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Canadian Equity Funds

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RANGA CHAND
From Ranga Chand's Getting Started with Mutual Funds

These funds invest in a wide range of Canadian companies through common and preferred shares. The primary objective of Canadian equity funds is to provide capital gains for investors through increases in stock prices.

Stock Basics

A stock is a share in a corporation's assets such as buildings, land, machinery, and furniture, and a share in its profits if it does well. Corporations issue two types of stocks. Common stocks give stockholders voting rights and may also pay dividends. Holders of preferred stock, on the other hand, generally have no voting rights but must receive dividend payments before common stockholders.

Typically, a company goes public (issues stock for the first time) when it needs to raise money, usually for expansion. This is called an initial public offering (IPO). In exchange for this money, the management of the company gives up some of its control to the people who buy the shares. After the IPO, the shares are bought and sold on the stock market and the company makes no further money on these trades. Stock prices are set by supply (who wants to sell) and demand (who wants to buy) and are influenced by many factors such as economic trends, interest-rate movements, consumer confidence, political events in Canada and overseas, market rumours, and the financial health of the company.

Stocks in Canada are traded on a variety of exchanges including the Toronto Stock Exchange (TSE), which is by far the largest, followed by the Montreal Exchange (ME), the Vancouver Stock Exchange (VSE), the Alberta Stock Exchange, and the Winnipeg Stock Exchange. Foreign exchanges are located in major cities such as New York, London, Paris, Tokyo, and Hong Kong. Stock prices are listed daily in the business section of newspapers either by company name or an abbreviation such as RY for Royal Bank.

Bear markets -- prolonged periods of falling prices in stocks -- are usually brought on by the anticipation of a decline in economic activity. Bull markets -- prolonged periods of rising prices -- are characterized by high trading volumes. Bull markets usually occur over a longer period, while bear markets tend to happen quickly.

Why Invest in Equity Funds?

Historically, the stock market has provided the highest returns. That's one good reason for investing in equity funds. The second is the diversity you can get for much less money. Even if you have the know-how, with $1,000 or $2,000 you are not going to be able to buy a wide range of shares in various companies. By investing that same amount of money in an equity mutual fund that holds shares in many different companies, you get diversification by the truckload. This diversification greatly reduces risk. If one or two companies do badly, the others may continue to perform well.

Equity funds invest in a wide range of Canadian companies and their main objective is to provide capital gains for investors through price appreciation of the shares held. This means that when the fund manager buys shares in XYZ Company at $15 per share and later sells them at $25, the fund realizes a capital gain of $10 per share. All capital gains are passed on to unitholders in the fund in the form of distributions, normally at year's end. This can be paid to you by cheque, or you can elect to reinvest in additional units of the fund.

"Blue-chip" equity funds typically .invest in large, well-established corporations, such as Imasco Limited, Bombardier Inc., and Power Corporation of Canada, with long histories of profitability and regular dividend payments. "Growth" funds may invest in shares of companies that have achieved above-average profitability in recent years and are expected to continue to do so. "Aggressive growth" funds, on the other hand, often invest in the common shares of small, emerging companies, often referred to as "small-cap," that are expected to grow rapidly. "Cap," or capitalization, is the total market value of a company and is determined by multiplying the current price of one share by the number of shares outstanding (sold). A company with 10 million shares trading at $10 each would have a $100-million market capitalization and would be considered a small company. Small new companies can often increase their sales very quickly because they are starting from such a small base. Their newness, however, can make them a riskier investment than well-established companies. Read the prospectus and annual report very carefully before you buy, to make sure the mutual fund is compatible not only with your investment objectives but also with your comfort level.

Buying units in an equity fund makes you a share-holder in the fund, not a shareholder in the corporations held by the fund. You have no voting rights in any of the companies the mutual fund holds shares in.

Investment Styles

There are various investment styles used by equity fund managers. Growth managers look for small- to medium-sized companies promising high revenue or earning increases and often pay high prices for companies they expect will show excellent potential. Value managers, by contrast, seek out stocks or securities that they feel are undervalued when compared to the company's actual earnings, cash flow, or book value. The reasoning behind this approach is the belief that sooner or later other investors will realize the true value of these companies and buy their stocks, thereby increasing the stock price. Some value managers will hold large stock or cash positions depending on the movement of the market.

Although many managers stick to one investment style, others show more flexibility depending on market conditions. The hallmark of a good fund manager is the ability to provide investors with consistently above-average returns. The hallmark of a good investor is the ability to identify and invest in those funds. For more on management styles, see Chapter 5.

Equity Funds and Volatility

The average volatility rating for Canadian equity funds is around 4 -- 1 being low, 10 being high. (For more on volatility, refer to Chapter 4.) A few of these funds are very volatile, with a rating of 6 or more. One fund has a volatility rating of 10! If you are comfortable with this volatility, that's fine. If you are not, that's fine too. It does not mean you should not invest in equity funds. What it does mean is that, perhaps, you should select a less volatile fund, with a rating of 4 or below, or put only a small percentage of your investment dollars into the more aggressive fund.

Equity Fund Returns

Many people, discouraged by the returns on their GICs, have misconceptions and unrealistic expectations when it comes to equity funds. While it is true that, historically, equity funds have provided a high average rate of return over the long term, this does not mean high rates of return year in and year out. Because of the volatility of the stock market, returns may be up dramatically one year but down considerably the next. You must be committed to leaving your money in this type of fund for at least five years to take advantage of market peaks. In other words, you can lose money if you don't do your homework and pull out at the wrong time.

You should also bear in mind that not all equity funds provide investors with high rates of return. Some Canadian equity funds, like some funds in other categories, consistently deliver below-average returns. It is therefore important to comparison shop before investing. Mutual fund salespeople, like car dealers, are not going to point you to a better deal at another dealership. They want to sell you their product, not someone else's! Also, as pointed out in Chapter 3 (How Much Will It Cost?), independent salespeople may be biased towards a particular fund company because of incentive considerations. The onus is on you to find the best deal. Chapter 18 tells you how.

The average return for equity funds over the five-year period to December 31, 1995, was 10.2%, and returns ranged from a high of 24.6% to a low of 2.7% -- a difference of 21.9%. The average return for small-to-mid-cap equity funds over the same period was 16.0%, with returns ranging from a high of 32.9% to a low of 6.5%, for a difference of 26.4%.

A Final Word

The goal for all growth funds is capital appreciation, not regular income or price stability. This makes them an unwise choice for people who need extra cash on a regular basis or who may have to use the money for short-term goals or in an emergency. But investors who want to earn higher returns cannot afford to ignore equity funds.

Key Points to Remember

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