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Canada’s Financial Services Sector

Canada’s Mutual Fund Industry

Updated (August 2003)

Overview

• The mutual fund industry was one of the fastest-growing segments of the financial services sector during the 1990s. Assets increased from $25 billion in December 1990 to $426 billion by December 2001, with most of the growth resulting from sales.

• However, by December 2002 the industry’s assets had declined by 8.2 per cent to $391 billion, largely due to market volatility throughout the year. This is the first time since 1981 that the assets of the industry have decreased on a year-to-year basis.

• The share of assets held in foreign funds increased substantially during the 1990s, growing from 17 per cent of total assets in 1990 to 34 per cent by 2001. However, lower sales and slightly higher redemption rates in 2002, particularly in foreign equity funds, reduced the share of assets held in foreign funds to 30 per cent of total assets.

• As of December 2002 there were 75 fund management companies operating in Canada, down from 80 the previous year. The market share of the top 10 mutual fund companies (by assets) increased by 7 percentage points between 1992 and 2002, accounting for 73 per cent of all assets by year-end 2002. The industry also included 111 dealer firms involved in the sale of mutual funds. In total, the industry employed about 90,000 people in 2001.

• There are three main types of mutual funds: money market funds, income funds and equity funds. In 2002 there were 1,956 mutual funds being sold in Canada, representing over 53 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.

• 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 securities laws. There is also extensive self-regulation by the Investment Dealers Association of Canada (IDA), the Mutual Fund Dealers Association of Canada and Market Regulation Services Inc., a national, not-for-profit organization owned jointly by the Toronto Stock Exchange (TSX) and the IDA.

Introduction

The mutual fund industry was one of the fastest-growing segments 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. However, by December 2002 industry assets had decreased to $391 billion, down 8.2 per cent from the previous year. These assets were managed in 1,956 different mutual funds and were held in over 53 million unitholder accounts (see Chart 1).

Industry analysts attribute the phenomenal growth in the 1990s to several factors. First, the entry of banks into the mutual fund market 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 cohort 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. In return for putting money into the fund, investors receive shares or units that represent their proportional share in the pool of fund assets. 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. Mutual funds are highly liquid investment vehicles, which means that new investors can purchase units or shares at any time, and existing investors can redeem their units or shares at any time based on the current market value 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. 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.

As of December 2002 there were 75 mutual fund companies in Canada sponsoring 1,956 mutual funds, each designed to meet different investor objectives varying with regard to risk, liquidity, income and tax treatment. On the distribution side, there were 111 dealer firms involved in the sale of mutual funds in 2002, down 23 per cent from 144 the previous year. The industry, including the manufacturers and distributors, employed about 90,000 people in 2001 (the 2002 figure is not available).

As shown in Chart 2, most mutual fund assets are managed either by the manufacturers, whose products are distributed by brokers and dealers (51 per cent), or by banks and trusts (32 per cent).

Similar to other industries in the financial services sector, the mutual fund industry continues to consolidate. For example, while there were 75 mutual fund management companies operating in Canada as of December 2002 (down from 80 in 2001), the top 10 companies accounted for 73 per cent of all mutual fund assets, (up 9 per cent since December 1997) and the top 20 companies for 96 per cent of the industry’s assets.

Mutual Fund Products

There are three main types of mutual funds: money market funds, income funds and equity 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 S&P/TSX Composite Index). Bond funds and mortgage funds are examples of income funds. 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 tend to 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. These 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 outperformed 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 registered retirement savings plan (RRSP)-eligible funds that use derivatives in order to mimic the return of 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 50 per cent of all mutual funds in December 2002, followed by balanced funds at 17 per cent and money market funds at 15 per cent. Within equity funds, 56 per cent of the assets were invested in foreign common shares and the balance in Canadian common shares.

While equity funds composed of common shares were very popular throughout much of the 1990s, the economic slowdown in 2001 resulted in a shift to mutual funds with lower risk profiles, such as money market mutual funds. However, this shift was reversed in 2002. During that year new sales of money market funds declined dramatically and recorded net redemptions of $4.9 billion, almost a $22-billion turnaround from the previous year, when sales of these funds accounted for close to 60 per cent of total net sales. The year 2002 was the first time that net sales for the mutual fund industry had nine consecutive months of net redemptions, with close to 95 per cent of the redemptions coming from money market funds. At the same time, net new sales of equity funds continued to decline due to market volatility throughout the year.

That same year net sales of dividend and income mutual funds totalled $2.4 billion, or 81 per cent of total industry net sales, as investors looking for income and safety turned to funds that focus on real estate investment trusts and bonds. Total net sales for the industry in 2002 were $3.4 billion, down almost 90 per cent from $28.6 billion the previous year (see Chart 4).

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. In 2002 there were 111 dealer firms selling mutual funds, including discount brokers conducting business over the Internet, down from 144 a year earlier.

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, with most of the growth having taken place in the 1990s. However, market volatility throughout 2002 caused assets to decrease by 8.2 per cent to $391 billion at year-end. This is the first time since 1981 that the assets of the industry have decreased year-over-year.

The share of assets held in foreign funds has also increased substantially since 1990: while foreign funds accounted for 17 per cent of total assets in 1990, by 2002 they made up fully 30 per cent of fund assets (see Chart 6). Some of this growth reflects the fact that the Canadian government increased the foreign content limits for RRSPs from 10 per cent in 1990 to 30 per cent in 2001. At the same time, the emergence of foreign clone funds, which are becoming increasingly popular among RRSP investors, may also have contributed to the growth of assets held in foreign funds.

