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.
[{{cite web|url=http://www.sec.gov/answers/mutfund.htm |title=US SEC answers on Mutual Funds |publisher=U.S. Securities and Exchange Commission (SEC)|accessdate=2006-04-11}}] In a mutual fund, the fund manager trades the fund's underlying securities, realizing
capital gains or loss, and collects the
dividend or
interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the
net asset value (NAV), is calculated daily based on the total value of the fund divided by the number of shares purchased by investors.
Legally
known as an "open-end company", a mutual fund is one of three basic types of
investment companies available in the
United States.
[{{cite web|url=http://www.sec.gov/answers/mfinvco.htm |title=Investment Companies |publisher=U.S. Securities and Exchange Commission (SEC)|accessdate=2006-04-11}}] Outside of the
U.S. (with the exception of
Canada which follows the
US model),
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.
History
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. Only in 1954 did the stock market finally rise 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. The first retail index fund was released in 1976, called the First Index Investment Trust. It is now called the Vanguard 500 Index fund and is one of the largest mutual funds 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 1975, 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.
As of April 2006, there are 8,606 mutual funds that belong to the
Investment Company Institute (ICI), the national association of Investment Companies in the United States, with combined assets of $9.207 trillion USD.
[{{cite web|url=http://www.ici.org/about_ici.html |title=About ICI |publisher=Investment Company Institute (ICI) |accessdate=2006-04-11}}]
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).
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. A mutual fund is administered through a parent management company, which may hire or fire fund managers.
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.
Net asset value
{{Main|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.
Turnover
Turnover is a measure of the fund's securities transactions, usually in a year, and usually expressed as a percentage of net asset value.
This value is usually calculated as the value of all transactions (buying, selling) divided by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and another one bought as one "turnover". Thus turnover measures replacing holdings.
In Cananda, under NI 81-106 (required disclosure for investment funds) turnover ratio is calculated based on the lesser of purchases or sales divided by the average size of the portfolio (including cash).
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.
Expenses and MER's
Mutual funds bear some expenses similar to other companies. Though usually the major expense is the Management Fee paid to the fund manager, there are other expenses like Legal Fees, Audit Fees, Custodian Fees, and other fees that must be borne by the fund. There has been some criticism of Mutual Funds over the amount of expenses that eat into returns made by funds. This has led to disclosure of Management Expense Ratios (MERs). This essentially is a calculation of all the expenses of a fund divided by the average NAV for the year. In the first year of operations (where the reporting period may be less than 365 days), MERs should be calculated based on expenses normalized for 365 days.
Types of mutual funds
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|Exchange-traded fund}}
A relatively new innovation, the exchange traded fund (ETF), is often formulated as an open-end investment company. The way ETFs work combines characteristics of both mutual funds and closed-end funds. An ETF usually tracks a stock index (see
Index funds). Shares are only created or redeemed by institutional investors in large blocks (typically 50,000 shares). Investors typically purchase shares in small quantities through brokers at a small premium or discount to the net asset value through which the institutional investor makes their profit. Because 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.
Equity funds
Equity funds, which mainly consist of stock investments, are the most common type of mutual fund. Equity funds hold 50 percent of total funds invested in mutual funds in the United States.
[{{cite web|url=http://www.ici.org/funds/abt/faqs_bond_funds.html |title=Frequently Asked Questions About Bond Mutual Funds |publisher=Investment Company Institute |accessdate=2006-04-11}}] Oftentimes equity funds focus investments on particular strategies and certain types of companies.
Capitalization
Some mutual funds focus investments on companies of particular size ranges, with size measured by their
market capitalization. The size ranges include
micro-cap ,
small-cap,
mid-cap, and
large-cap. Fund managers and other investment professionals have varying definitions of these market cap ranges. The following ranges are used by
Russell Indexes [{{cite web|title=U.S. Indexes: Construction & Methodology |url=http://www.russell.com/US/Indexes/US/methodology.asp |accessdate=2006-04-23}}] include:
Growth vs. value
Another division is between
growth funds, which invest in stocks of companies that have the potential for large
capital gains, versus
value funds, which concentrate on stocks that are undervalued. Growth stocks typically have a potential for larger return, however such investments also bear larger risks. Growth funds tend not to pay regular
dividends.
Sector funds focus on specific industry sectors, such as
biotechnology or
energy.
Income funds tend to be more conservative investments, with a focus on stocks that pay dividends. A
balanced fund may use a combination of strategies, typically including some investment in
bonds, to stay more conservative when it comes to risk, yet aim for some growth.
