Mutual Funds

A mutual fund is a form of collective investment that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, and/or other securities. Legally known (in the US) as an "open-end company," a mutual fund (click here for US SEC definition) is one of three basic types of investment company available in the US. [1].

The portfolio manager trades the fund's underlying securities, realizing a gain or loss, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. There are more mutual funds than there are individual stocks.

Outside of the US, mutual fund is a generic term for various types of collective investment. In the UK and western Europe (including offshore jurisdictions) other forms of collective investment are prevalent including unit trusts, Open-Ended Investment Companies (OEICs), SICAVs and unitized insurance funds.

This article deals with U.S. mutual funds, for other forms of mutual investment see the main article: Collective investment schemes.

Usage

Mutual funds can invest in many different kinds of securities. The most common are cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as technology or utilities. These are known as sector funds. Bond funds can vary according to risk (high yield or junk bonds, investment-grade corporate bonds), type of issuers (government agencies, corporations, or municipalities), or maturity of the bonds (short or long term). Both stock and bond funds can invest in primarily US securities (domestic funds), both US and foreign securities (global funds), or primarily foreign securities (international funds). By law, mutual funds cannot invest in commodities and their derivatives or in real estate. (However, there do exist real estate investment trusts, or REITs, which invest solely in real estate or mortgages, and mutual funds are allowed to hold shares in REITs. Likewise, another type of fund, hedge funds, which are restricted to the wealthy, are allowed to invest in real estate (as well as certain other practices which mutual funds may not do)) A mutual fund may restrict itself in other ways. These restrictions, permissions, and policies are found in the prospectus, which every open-end mutual fund must make available to a potential investor before accepting his or her money.

Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts the future performance of investments appropriate for the fund and chooses the ones which he or she believes will most closely match the fund's stated investment objective. This is called active management, in contrast to indexing, in which a fund's assets are managed to closely approximate the performance of a particular published index. Because the composition of an index changes less frequently than the condition of the market, an index fund manager makes fewer trades, on average, than does an active fund manager.

For this reason, index funds generally have lower expenses than actively-managed funds, and typically incur fewer capital gains which must be passed on to shareholders. The majority of actively managed funds outperform an index fund before costs, but they then underperform the index funds after costs are considered. For this reason, some fee-only advisers strongly suggest index funds. (If the advisor is not fee only but instead is compensated by commissions, the advisor may have a conflict of interest in selling high commission load funds.)

Mutual funds are subject to a special set of regulatory, accounting, and tax rules. Unlike most other types of business entities, they are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are also tax-free to the shareholder. Taxable distributions can either be ordinary income or capital gains, depending on how the fund earned it.

Structure

Open-end fund

The term Mutual fund is the common name for an open-end investment company. Being open-ended means that at the end of every day, the investment management company sponsoring the fund issues new shares to investors and buys back shares from investors wishing to leave the fund.

Mutual Funds may be legally structured as corporations or business trusts but in either instance are classed as open-end investment companies by the SEC.

Other funds have a limited number of shares these are either closed-end fund or unit investment trusts neither of which are mutual funds.

Exchange-traded funds

Main article: Exchange-traded fund

A relatively new innovation, the exchange traded fund (ETF) are often formulated as open-end investment companies. The way ETFs work combines characteristics of both mutual funds and closed-end funds. An ETF usually tracks a stock index, like an index fund. Shares are only created or redeemed by institutional investors in large blocks (typically 50,000 shares). Investors tyically purchase shares in small quantities through brokers at a small premium or discount to the net aset value through which the institutional investor makes their profit. Because the the institutional investors handle the majority of trades ETFs are more efficient than traditional mutual funds and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock exchange, just like closed-end funds.

Net asset value

Main article: net asset value

The net asset value, or NAV, is a fund's value of its holdings, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but some funds update their NAV multiple times during the trading day. Open-end funds sell and redeem their shares at the NAV, and so only process orders after the NAV is determined. Closed-end funds may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes.

Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus.

Share class

Many mutual funds divide their assets up among multiple classes of shares. All of the assets of each class are effectively pooled for the purposes of investment management, but classes typically differ in the fees and expenses paid out of the fund's assets. These differences are supposed to reflect different costs involved in servicing investors in various classes; for example, one class may be sold through brokers with a front-end load, and another class may be sold direct to the public with no load but a "12b-1 fee" included in the class's expenses. Still a third class might have a minimum investment of $10,000,000 and only be open to financial institutions (a so-called "institutional" class). In some cases, by aggregating regular investments by many individuals, a retirement plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the benefit of their typically-lower expense ratios) even though no members of the plan would qualify individually.

Turnover

Turnover is a measure of the amount of securities that are bought and sold, usually in a year, and usually expressed as a percentage of net asset value. It shows how actively managed the fund is.

A caveat is that this value is sometimes calculated as the value of all transactions (buying, selling) divided by 2; i.e., the fund counts one security sold and another one bought as one "transaction". This makes the turnover look half as high as would be according to the standard measure.

Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The very process of buying and selling securities also has its own costs, such as brokerage commissions, which are borne by the fund's shareholders.

The Dalbar Inc. consultancy studied stock mutual fund returns over the period from 1984 to 2000. Dalbar found that the average stock fund returned 14 percent; during that same period, the typical mutual fund investor had a 5.3 percent return ([2]). This finding has made both "personal turnover" (buying and selling mutual funds) and "professional turnover" (buying mutual funds with a turnover above perhaps 5%) unattractive to some people.

Load

A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased, taken as a percentage of funds invested. The value of the investment is reduced by the amount of the load. Some funds have a deferred sales charge or back-end load. In this type of a fund an investor pays no sales charge when purchasing shares, but will pay a commission out of the proceeds when shares are redeemed depending on how long they are held. Another derivative structure is a "level-load" fund, in which no sales charge is paid when buying the fund, but a back-end load may be charged if the shares purchased are sold within a year.

Load funds are sold through financial intermediaries such as brokers, financial planners, and other types of registered representatives who charge a commission for their services. Shares of front-end load funds are frequently eligible for "breakpoint" reduction in the commission paid based on a number of variables. These include other accounts in the same fund family held by the investor or various family members, or committing to buy more of the fund within a set period of time in return for a lower commission "today".

It is possible to buy many mutual funds without paying a sales charge. These are called no-load funds. Some discount brokers will sell no-load funds, sometimes for a flat transaction fee or even no fee at all. (This does not necessarily mean that the broker is not compensated for the transaction; in such cases, the fund may pay brokers' commissions out of "distribution and marketing" expenses rather than a specific sales charge.)

No load funds have higher average returns than load funds. No load index funds often experience higher average returns than the average mutual fund. For example, during the most recent ten-year period, a typical no load index fund tracking the Standard and Poor's 500 Index of US large company stocks will have a higher total return (dividends and capital gains) than the most US large company stock funds. Volatility also tends to be less in highly diversified no load index funds than the less diversified (typically only about 60 stock) managed funds. No load index funds often good choices for investors willing to do perform limited research and make their own investment decisions.

The largest mutual fund families selling no load index funds are Vanguard (vanguard.com) and Fidelity (fidelity.com) though there are a number of smaller mutual fund families with no load index funds as well. Expense ratios in some of these no load index funds are less than .2% per year versus the typical managed fund's expense ratio of about 1.5% per year. Load managed funds usually have even higher expense ratios when the load is considered. The expense ratio is the anticipated cost to the investor per year. For example, on a $100,000 investment, an expense ratio of .2% means $200 of annual expense, while a 1.5% expense ratio would result in $1,500 of annual expense. These expenses are before any sales commissions paid to own the mutual fund.

Index funds typically have much lower expenses than actively managed funds, because the index funds trade so much less (they own the securities that an index "owns") and so are not burdened with the cost of finding and buying securities expected to outperform an index. Although the expense ratio of indexed funds may be lower than an actively managed fund, an index fund may perform better or worse that actively managed funds depending on the investment class or market cycles. For example an "S&P Index fund" will potentially greatly underform a "gold fund" when stock market returns are flat and gold prices are rising.

History

The first open-end mutual fund, Massachusetts Investors Trust was founded on March 21, 1924 and after one year had 200 shareholders and $392,000 in assets. The entire industry, which included a few closed-end funds, represented less than $10 million in 1924.

The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require that a fund be registered with the SEC and provide prospective investors with a prospectus. The SEC (U.S. Securities and Exchange Commission) helped create the Investment Company Act of 1940 which provides the guidelines that all funds must comply with today.

In 1951, the number of funds surpassed 100 and the number of shareholders exceeded 1 million. It wasn't until 1954 that the stock market finally rose above its 1929 peak and by the end of the fifties there were 155 mutual funds with $15.8 billion in assets. In 1967 funds hit their best year, one quarter earning at least 50% with an average return of 67%, but it was done by cheating using borrowed money, risky options, and pumping up returns with privately traded "letter stock." By the end of the 60's there were 269 funds with a total of $48.3 billion.

With renewed confidence in the stock market, mutual funds began to blossom. By the end of the 1960s there were around 270 funds with $48 billion in assets. 1976 introduced the first retail index fund called the First Index Investment Trust. It is now called the Vanguard 500 Index fund and is one of the largest mutual fund ever with in excess of $100 billion in assets.

One of the largest contributors of mutual fund growth was Individual Retirement Account (IRA) provisions made in 1981, allowing individuals (including those already in corporate pension plans) to contribute $2,000 a year. Mutual funds are now popular in employer-sponsored defined contribution retirement plans (401k), IRAs and Roth IRAs.

Picking a mutual fund

Picking a mutual fund from among the thousands offered is not easy. The following is just a rough guide, with some common pitfalls.

