3.4 Mutual Funds
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Two Cents: What the Heck is a Mutual Fund? (all rights reserved)
A mutual fund is a portfolio of securities, consisting of one type of security or a combination of several different types. A fund serves as a convenient way for an investor to have a diversified portfolio of investments in just about any investable asset. The oldest mutual fund is believed to have been founded by Adriaan van Ketwich in 1774. Ketwich invited investors to contribute to a trust fund to spread the risk of investing in foreign bonds. The idea moved from the Netherlands to Scotland to the United States, where the Boston Personal Property Trust established the first mutual fund in 1893.FinanceScholar.com, http://www.financescholar.com/history-mutual-funds.html (accessed June 15, 2009).
The mutual fund’s popularity has grown in periods of economic expansion. At the height of the stock market boom in 1929, there were over seven hundred mutual funds in the United States. After 1934, mutual funds fell under the regulatory eye of the Securities and Exchange Commission (SEC), and it wasn’t until the 1950s that there were once again over one hundred mutual funds in the United States.
Mutual funds multiplied in the 1970s, spurred on by the creation of IRAs and 401(k) retirement plans, and again in the 1980s and 1990s, inspired by economic growth and the tech stock boom. By the end of 2008, U.S. mutual funds—which account for just over half of the global market—had $9.6 trillion in assets under management. Forty-five percent of all U.S. households owned mutual funds, compared to 6 percent in 1980. For 69 percent of those households, mutual funds were more than half of their financial assets.The Investment Company Institute, 2009 Investment Company Fact Book, 49th ed., 2009, http://www.ici.org/pdf/2009_factbook.pdf (accessed June 15, 2009). Mutual funds play a significant role in individual investment decisions.
A mutual fund provides an investor with cheaper and simpler diversification and security selection, requiring only one transaction to own a diversified portfolio (the mutual fund). By buying shares in the fund rather than individual securities, you achieve extensive diversification for a much lower transaction cost than by investing in individual securities and making individual transactions. You also receive the benefit of professional security selection, which theoretically minimizes the opportunity costs of lesser choices. So by using a mutual fund, you get more and better security selection and diversification.
A mutual fund also provides stock and bond issuers with a mass market. Rather than selling shares to investors individually (and incurring the costs of doing so), issuers can more easily find a market for their shares in mutual funds.
Structures and Types of Mutual Funds
Like stocks and bonds, mutual funds may be actively or passively managed. Actively managed funds provide investors with professional management and the expected research, analysis, and watchfulness that goes with it. Passively managed index funds[1], on the other hand, are designed to mirror the performance of a specific index constructed to be representative of an asset class. Recall, for example, that the Standard & Poor’s (S&P) 500 Index is designed to mirror the performance of the five hundred largest large cap stocks in the United States.
Mutual funds are structured in three ways:
- Closed-end funds
- Open-end funds
- Exchange-traded funds
Closed-end funds[2] are funds for which a limited number of shares are issued. Once all shares have been issued, the fund is “closed” so a new investor can only buy shares from an existing investor. Since the shares are traded on an exchange, the limited supply of shares and the demand for them in that market directly determines the value of the shares for a closed-end fund.
Most mutual funds are open-end funds[3] in which investors buy shares directly from the fund and redeem or sell shares back to the fund. The price of a share is its net asset value (NAV)[4], or the market value of each share as determined by the fund’s assets and liabilities and the number of shares that exist. Here is the basic formula for calculating NAV:
NAV = (market value of fund securities − fund liabilities) ÷ number of shares outstanding.
Demand for shares is reflected in the number of shares outstanding, because the fund can create new shares for new investors. NAV calculations are usually done once per day at the close of trading, when mutual fund transactions are recorded.
The NAV is the price that the fund will pay you when you redeem your shares, so it is a gauge of the shares’ value. It will increase if the market value of the securities in the fund increases faster than the number of new shares.
Exchange-traded funds (ETFs)[5] are structured like closed-end funds but are traded like stocks. Shares are traded and priced continuously throughout the day’s trading session, rather than once per day at the end of trading. ETFs trade more like individual securities; that is, if you are trying to time a market, they are a more nimble asset to trade than open-end or closed-end funds.
Originally designed as index funds, exchange-traded funds now target just about every asset, sector, and economic region imaginable. Because of this, ETFs have become quite popular, with over $4.9 trillion (up from a half billion in 2009) invested in over 5,000 funds (up from 700 in 2009).