Total asset growth can be further broken down into growth from new sales of mutual funds and growth in existing assets. Most of the asset growth from 1990 until 2001 was due to new sales. However, net new sales in 2002 dropped substantially to $3.4 billion from $28.6 billion in 2001, largely due to the volatility of equity markets throughout 2002. At the same time, the success of other investment instruments offered by retail brokers, such as income trusts and real estate investment trusts, also accounts for the decline in new sales. For example, while the assets of the mutual fund industry decreased by 8.2 per cent in 2002, assets managed in fee-based accounts by full-service brokers increased by an estimated 5 per cent during the same period.

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 average total assets, 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 the commissions paid by investors to the financial advisors and dealers who sell the funds on behalf of the mutual fund companies. These fees may be applied when an investor buys units of the fund (front-end load) or redeems units (back-end load). Sales fees also include service fees, which are ongoing commissions to pay advisors and dealers for their ongoing services. Service fees, like management fees, are deducted directly from mutual funds. Special fees apply to specific administrative costs (e.g. account set-up fee, transfer fee, RRSP registration fee) and are paid directly by individual investors.

Regulation and Supervision

The mutual fund industry is governed by provincial and territorial securities legislation regulating the underwriting, distribution and sale of securities. The main objectives of this legislation are the protection of investors and the promotion of fair, efficient and transparent markets. To this end, there is strong emphasis on mandatory disclosure of information that investors should consider in connection with investment decisions. Disclosure requirements relating to mutual funds include the provision of a prospectus issued by the company at the time an investor purchases units in a fund, and the ongoing provision of financial statements to unit shareholders. Legislation also requires that securities dealers and advisors be registered (licensed) with the relevant provincial or territorial regulatory authority where they do business.

While each province and territory has its own laws, securities regulators meet regularly as members of the Canadian Securities Administrators (CSA),¹ an informal body whose goal is to coordinate and harmonize securities regulation in Canada through enhanced interprovincial cooperation. The CSA has developed a number of national rules, regulations and policies for the securities industry in an effort to streamline the regulatory process for market participants. Nevertheless, mutual fund companies must still file regulatory documents with the securities commissions in all provinces and territories in which their products are offered for sale.

In addition, all mutual fund dealers are required by the securities commissions to be members of a recognized self-regulatory organization such as the Investment Dealers Association of Canada (IDA), the Mutual Fund Dealers Association of Canada (MFDA), Market Regulation Services Inc., or a stock exchange. The IDA regulates its own members who are involved in the sale of securities including mutual funds, while the MFDA regulates the operations, standards of practice and business conduct of its members and their representatives who are exclusively involved in the sale of mutual funds, with a view to promoting the protection of investors and the public interest. 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 provincial securities commission 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.

Bill C-8, which came into force on October 24, 2001, introduced a number of important changes to Canada’s national payment clearing and settlement systems. One of these changes was to broaden entitlement to membership in the Canadian Payments Association to life insurance companies, securities dealers and money market mutual funds. To date no trustees of money market mutual funds have applied for membership in the Canadian Payments Association.

Recent Developments

Two important initiatives were undertaken in 2002 to improve the supervision and regulation of the mutual fund industry, as well as the protection of investors. In March 2002 the Ontario Securities Commission (OSC), which is the principal regulator of the majority of Canadian mutual funds and their managers, published a concept proposal developed by the CSA.² This proposal calls for the establishment of independent mutual fund governance agencies to oversee the activities of fund managers and a broader set of regulatory principles. The OSC plans to issue a draft set of rules this year. The second initiative was the establishment of a new single Ombudsman for Banking Services and Investments in August 2002. The new ombudsman service, which is free of charge and independent of the financial services industry, deals with customer complaints about banks, investment dealers, mutual fund dealers and trust companies.

It is also worth noting that a number of investors have become attracted to ethical funds, more commonly referred to as socially responsible investment funds (SRIs). These funds, which represent a wide variety of industry sectors, screen companies for their standards and practices in areas such as the environment, human rights, employee relations and corporate governance. While SRI assets represent only 1 per cent of total mutual fund assets in Canada, the popularity of these funds is starting to increase, particularly among RRSP investors.

In 2002 the domestic mutual fund industry continued to experience competition from large foreign firms, with three U.S. fund companies (AIM Trimark Investments, Fidelity Investments Canada Limited and Franklin Templeton Investments Corp.) managing 20 per cent of mutual fund assets in Canada. These companies, which are able to draw from a large and global platform, are expected to remain big players in the Canadian marketplace.

At the same time, the industry is facing new and intense competition from both retail broker networks and substitute investment products. For example, the growth in managed assets in fee-based accounts at full-service brokers and the emergence of income trusts and real estate investment trusts had a significant impact on the flow of new assets into the mutual fund sector in 2002. It is expected that these trends, particularly fee-based programs, will continue to challenge the mutual fund industry.

Industry analysts expect the mutual fund industry to continue to consolidate as competition intensifies and the manufacturers of mutual funds seek to reduce costs. They also believe that consolidation is necessary among the small to mid-size operators as changes in the distribution of retail mutual funds are increasingly marginalizing the smaller fund companies. 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 consolidation to ensure that their products are also available from distributors and banks.

Annex

Mutual Fund Assets Under Management, December 2002

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

2 The CSA proposal, entitled Striking a New Balance: A Framework for Regulating Mutual Funds and Their Managers, can be found on the OSC Web site at www.osc.gov.on.ca.  [Return]