1. Check with your tax advisor prior to investing in a tax-exempt or tax-managed fund.
2. Match the term of the investment to the time you expect to keep it invested. Money you may need right away (for example, if your car breaks down) should be in a money market account. Money you will not need until you retire in decades(or for a newborn's college education) should be in longer-term investments, such as stock or bond funds. Putting money you will need soon in stocks risks having to sell them when the market is low and missing out on the rebound.
3. Expenses matter over the long term, and of course, cheaper is usually better. You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio.
4. Sector funds often make the "best fund" lists you see every year. The problem is that it is usually a different sector each year (internet funds, anyone?). Also some sectors are vulnerable to industry-wide events (airlines do come to mind). Avoid making these a large part of your portfolio.
5. Closed-end funds often sell at a discount to the value of their holdings. You can sometimes get extra return by buying these in the market. Hedge fund managers love this trick. This also implies that buying them at the original issue is usually a bad idea, since the price will often drop immediately.
6. Mutual funds often make taxable distributions near the end of the year. If you plan to invest money in the fund in a taxable account, check the fund company's website to see when they plan to pay the dividend; you may prefer to wait until afterwards if it is coming up soon.
7. Research. Read the prospectus, or as much of it as you can stand. It should tell you what these strangers can do with your money, among other vital topics. Check the return and risk of a fund against its peers with similar investment objectives, and against the index most closely associated with it. Be sure to pay attention to performance over both the long-term and the short-term. A fund that gained 53% over a 1-yr. period (which is impressive), but only 11% over a 5-yr. period should raise some suspicion, as that would imply that the returns on four out of those five years were actually very low (if not straight losses) as 11% compounded over 5 years is only 68%.
8. Diversification can reduce risk. Most people should own some stocks, some bonds, and some cash. Some of the stocks, at least, should be foreign. You might not get as much diversification as you think if all your funds are with the same management company, since there is often a common source of research and recommendations. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher. Buying individual stocks exposes you to company-specific risks, and if you buy a large number of stocks the commissions may cost more than a fund will.
9. The compounding effect is your best friend. A little money invested for a long time equals a lot of money later.

Scandals

In September 2003, the US mutual fund industry was beset by a scandal in which major fund companies permitted and facilitated "late trading" and "market timing".

Criticism of mutual funds

The primary criticism of actively managed mutual funds comes from the historical fact that, over long periods of time, most have not returned as much buying an index fund.

There are also other criticisms levied against mutual funds as a consequence of the first criticism. One critique covers the concept of the sales load, an upfront or deferred fee as high as 8.5 percent of the amount invested in a fund. Firstly, some critics do not believe that this should be charged on a percentage basis instead of a flat fee basis. Secondly this payment for advice and other services seems dubious to these critics because with so many mutual funds underperforming, but yet visibly attracting money, the advice given seemingly would be bad advice.

Mutual funds are also seen by some to have a systemic conflict of interest with regards to their size. Fund companies typically make money by charging a management fee of anywhere between 0.5-2.5 percent of the funds total assets. Although theoretically this could incent them to cause the fund to perform well, since a well performing fund would caused the amount invested in the fund to rise and thus increasing the fee earned, it also could incent the fund to focus on attracting more and more new investors, as the new investors adding money to the fund would also cause the assets of the fund to increase. Many investors believe however that the larger the pool of money one works with, the harder it is to invest. Thus the harder it becomes for the mutual fund to perform well. Thus a fund company can be focused on attracting new customers, hurting its existing investors' performance. A great deal of the funds costs are flat and fixed costs, such as the salary for the manager. Thus it can be more profitable to the fund to try and allow it to grow as large as possible, instead of limiting its assets.

Other practices of mutual funds have been criticized from time to time, such as funds allowing market timing. More recent criticisms have focused on the fund managers accepting extravagant gifts in exchange for trading stocks through certain investment banks, who presumably overcharge the fund compared to what another, non-gifting investment bank would charge.

See also

• closed-end fund
• index fund
• list of mutual-fund families
• mutual fund scandal (2003)
• open-end fund
• unit trust

References

• Gross, Daniel (Nov. 10, 2005). "The Big Money". Slate.

External links

• Asset Allocation Software and Wealth Management Software

• Morningstar uses a star system for its ratings, similar to a restaurant review. This site also lets you search, filter, and screen many mutual funds.
• About Mutual Funds is a site with over 800 pages dedicated towards mutual fund education. Those new to mutual funds should consider taking the free course Mutual Funds 101.
• Mutual Funds A complete, but concise, tutorial about mutual funds in a one-page format with sidebars, illustrations, formulas, examples, and clear definitions of basic terms.
• Investopedia Another tutorial on Mutual Fund basics from Investopedia.com. Can also link to information on all things involved with finance.
• Mutual Fund Directory and Resource
• Investing in Mutual Funds Quiz
• Canadian Mutual Funds News and Information

Associations

• The Investment Company Institute is the fund industry group. Its website includes investor education materials.

Flows

• AMG Data Services - AMG Data Services
• TrimTabs Investment Research

Industry news

• Ignites
• Mutual Fund Wire
• Fund Action
• Fund Marketing
• Money Management Executive