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"An investment in knowledge always pays the best interest." — Benjamin Franklin
A mutual fund company is an investment company that receives money from investors for the sole purpose to invest in stocks, bonds, and other securities for the benefit of the investors. A mutual fund is the portfolio of stocks, bonds, or other securities that generate profits for the investor, or shareholder of the mutual fund. A mutual fund allows an investor with less money to diversify his holdings for greater safety and to benefit from the expertise of professional fund managers. Mutual funds are generally safer, but less profitable, than stocks, and riskier, but more profitable than bonds or bank accounts, although its profit-risk profile can vary widely, depending on the fund's investment objective.
It is easier to pick an investment strategy, such as growth or income, with mutual funds than by buying the individual securities, since mutual fund companies clearly specify the investment objectives of each fund that they manage. Other advantages to investing in mutual funds is that the initial investment is generally low, it is easy to reinvest profits, and money can be invested continually, often in amounts less than the initial investment, such as every month. It can even be done automatically.
Mutual fund companies are investment companies registered under the Investment Company Act of 1940.
Funds are managed by an investment advisor or by professional money managers under contract with the fund to invest to achieve the specific investment objectives of the fund, such as growth or income. The investment advisor, who could be officers of the fund or a management company, makes the daily investment decisions for the fund, and the fund's success largely depends on their ability.
The initial contract is for 2 years, and must be approved by the board of directors and the shareholders. Afterwards, the contract must be renewed annually by the approval of the board of directors or the shareholders.
The prospectus lists the name of the investment adviser, their location, the term of their contract, and their principle duties and responsibilities. Their typical management fee is 1/2% of the funds assets.
Every investment company must have a board of directors, with no more than 60% of the board consisting of insiders, and at least 40% consisting of individuals who have no affiliation with the company, the fund's investment adviser, its underwriter, or any organization related to these entities.
Although the outside representation may be in the minority, several important decisions regarding the fund require the majority approval of the outsider representation to prevent conflicts of interest.
A custodian, usually a bank, holds the money and securities in trust, and handles the relationships with the investors, such as sending the monthly financial statements and proxy forms for voting. It has no part in the investment choices or decisions of the fund.
The Investment Company Act of 1940 allowed the creation of 3 different types of investment companies:
Face amount certificates are rare. The holder of the certificates pay money periodically to issuer in exchange for the face value of the certificate at maturity, or a surrender value if surrendered earlier.
Unit investment trusts are investment companies with trustees, but without a board of directors, that issue securities representing an undivided interest in the principal and income of a fixed portfolio of securities, usually consisting of bonds, but may also include mortgage-backed securities, or preferred or common stock. Unit investment trusts terminate either when the bonds mature or on a specified date. These securities trade just like stock or closed-end mutual funds. Many exchange-traded funds are organized as unit investment trusts.
The companies that operate mutual funds are called management companies in the Investment Company Act, and are classified as:
Most mutual funds are open-end funds, which sells new shares continuously or buys them back from the shareholder (redeems them), dealing directly with the investor (no-load funds) or through broker-dealers, who receive the sales load of a buy or sell order. The purchase price is the net asset value at the end of the trading day, which is the total assets of the fund minus its liabilities divided by the number of shares outstanding for that day. The number of shares of an open-end fund varies throughout its existence, depending on how many shares are bought or redeemed by investors.
A major disadvantage to open-end funds is that they need cash to redeem their shares for investors who want out, so they either have to have a lot of cash on hand, which earns only the current prevailing interest rate, or they have to sell securities to raise the cash, possibly generating capital gains taxes for the remaining investors of the fund.
A closed-end mutual fund sells shares of the fund in an initial public offering (IPO). After the offering, no more shares are created or redeemed. Therefore, less money is needed to manage the fund, since there is no need to deal directly with individual investors, such as sending periodic statements, and it also eliminates the need to redeem shares to pay investors who want to cash out, such as occurs in open-end mutual funds. Consequently, a closed-end fund can be more fully invested, since it doesn’t need as much cash, and it is more tax efficient.
The money from the IPO is used to buy a specific portfolio of securities that satisfies the advertised investment objective of the fund. Thereafter, shares of the company are bought and sold over a stock exchange or over-the-counter, just like any stock.
Because fund shares cannot be exchanged for the underlying securities that the shares represent an interest in, there is usually a large difference between the share price of the fund, and the net asset value (NAV) of the fund, which is the actual value of the securities represented by each mutual fund share. This results because the actual share price is determined by the supply and demand for the shares, which usually results in a market price that is different from the fund's NAV. When a fund is first sold, the share price is often at a premium to the NAV, which is how the fund's sponsors make money in creating the fund, but eventually it drops to a discount, and remains there. If the fund's share price is higher than its underlying NAV, then the shares are said to selling at a premium over their net asset value; if the price is lower, then the shares are selling at a discount from their net asset value.
Closely related to mutual funds, and sometimes organized as unit investment trusts, exchange traded funds, sometimes called exchange listed portfolios, exchange index securities, exchange shares, or listed index securities, are like closed-end mutual funds in that they are based on a portfolio of securities representing a category or an index and are traded like stocks on organized stock exchanges.
