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Canada’s Financial Services Sector

Canada’s Mutual Fund Industry

March 2002

Overview

• The mutual fund industry was the fastest-growing segment of the financial services sector during the 1990s, with assets increasing from $25 billion in December 1990 to $426 billion by December 2001. For almost every year since 1990, the majority of asset growth has been due to sales.

• The share of assets held in foreign funds has also increased substantially over the past 10 years. In 1990 foreign funds accounted for 17 per cent of total assets; by 2001 they made up fully 34 per cent of fund assets.

• There are 80 fund management companies operating in Canada. The industry is moderately concentrated, with the top 10 companies accounting for 72 per cent of all assets. The industry also includes 144 dealer firms involved in the sale of mutual funds. In total, the industry employs about 90,000 people.

• The main types of mutual funds are money market funds, bond funds, equity funds, dividend funds, mortgage funds and real estate funds. In 2001 there were about 1,800 mutual funds in Canada representing over 50 million unitholder accounts.

• The industry can generally be divided into the manufacturers of funds and the distributors, although the banks, credit unions and caisses populaires are involved in both sides of the industry.

• Companies involved solely in the manufacture of mutual funds tend to distribute their funds through investment advisors, financial planners, mutual fund dealers and life insurance agents, while the banks, credit unions and caisses populaires distribute their fund products through their retail branches as well as via brokers.

• Manufacturers and distributors obtain revenue from three main categories of fees: management fees (to pay for the management of the fund), sales fees (to pay for buying and selling the fund units) and special fees (for specific administrative costs).

• The mutual fund industry is governed by provincial and territorial legislation regulating the underwriting, distribution and sale of securities. There is also extensive self-regulation by the Investment Dealers Association of Canada, the Mutual Fund Dealers Association of Canada and the stock exchanges.

Introduction

The mutual fund industry was the fastest-growing segment of the financial services sector during the 1990s, with assets under management increasing from $25 billion in December 1990 to $426 billion by December 2001, an increase of 1,700 per cent. These assets were managed in approximately 1,800 different mutual funds and held in over 50 million unitholder accounts (see Chart 1).

Industry analysts attribute this phenomenal growth to several factors. First, the entry of banks into the mutual fund market has popularized these investment products among ordinary consumers, particularly because they are easily distributed through bank branches. Second, the aging of the population as the baby boom generation approaches retirement, combined with increasing life expectancy, has increased the popularity of mutual funds as a private means of saving adequate funds for retirement. Third, the 1990s were generally years of lower interest rates and strong equity markets. The lower interest rates meant lower rates of return on traditional savings vehicles, such as guaranteed investment certificates, compared to the higher rates of return available in the equity market. Finally, mutual funds offer professional management and diversification at minimal cost, a significant advantage for small investors.

Structure of the Industry

A mutual fund is a corporation or trust that raises money by selling shares or units of the mutual fund to many investors. Trusts, which make up the majority of mutual funds, set out the fund objectives, investment policy, management team, distributor and custodian. Unitholders may also have voting rights under the trust agreement and must be notified of meetings to approve such things as changes in a fund’s fundamental objectives or a change in the fund manager or auditor. Mutual funds employ professional managers to invest the money in such a way as to meet certain objectives, such as capital gains, liquidity or low risk. They provide a way for many small investors to have their money managed by professionals. Mutual funds are also highly liquid investment vehicles – units can be purchased or redeemed at any time based on the current valuation of the fund shares (i.e. the net asset value per share), subject to some restrictions.

The mutual fund industry can be divided into the manufacturers of funds and the distributors, although there are some companies involved in both segments of the business, particularly the banks, credit unions and caisses populaires. In Canada there are currently 80 mutual fund companies sponsoring over 1,800 mutual funds, each designed to meet different investor objectives varying with regard to risk, liquidity, income and tax treatment. On the distribution side, there are 144 dealer firms involved in the sale of mutual funds. In total, the industry employs about 90,000 people.

As shown in Chart 2, the majority of mutual fund assets are managed either by the manufacturers, whose products are distributed by brokers and dealers (50 per cent) or by banks and trusts (31 per cent).

