacks liquidity. Due to the infrequent valuation and illiquidity of real estate investments, these funds tend to lack liquidity.
• It may borrow to finance the mortgages on real estate holdings. Most other funds cannot borrow money except to meet redemptions.
• Investing in real estate allows the fund to pass on tax benefits to the fund holders through Capital Cost Allowance (CCA) write-offs.

Fund Objectives
This fund provides investors with attractive income through the distribution of rental income, growth potential through the expected appreciation potential of the real estate holdings, and moderate tax benefits through CCA write-offs.

Who would it appeal to?
It would appeal to the investor who wants income from their investments, as well as capital appreciation through holding commercial real estate assets.

8. Specialty Fund

This fund invests in a specific sector of the economy such as a particular industry (e.g. oil and gas or precious metals).

Fund Objectives
The major objective of a specialty fund is to provide growth. Due to the concentration of investments in a particular area, the growth potential of this fund is much greater than a diversified equity fund. Conversely, the risk in a specialty fund is greater due to its lack of diversification.

Who would it appeal to?
To the investor who is willing to accept a higher degree of risk in return for a higher potential return on his or her investment.

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