Another popular type of fund is called a “fund of funds.” This is a mutual fund that owns shares in other mutual funds rather than in specific securities. If you decide to use mutual funds rather than select securities, a fund of funds will provide expertise in choosing funds. These have become popular with the use of retirement year targeted mutual funds where a fund manager adjusts the types of mutual funds based on your age (becoming safer as you approach retirement.)
Mutual Fund Fees and Returns
All funds must disclose their fees to potential investors: sales fees, management fees, and expenses. A load fund[9] charges a sales commission on each share purchase. That sales charge (also called a front-end load[10]) is a percentage of the purchase price. A no-load fund[11], in contrast, does not charge a sales commission, because shares may be purchased directly from the fund or through a discount broker. The front-end load can be as much as 8.5 percent, so if you plan to invest often or in large amounts, that can be a substantial charge. For example, a $5,000 investment may cost you $425, reducing the amount you have to invest and earn a return.
A fund may charge a back-end load[12], actually a deferred sales charge, paid when you sell your shares instead of when you buy them. The charge may be phased out if you own the shares for a specified length of time, however, usually five to seven years.
A fund may charge a management fee on an annual basis. The management fee is stated as a fixed percentage of the fund’s asset value per share. Management fees can range from 0.1 percent to 2.0 percent annually. Typically, a more actively managed fund can be expected to charge a higher management fee, while a passively managed fund such as an index fund should charge a minimal management fee.
A fund may charge an annual 12b-1 fee[13] or distribution fee, also calculated as not more than 1.0 percent per year of the fund’s asset value. Some mutual funds charge other extra fees as well, passing on fund expenses to shareholders. You should consider fee structure and rate when choosing mutual funds, and this can be done through calculations of the expense ratio.
Note: Many ETFs carry a very low or zero fee structure.
Learn to Invest: Introduction to Mutual Fund Fees (all rights reserved)
Mutual Fund Information and Strategies
All mutual fund companies must offer a prospectus[19], a published statement detailing the fund’s assets, liabilities, management personnel, and performance record. You should always take the time to read it and to take a closer look at the fund’s investments to make sure that the fund will be compatible and appropriate to your investment goals.
For example, suppose you have an investment in an S&P 500 Index fund and now are looking for a global stock fund to complement and diversify your holdings in domestic (U.S.) equities. You go to the Web site of a large mutual fund company offering hundreds of funds. You find a stock fund called “Global Stock Fund”—sounds like it’s just what you are looking for. Looking closer, however, you can see that this fund is invested in the stocks of companies in Germany, Japan, and the United Kingdom. While they are not U.S. stocks, those economies are similar to the U.S. economy, perhaps too similar to provide the diversity you are looking for.
Or suppose you are looking for a bond fund to create income and security. You find a fund called the “Investment Grade Fixed Income Fund.” On closer inspection, however, you find that the fund does not invest only in investment grade bonds but that the average rating of its bonds is investment grade. This means that the fund invests in many investment grade bonds but also in some speculative grade bonds to achieve higher income. While this fund may suit your need for income, it may not be appropriate for your risk tolerance.
Mutual fund companies make this information readily available on Web sites and in prospectuses. You should always make the extra effort to be sure you know what’s in your fund. In addition, mutual funds are widely followed by many performance analysts. Ratings agencies such as Morningstar and investment publications such as Barron’s and Forbes track, analyze, and report the performance of mutual funds. That information is available online or in print and provides comparisons of mutual funds that you may find helpful in choosing your fund.
In print and online newspapers, mutual fund performance is reported daily in the form of tables that compare the average returns of funds from week to week. Reported average returns are based on the net asset value per share (NAVPS). Investors can use this information to choose or compare funds and track the performance of funds they own.
In conclusion, since a mutual fund may be made up of any kind or many kinds of securities (e.g., stocks, bonds, real estate, and commodities), it is not really another kind of investment. Rather, it is a way to invest without specifically selecting securities, a way of achieving a desired asset allocation without choosing individual assets.
The advantages of investing in a mutual fund are the diversification available with minimal transaction costs and the professional management or security selection that you buy when you buy into the fund.
Compared to actively managed funds, passively managed or index funds offer similar diversification but with lower management fees and expense ratios because you aren’t paying for market timing or security selection skills. The turnover ratio shows how passive or active the fund management is. About half of all equity mutual funds have a turnover ratio of less than 50 percent.
