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Specialized Funds

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From Ranga Chand's Getting Started with Mutual Funds

The following types of funds provide more investment opportunities geared to meet special needs or specific investment goals.

Dividend Funds

Many Canadian corporations pay a portion of their annual profits to shareholders in the form of dividend income. Dividend mutual funds invest in dividend-paying preferred shares of these corporations, and in common shares that are expected to yield a high level of dividend income.

Investors who purchase dividend funds receive a regular stream of income, usually monthly. Since some funds make distributions less frequently, you should investigate this before you buy if it is important for you to receive more regular payments. As with equity funds, there is also the potential for long-term capital growth through higher share prices of the fund's holdings. As dividend income is taxed at a much lower rate than other types of investment income, these funds are generally held outside of a registered plan.

To maximize the dividend tax credit, look for a mutual fund that holds most of its assets in preferred shares and high-yielding common stocks. If you normally invest in GICs but are considering a dividend fund, you may feel more secure investing in a fund with at least a P-2 rating (P-1 is the highest credit rating issued by the Canadian Bond Rating Service and Dominion Bond Rating Service, P-2 next). Also, keep in mind that if you buy units in a dividend fund and then place them in your RRSP or RRIF, you negate the benefits of this tax credit.

Index Funds

The objective of an index fund is to mirror the performance of a benchmark, such as the TSE 300 Index, by investing in the same securities. If the index rises 14% in a year, an index fund will rise to nearly 14%. If the index falls 14%, an index fund will fall a little more than 14%. The fact that this type of fund does not increase as much and falls further than its benchmark is due to management fees. Therefore, the higher the fees, the greater the difference. Because managing an index fund requires no research or stock picking, there is little justification for high management fees. Look for a no-load index fund with the lowest management fees.

Special Equity Funds

These funds focus exclusively on specific industries and sectors of the economy and invest in companies in specialized areas such as real estate, resources, or precious metals. Given the cyclical nature of these industries (industries that are particularly sensitive to swings in economic conditions), special equity funds are the most volatile of all mutual funds. Some have a volatility rating of 9. Bear in mind that 10 is as high as you can go. Returns tend to fluctuate widely on an annual basis, which may mean posting a return of 85% one year and -14% the next. For investors who are willing to tolerate the volatility associated with these funds, the pay-off can be handsome. But losses, unfortunately, can be ugly. The experienced investor will have, at most, a small percentage of his or her portfolio invested in these funds. Remember: you are investing, not gambling!

Precious Metals Funds. These special equity funds invest in precious metals such as gold, silver, platinum, palladium, and rhodium and also in shares of mining exploration and production companies. Many financial planners recommend that investors keep 5% of their assets in this type of fund as a hedge against inflation. But because gold and other precious metals are subject to sudden and significant price movements, investment in this type of fund should be considered highly speculative. Although these funds offer investors the potential for substantial gains, there is also the possibility of considerable loss. Any capital gains are paid annually or can be reinvested in additional fund units.

Resource Funds. These funds invest in securities of Canadian companies involved in metals and minerals, oil and gas, forestry products, and water resources. Some also invest in precious metals. Again, returns will be volatile. Any capital gains are paid annually or can be reinvested in additional fund units.

Real-Estate Funds. Real-estate funds invest in commercial and industrial real estate. Returns are generated by the income from these investments, that is, rental and leasing, and potential capital gains -- selling the properties for a profit. The attraction of this type of fund is the tax-sheltered rental income, so the fund is best kept outside of a registered plan. Due to the slump in real estate in the late 1980s, these funds have not fared well.

Moreover, units in some real-estate funds are not as easy to redeem as units in other types of mutual funds. A fund must have its properties appraised before the fund's assets can be valued and the unit price established. Appraisals are done quarterly or monthly, at which time you can get your money out. Income from real-estate funds is distributed quarterly and any capital gains annually.

Closed-End Funds

Like Canadian mutual funds, closed-end funds combine investors' money in a diversified portfolio of securities. But there the similarities end. Unlike open-ended mutual funds, the focus of this book, which create new shares based on investor demand, closed-end funds begin business with a fixed number of shares. The original sale of these shares is called an initial public offering (IPO). After this issue is sold, the shares are traded on major stock exchanges like regular shares of common stock.

The most important difference between a mutual fund and a closed-end fund is how the unit price is set. The unit price of a mutual fund is its net asset value -- the value of the fund's holdings, less liabilities, divided by the number of shares outstanding. Since shares of closed-end funds are traded on the stock exchange, their price is set by supply and demand. They can trade for more (sell at a premium) or less (sell at a discount) than their net asset value.

Selecting a closed-end fund is much like choosing a mutual fund. Match the fund's objectives and risk levels with your own. It rarely makes sense, however, to buy a new issue of closed-end funds (unless they offer unusual investment opportunities), since they are usually offered at a high premium. Wait until the shares begin trading to buy them, usually at a discount.

Closed-end funds cannot be cashed in on demand like mutual funds, and in a declining market, finding buyers may prove difficult.

Segregated Funds

A segregated fund is a mutual fund offered by a life insurance company. The assets of the fund are segregated -- hence the name -- from the other assets of the company. Unlike mutual funds that are not protected by insurance, a segregated fund may guarantee that at maturity, or on your death, you, or your estate, will receive not less than 75%, and sometimes 100%, of the total amount originally invested. This means if you put in $10,000, you are guaranteed to receive at least $7,500. Sales commissions for segregated funds are usually non-negotiable. Also, life insurance funds offered through subsidiaries, rather than the life insurance company itself, may not be segregated and as such will not be guaranteed.

Key Points to Remember

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