Similar to other industries in the financial services sector, the mutual fund industry continues to consolidate. For example, while there are 80 mutual fund companies operating in Canada, the top 10 companies accounted for 72 per cent of all mutual fund assets in December 2001, up from 63 per cent in December 1997. Recent acquisitions include AMVESCAP’s purchase of Trimark Financial Corporation, C.I. Fund Management’s purchase of BPI Financial Corporation, AGF Management’s purchase of Global Strategy Holdings, Franklin Templeton Investments’ purchase of Bissett & Associates Investment Management, and Investors Group’s purchase of Mackenzie Financial Corporation.

Mutual Fund Products

The main types of mutual funds are money market funds, bond funds, equity funds, dividend funds, mortgage funds and real estate funds. Within these broad categories are many smaller sub-categories. For example, there are many different types of equity funds that differ by level of risk as well as index funds, which track a particular market index (e.g. the TSE 300). Balanced funds consist of a combination of the main categories listed above and provide a means of further managing risk through fund diversification.

Money market funds invest in short-term money market instruments such as Treasury bills, commercial paper and short-term government bonds. They represent low risk and high liquidity, but also earn a lower rate of return than other funds. Bond funds invest in government and corporate bonds with the objective of generating income and maintaining the safety of principal. Equity funds invest in common stocks issued by companies, primarily with a view to generating capital gains. Equity funds have a higher risk than money market or bond funds, but also provide the greatest potential for high returns. Equity funds are seen as good long-term investments as, historically, common stocks have performed better than bonds and money market instruments over the long term. Dividend funds invest in preferred shares and common shares paying dividends in order to take advantage of the dividend tax credit as well as potential capital gains. Mortgage funds invest mainly in mortgages on residential units but may also include mortgages on commercial and industrial property, while real estate funds invest in income-producing real property. Mortgage funds offer income and safety while real estate funds offer long-term growth through capital appreciation.

Two innovations that are becoming increasingly popular are clone funds and wrap accounts. Clone funds are 100-per-cent RRSP-eligible funds that allow investors to mimic the return of actively managed foreign mutual funds. Wrap accounts are accounts where brokers manage groups of investments consisting of stocks, bonds, cash and mutual funds for a set annual fee, rather than receiving fees on a transaction basis.

As shown in Chart 3, equity funds made up 55 per cent of all mutual funds in December 2001, followed by balanced funds at 16 per cent and money market funds at 15 per cent. Within equity funds themselves, about half of the assets were invested in foreign common shares and half in Canadian common shares.

While equity funds composed of common shares were very popular throughout much of the last decade, the recent economic slowdown has resulted in a shift to mutual funds with lower risk profiles, such as money market mutual funds. As shown in Chart 4, net new sales of equity funds declined dramatically in December 2001 over December 2000, while net new sales of money market mutual funds increased as investors sought to minimize risk. However, despite the recent economic downturn, total net new sales increased by 26 per cent in December 2001 over December 2000.

Distribution Network

Companies solely involved in the manufacture of mutual funds tend to distribute their funds through investment advisors, financial planners, mutual fund dealers and life insurance agents, although one company makes use of a dedicated sales force, while two others sell their funds directly to the public through the mail, over the telephone and over the Internet. There are currently 144 dealer firms selling mutual funds, including discount brokers conducting business over the Internet.

Canada’s banks, credit unions and caisses populaires are also active in the mutual fund industry, selling their fund products through the retail branch and broker network. The banks have also recently begun selling third-party mutual funds through their retail branch network, generally focusing on the larger manufacturers’ products.

Assets and Revenue

As shown in Chart 5, total assets held in mutual funds have increased exponentially in the last two decades from $3.6 billion in 1980 to $426 billion in 2001. Most of this growth has taken place over the past decade.

The share of assets held in foreign funds has also increased substantially over the past 10 years (see Chart 6). In 1990 foreign funds accounted for 17 per cent of total assets; by 2001 they made up fully 34 per cent of fund assets. This growth reflects the fact that the Canadian government has increased the foreign content limits for RRSPs from 10 per cent in 1990 to 30 per cent in 2001.

Total asset growth can be further broken down into growth from new sales of mutual funds and growth in existing assets. For almost every year since 1990, the majority of growth in assets has been due to new sales.

