Understanding Pool Funds [Video]

As HighView believes in education and transparency, we feel it is important that investors understand how they are invested. Today’s topic is: Understanding Pool Funds.

So let’s review. Watch this video or read below for a better understanding of pool funds:

What Are Pool Funds and How Do They Differ from Mutual Funds?

Pool funds, like mutual funds, co-mingle investor funds for purposes of investing. Investors hold units in the pool fund, and ideally the unitholder (investor) achieves lower costs for portfolio diversification and benefits from efficiencies of scale. Pool funds are also designed to achieve fairness of allocation across clients.

Unit values are calculated by taking all the underlying investments in the pool fund at a specific date and dividing by the number of units issued and outstanding. Unit values fluctuate based on the value of the underlying investments.

Pool funds differ from mutual funds in that they do not require a prospectus, they are generally not advertised, they typically have lower fees, and they are not available to the public at large. Pool funds may have daily or monthly liquidity.

Pool funds are usually issued in Series – A, F, or O. Each of these series will be explained further on.

Concerns to Be Aware of for Pool Funds

Pool funds must annually distribute all interest income, dividends, and net capital gains. Capital losses are not distributable but are used to net against capital gains. Note that an annual distribution is unrelated to the unit value. You can also experience capital gains when you sell units of the pool. This can be confusing  at times because there can be years when capital gains distributions are made due to sales inside the pool fund, while the unit value may have experienced a decline in value.

Regardless of when you buy units of a pool, annual distributions are completed pro rata. This means that if, as an investor, you purchase units in November and there is a year-end distribution, your distribution per unit is the same as an investor who purchased units in January of the same year. For this reason, you want to understand what the estimated distribution for year-end will be should you choose to buy units in the last quarter of the year. You do not want to be hit with a surprisingly large distribution when you were not invested for very long.

Transparency of Fees

As mentioned earlier, pool funds are typically available in Series A, F, or O. Each series is designed for a different management fee structure:

• Series A:

Series A is usually for the direct investor and includes a management (and advice) fee; let’s say 1.87%. Brokers may also use A Series in their client accounts and will receive a trailer fee from the pool fund manager, typically 1.00%.

You want to be careful that you are not paying a Series A fee and also paying a fee for service.

• Series F:

Series F is used by brokers for their client accounts and includes a management fee only. The advice fee (fee for service) is charged separately by the broker (i.e. 0.87% for management fee and broker charges an advice fee separately of 1.00%).

The F Series is becoming more common as brokers move to “fee for service” models. CRM2 only requires the “Fee for Service” be disclosed, not the investment management fee or MER. These can be found in FACT sheets or by asking the question.

• Series O:

Series O is typically reserved for institutional or very large accounts – fees are negotiated separately and charged outside the pool.

For Series A and F, many investment managers charge management fees inside the pool. This does not provide complete transparency of fees. Clients may know the percentage fees charged, but dollar fees are not disclosed and returns are shown net of fees.

When fees are charged inside the pool, the investment manager will take their fee from the income earned inside the pool prior to any distributions. For this reason, fees charged inside pools are not then available for tax deductions in non-registered accounts. However, this may not be the most tax-efficient when income from capital gains or dividends is used for paying fees. Thus, the argument that fees being netted against income results is a wash and is no different from paying fees outside of the pool and reporting full income, is not fully true. While this may work for income funds where interest is the predominant source of income, it most definitely does not work for equity funds where most income should be capital gains.

Some investment managers also charge performance fees in addition to management fees. It is important to understand how the performance fee is calculated and if there is a highwater mark.

It is also important to note that when switching from one pool to another, performance history typically does not roll over. Each pool stands on its own for performance metrics. This may mean you lost money in one pool and then when switched to another, the highwater mark starts fresh; it does not carry over – you could effectively pay a performance fee even though your total portfolio value declined.

HighView believes that all management and advice fees should be completely transparent in dollar value and fees should be available for tax deduction purposes. For this to be done, management (and advice) and performance fees should be charged outside of the pool. (Specifically for IPP accounts, all fees should be charged outside the pool as the fee is payable and tax deductible by the company sponsoring the IPP, not the IPP itself).