Index funds versus active management
{{Main|Index fund|active management}}
An
index fund maintains investments in companies that are part of major stock indices, such as the
S&P 500, while an
actively-managed fund attempts to outperform a relevant index through superior stock-picking techniques. The assets of an index fund are managed to closely approximate the performance of a particular published index. Since the composition of an index changes infrequently, an index fund manager makes fewer trades, on average, than does an active fund manager. For this reason, index funds generally have lower trading expenses than actively-managed funds, and typically incur fewer short-term
capital gains which must be passed on to shareholders. Additionally, index funds do not incur expenses to pay for selection of individual stocks (proprietary selection techniques, research, etc.) and deciding when to buy, hold or sell individual holdings. Instead, a fairly simple computer model can identify whatever changes are needed to bring the fund back into agreement with its target index.
The performance of an actively-managed fund largely depends on the investment decisions of its manager. Statistically, for every investor who outperforms the market, there is one who underperforms. Among those who outperform their index
before expenses, though, many end up
underperforming after expenses. Before expenses, a well-run index fund should be average. By minimizing the impact of expenses, index funds should be able to perform better than average.
Certain empirical evidence seems to illustrate that mutual funds do not beat the market and actively managed mutual funds under-perform other broad-based portfolios with similar characteristics.
[{{cite journal | author = Mark Carhart | year = 1997 | month = March | title = On Persistence in Mutual Fund Performance | journal = Journal of Finance | volume = 52 | issue = 1 | pages = 56-82 }}] finds that nearly 1,500 U.S.A. mutual funds under-performed the market in approximately half the years between 1962 and 1992. Moreover, funds that performed well in the past are not able to beat the market again in the future (shown by Jensen, 1968; Grimblatt and Titman, 1989.
[{{cite journal | author = M. Grimblatt and S. Titman | year = 1989 | title = Mutual Fund Performance: an Analysis of Quarterly Portfolio Holdings | journal = Journal of Business | volume = 62 | pages = 393-416}}] However, as quantitative finance is in its early stages of development more accurate studies are required to reach a decisive conclusion.{{citation needed}}
Bond funds
Bond funds account for 18% of mutual fund assets.
[{{cite web|url=http://www.ici.org/funds/abt/faqs_bond_funds.html |title=Frequently Asked Questions About Bond Mutual Funds |publisher=Investment Company Institute |accessdate=2006-04-11}}] Types of bond funds include
term funds, which have a fixed set of time (short, medium, long-term) before they mature.
Municipal bond funds generally have lower returns, but have
tax advantages and lower risk.
High-yield bond funds invest in corporate bonds, including high-yield or
junk-bonds. With the potential for high yield, these bonds also come with greater risk.
Money market funds
Money market funds hold 26% of mutual fund assets in the United States.
[{{cite web|url=http://www.ici.org/funds/abt/faqs_money_funds.html |title=Frequently Asked Questions About Money Market Mutual Funds |publisher=Investment Company Institute |accessdate=2006-04-11}}] Money market funds entail the least risk, as well as lower rates of return. Unlike
certificate of deposits (CDs), assets in money market funds are
liquid and redeemable at any time. The interest rate quoted by money market funds is known as the
7 Day SEC Yield.
Hedge funds
{{Main|Hedge fund}}
Hedge funds in the United States are pooled investment funds with loose
SEC regulation, and should
not be confused with mutual funds. Certain hedge funds are required to register with SEC as investment advisers under the Investment Advisers Act.
[{{cite web|url=http://www.sec.gov/answers/hedge.htm |title=Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds |publisher=U.S. Securities and Exchange Commission (SEC) |accessdate=2006-04-11}}] The Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. Hedge funds typically charge a fee greater than 1%, plus a "performance fee" of 20% of a hedge fund's profits. There may be a "lock-up" period, during which an investor cannot cash in shares.
Mutual funds vs. other investments
Mutual funds offer several advantages over stock investments, including
diversification and professional management. A mutual fund may hold investments in hundreds or thousands of stocks, thus reducing risk of any particular stock. Also, the transaction costs associated with buying individual stocks are also spread around among all the mutual fund shareholders. As well, a mutual fund benefits from professional fund managers who can apply their expertise and dedicate time to research investment options. Mutual funds, however, are not immune to risks. Mutual funds share the same risks associated with the types of investments the fund makes. If the fund mainly invests in stocks, the mutual fund is usually subject to the same ups and downs and risks as the
stock market.
Selecting a mutual fund
{{tone}}
Picking a mutual fund from among the thousands offered is not easy. Following are some common pitfalls.
#Prior to investing in a tax-exempt or tax-managed fund, it is best to determine if the tax savings will off-set the possibly lower returns. Additionally, these funds are inappropriate for IRAs and other tax-sheltered account types.
#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) or expect to use soon should generally be in a less volitile fund, such as a money market. Money you will not need until you retire in decades (or for a newborn's college education) can reasonably be invested in longer-term, higher-risk investments, such as stock or bond funds. Putting money you will need soon in volatile investments risks having to sell them when the market is low. Investing long term in very stable investments, on the other hand, significantly reduces potential returns.
#Expenses matter over the long term, and, all other things being equal, cheaper is 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.