Manufacturers and distributors of mutual funds generate revenue from three main categories of fees: management fees, sales fees and special fees. Management fees pay for the management and operation of funds and are deducted directly from them. These fees, which are usually expressed as a percentage of a fund’s net asset value, are known as the management expense ratio or MER. Published rates of return for mutual funds are calculated after the MER has been deducted. Sales fees are paid by investors to the financial advisors and dealers who sell the funds on behalf of the mutual fund companies. There are two types of sales fees: commissions, which are paid at the time of sale or shortly thereafter, and service fees, which are ongoing commissions to pay advisors and dealers for their ongoing services. Service fees are also deducted directly from mutual funds. Special fees apply to specific administrative costs (e.g. account set-up fee, transfer fee) and are paid directly by individual investors.

Regulation and Supervision

The mutual fund industry is governed by provincial and territorial legislation regulating the underwriting, distribution and sale of securities. A primary objective of this legislation is full disclosure for all securities, including mutual funds. Disclosure requirements are usually met through the provision of a prospectus issued by the company and accepted for filing by the regulatory body. Securities legislation also requires the continual disclosure of information by companies, such as the regular issuing of financial statements, and most provinces and territories require that this information be sent directly to individuals purchasing units in mutual funds and to other shareholders. Legislation also requires that securities dealers and advisors register with the relevant provincial or territorial regulatory authority.

While each province and territory has its own legislation, regulators meet on a regular basis in an effort to coordinate and harmonize regulation of the securities industry and markets. For example, there has been an increase in the number of national policies issued by the Canadian Securities Administrators¹ in an attempt to create a consistent set of regulations across Canada. Nevertheless, mutual fund companies must file regulatory documents with the relevant provincial and territorial securities authorities.

There is also extensive self-regulation by the Investment Dealers Association of Canada (IDA), the Mutual Fund Dealers Association of Canada (MFDA) and the stock exchanges. The IDA regulates its own members who are involved in the sale of securities including mutual funds, while the MFDA regulates the distribution side of the mutual fund industry. Self-regulatory organizations have the power to admit members and perform compliance reviews. For example, investment advisors involved in the sale of mutual funds to the public must register with the applicable stock exchange or the IDA, and must complete industry-sponsored training programs before being permitted to sell mutual funds and other securities. The self-regulatory organizations also have the power to establish and enforce industry regulations to protect consumers and to ensure companies conduct their business in a fair and ethical manner.

Legislative Reform

In June 2001 the Government of Canada passed legislation (Bill C-8) reforming the regulatory framework governing the financial services sector and the legislation came into force on October 24, 2001. The legislative measures include expanding access to the payments system to money market mutual funds, as well as to securities firms and life insurance companies. This measure will enable these financial institutions to offer a broader range of services to their clients, thus promoting increased competition in the domestic marketplace.

Recent Developments

The domestic mutual fund industry is experiencing increasing competition from large foreign firms, with three foreign fund companies (AIM Funds Management Inc., Fidelity Investments Canada Limited and Franklin Templeton Investments Corp.) now managing 20 per cent of mutual fund assets in Canada. These companies are world leaders and bring significant resources to their Canadian operations.

Industry analysts expect the mutual fund industry to continue to consolidate as competition intensifies and the manufacturers of mutual funds seek to reduce costs. Changes taking place on the distribution side of the mutual fund industry are also seen by many industry analysts as a key factor in the trend towards consolidation. Specifically, distributors and financial planners are increasingly focusing on products from the larger fund companies, while the banks are beginning to also sell the larger manufacturers’ products in their retail branches. As a result of these changes, the manufacturers of mutual funds have begun seeking scale through merger and acquisition activity to ensure that their products are also available from distributors and banks. Some industry analysts predict that the mutual fund industry will evolve from one with many players to one which is dominated by a few large firms.

Annex

Mutual Fund Assets Under Management, December 2001

Further information on legislation to reform the financial services sector can be obtained from the Department of Finance at www.fin.gc.ca. Additional information on the mutual fund industry is available from the Investment Funds Institute of Canada at www.ific.ca and the Mutual Fund Dealers Association of Canada at www.mfda.ca.

¹ The Canadian Securities Administrators is an association made up of the securities administrators of each province and territory. It meets regularly to discuss regulatory issues of national importance and to coordinate the implementation of national policies. [Return]