Aside from management (and advice) fees, other fees are also associated with pools, namely operating costs, such as audit and legal costs, and trading costs. It is important to understand all the costs.

The following metrics are important and should be asked of any investment manager: 

• MER – the Management Expense Ratio.

This is different from the management/advice fee. This metric includes the management/advice fee, HST, and all operating costs of the pool. It does not, however, include the trading and commission costs.

• TER – the Total Expense Ratio.

This metric includes all costs (should be higher than the MER) – management/advice, HST, operating, and trading and commission costs. If the investment manager does a lot of trading, you can expect this ratio to be high.

NOTE: Sometimes TER can be termed Trading Expense Ratio – this does not however include operating and management fees.

Understanding the Financials

We believe that it is important to understand how a pool has made its return, and the associated costs and various metrics. The best way to understand performance and metrics is by reviewing the audited annual financial statements of the pool. These can be requested at any time from your investment manager.

For some, reading financial statements may seem daunting. In this regard, we would point you to a few specific areas of the financial statements:

• Statement of Financial Position:

Review Current Assets to gain an understanding if the pool has experienced growth or redemptions – a significant decrease in assets should be a red flag.

• Statement of Comprehensive Income:

Review the income and expenses to understand how the pool made its return and what the expenses were. From here, you can calculate approximate MER and TER ratios by using a 2 year average of Net Assets of the Pool found on the Statement of Financial Position. When reviewing this statement, you can see what the pool earned in terms of income sources such as interest and capital gains, and what losses may have been incurred such as capital losses or losses on futures and forward contracts (typically associated with currency hedging and other such strategies). You can also determine what operating and trading and commission costs were.

• Statement of Cash Flows:

Review of proceeds of sale of investments and purchase of investments to understand portfolio turnover characteristics.

Understanding Distributions

Distributions are not to be confused with dividends. Many pools and mutual funds provide for monthly distributions. A distribution can be made up of interest, dividends, foreign dividends, capital gains, and Return of Capital (“ROC”). Typically, the makeup of the distribution for tax purposes changes from year to year depending on the underlying income sources of the distribution.

Return of Capital (“ROC”) is often associated with pools that pay out a monthly distribution.

Pools with higher distributions often have a large component of ROC as part of the distribution as the income earned (in the pool) is not enough to support the distribution being sent to the investor.

Since ROC is simply the return of the money invested in the pool – it will lower the adjusted the cost (or in general terms, your initial investment or starting point). For taxable accounts, this can result in a cost base that decreases quickly, which can result in a significant capital gain when you eventually sell.

Also, if you step back and think that Return of Capital is the investment manager returning a portion of the monies he or she manages, what happens when the pool fund receives a lot of redemption requests (investors pulling their money away)? In this case, less capital will be available to return to the investors that have stayed invested. More often than not, this causes a cut in distribution and expected investment income.

Basic Questions to Ask When Investing in Pool Funds

1. What is the purpose of the pool for investing – income, balanced, capital gains?
2. Review historical performance and metrics such as upside and downside capture. A FACT sheet should answer most questions.
3. What is the total fee? For Series A, what is the fee that covers both management and advice, and what trailer goes to the broker? For Series F, what is management fee, and what fee for service is the broker taking? For Series O, is this available to me and if so, what is the fee?
4. Can I have fees available for tax deduction purposes? (Some investment managers charge fees outside pools; O Series can also be used.)
5. What is the MER?
6. What is the TER? (Specifically TOTAL Expense, not Trading Expense.)
7. What is the historic makeup of the distribution?
8. Do you adjust the cost base for ROC?
9. Can we review the financial statements together? Review 5 years for asset growth, income and expenses, and to understand trading and commission costs.

At HighView, we believe that advisors and investment managers should provide full transparency of all investment solutions recommended to clients. This transparency should include all aspects of the clients’ portfolios with respect to fees and costs, so investors can easily understand a “total cost of ownership”.

HighView Financial Group is an investment counselling firm for affluent families and foundations. We are happy to discuss our fee and cost structure with you. Schedule a complimentary discovery session to see if we’re the right investment counsellors for you. 

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