#Several sector funds often make the "best fund" lists each year. However, which sector varies from year to year. Most sectors are vulnerable to industry-wide events that can have a significant impact on your holdings. It is generally best to avoid making these a large part of your portfolio.
#Closed-end funds often sell at a discount to the value of their holdings. You can sometimes get extra return by buying these, if you are willing to hold the fund until the discount rebounds. Some hedge fund managers use this gambit. This also implies that buying them at the original issue may be a bad idea, since the price will often drop immediately, due to liquidity concerns.
#Mutual funds often make taxable distributions near the end of the year (semi-annual and quarterly distributions are also fairly common). 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 distribute dividends and capital gains. Investing just before the distribution results in part of your investment being returned to you as taxable without increasing the value of your account.
#Read the prospectus, even though it may seem boring. It should tell you what risks will be taken 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 50% for a 1-yr. period (which is impressive), but only 10% for the 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 10% compounded over 5 years is only 61%.
#Diversification can reduce risk. Depending on your risk tollerance and how long you will be investing it may be advisable to own some stocks, some bonds, and some cash. For longer-term investments, there may be added reason for some of the stocks to be foreign. You might not get as much diversification as you think if all your funds are with the same management company, since may share research and recommendations. The same is true if you have multiple funds with the same profile or investing strategy; their returns will likely be similar. 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 and industry-specific risks, and if you buy a large number of stocks the commissions may cost more than a fund will.
#The
compounding effect is your best friend. A modest return over a long period of time equals a large return overall.
Share class
Many mutual funds offer more than one class of shares. For example, you may have seen a fund that offers "Class A" and "Class B" shares. Each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses. 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 (sometimes referred to as "Class C" shares). 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.
[{{cite web|url=http://news.morningstar.com/article/article.asp?id=142323| title=Which Is the Right Fund Share Class for You? |author= Christine Benz |publisher=Morningstar (registration required)|accessdate=2006-04-11}}]As a result, each class will likely have different performance results.
[{{cite web |url=http://www.sec.gov/investor/pubs/inwsmf.htm Sources of Information |title=Invest Wisely: An Introduction to Mutual Funds |publisher=U.S. Securities and Exchange Commission (SEC)|accessdate=2006-04-11}}]
A multi-class structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the time that they expect to remain invested in the fund).
[{{cite web|url=http://www.sec.gov/investor/pubs/inwsmf.htm#factors Sources of Information |title=Invest Wisely: An Introduction to Mutual Funds |publisher=U.S. Securities and Exchange Commission (SEC)|accessdate=2006-04-11}}]
Load and expenses
{{Main|Mutual fund fees and expenses}}
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
breakpoints 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. In addition to being available from the fund company itself, no-load funds may be sold by some discount brokers 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. The purchaser is therefore paying the fee indirectly through the fund's expenses deducted from profits.)
No-load funds include both index funds and actively-managed funds. The largest mutual fund families selling no-load index funds are
Vanguard and
Fidelity though there are a number of smaller mutual fund families with no load funds as well. Expense ratios in some of these no-load index funds are less than 0.2% per year versus the typical actively-managed fund's expense ratio of about 1.5% per year. Load 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 0.2% 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.
Many
fee-only financial advisors strongly suggest no-load funds such as 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.
Criticism of managed mutual funds
Historically,
actively managed mutual funds, over long periods of time, have not returned as much as a comparable
index mutual fund. This, of course, is a criticism of one type of mutual fund over another.
Another criticism covers sales commissions on
load funds, an upfront or deferred fee as high as 8.5 percent of the amount invested in a fund (
No load funds, as the name implies, do not charge these fees). Critics point out high sales commissions represent a conflict of interest, as high commissions benefits the sales people, but hurt the investors. High commissions can also cause sales people to recommend funds that maximize their income. Again, this is a criticism of one type of mutual fund over another.
Mutual funds are also seen by some to have a conflict of interest with regards to their size. Fund companies charge a management fee of anywhere between 0.5-2.5 percent of the fund's total assets. Theoretically, this could motivate the fund managers, since a well performing fund would cause the amount invested in the fund to rise and increasing the fee earned. It also could motivate the fund company to focus on advertising to attract more and more new investors, as new investors would also cause the fund assets to increase.
Many analysts, however, believe that the larger the pool of money one works with, the harder it is to manage actively, and harder to have good performance. 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. Some fund companies, notably the
Vanguard Group and
Fidelity, have closed some funds to new investments to maintain the integrity of the funds for existing investors.
Other mutual funds have been criticized from time to time, such as funds allowing
market timing (many fund companies tightly control this). 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. As a result, many fund companies strictly limit -- or completely bar -- such gifts.
Scandals
In September
2003, the United States mutual fund industry was beset by a scandal in which major fund companies permitted and facilitated "
late trading" and "
market timing". See:
Mutual-fund scandal (2003)
See also