ETFs differ from closed-end funds in that ETFs have an arbitrage mechanism that allows certain market makers or institutional investors, who have signed Participating Agreements with the fund sponsor and who are referred to as Authorized Participants (also called creation unit holders), to exchange the basket of securities for creation units consisting of 50,000 ETF shares or a multiple thereof. The exchange involves only securities—no cash—which reduces capital gains taxes for shareholders. Only Authorized Participants can create and redeem ETF shares with the fund sponsor, and they also sell the ETF shares they create on the exchanges to retail investors.
When the ETF share price is significantly higher than the NAV, then Authorized Participants can buy the basket of securities on the open market, exchange the securities for ETF shares, then sell the shares on the market for a profit, which is how ETF shares are created. When the NAV is significantly higher, then the Authorized Participants trade their ETF shares for the basket of securities, then sell the securities on the exchanges for a profit, which is how ETF shares are destroyed. It is this process that keeps the ETF share price and NAV approximately, but not exactly, equal, because it takes a certain amount of time and expense to profit from this difference through arbitrage, and the market supply and demand for both ETFs and their underlying securities, with the concomitant affect on prices, change constantly and quickly.
Like stocks and shares of closed-end mutual funds, but unlike open-end mutual funds, exchange-traded funds can be bought anytime during market hours, can be ordered conditionally by setting limit orders, prices are based on market supply and demand for the shares rather than the underlying NAV, can be shorted even on a downtick, can be bought on margin, and options—calls and puts—can be based on them. Expenses are very low, from .09% to .65%, because the securities that comprise the fund are not traded very often, and thus, do not generate capital gains tax liabilities for investors that results from such trades in a regular mutual fund or even a closed-end fund.
Generally, an index ETF will do better than a index mutual fund based on the same index because of slightly lower expenses, but only if very few investments are made, because buying an ETF must be done through a broker who charges a commission. For an investor that makes frequent contributions, an index mutual fund would be much cheaper, and the fund would allow automatic reinvestment of income. However, there are some brokers who charge minimum fees for buying ETFs by consolidating such purchases into 1 large block trade. So it helps to shop around when you do decide to invest in an index fund.
The first ETF, created by the American Stock Exchange in 1993, was the Standard & Poor's Depositary Receipts Trust, usually called a SPDR, or spider (ticker: SPY), and is based on the S&P 500 index. Two other major ETFs are the QQQQ (nickname: qubes) based on the NASDAQ 100, and the DIA (nickname: diamonds) based on the Dow Jones Industrial Average.
When a mutual fund is created, the founders decide what market strategies to pursue and its investment objectives. A required prospectus is prepared for potential investors that details the company's objectives, expenses, fees, and management, so that an investor can make an informed decision about the mutual fund. When an investor buys the shares of the mutual fund, he becomes a shareholder of the company, with basically the same rights and privileges as a shareholder of any other company.
The Securities and Exchange Commission (SEC) requires that mutual fund companies give each prospective investor a prospectus, which details investment objectives, management, portfolio holdings, performance, and fees. The prospectus has at least the following:
Also known as Part B of the registration statement, the SAI explains a fund's operations in greater detail than the prospectus — including the fund's financial statements and details about the history of the fund, fund policies on borrowing and concentration, the identity of officers, directors, and persons who control the fund, investment advisory and other services, brokerage commissions, tax matters, and performance such as yield and average annual total return information. If you ask, the fund must send you an SAI. The back cover of the fund's prospectus should contain information on how to obtain the SAI.
Numerous studies have shown that a fund that performed better than the market in the past is just as likely to underperform in the future as it is to outperform the market. This will be particularly true for growth funds and aggressive growth funds, since there is much more uncertainty and risk associated with such stocks, and to maintain such growth, the funds' portfolio will have to be more actively managed, with the concomitant increase of mistakes in selecting stocks and the fees associated with active management. This is why few funds do better than index funds over the long term. Short-term performance could be due more to luck than to investing savvy.
There are numerous fees associated with specific activities, the total of which can vary from .5% to 8.5%, the legal maximum. Management fees are annual charges for administering the fund, which can vary from about .5% to 2%. Distribution and service fees (12b-1 fees) cover marketing expenses to bring in new investors, and may be used to pay bonuses for employees. Redemption fees, sometimes referred to as a deferred sale load or back load fees, are assessed when shares of the fund are sold, to discourage frequent trading, unless the investor has held the shares for a minimum of time, specified in the prospectus. Reinvestment fees can be charged if the investor reinvests his profits in the fund. Exchange fees can be charged if an investor transfers his money from one fund to another within the same company.
No load funds do not charge a front-end sales charge or a deferred sales charge, such as a CDSC. NASD rules also require that the 12b-1 fees not exceed 0.25% of the fund's average annual net assets in order to call itself a no load fund.
Many mutual funds with sales loads offer more than one class of shares. Each class will have the same portfolio of securities, investment objectives, and policies, but each class will have different shareholder services and/or distribution arrangements with different fees and expenses. As a result, each class will likely have different performance results.
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). Here are some key characteristics of the most common mutual fund share classes offered to individual investors:
Class A Shares typically impose a front-end sales load. They also tend to have a lower 12b-1 fee and lower annual expenses than other mutual fund share classes. Some mutual funds reduce the front-end load as the size of your investment increases. If you're considering Class A shares, be sure to inquire about breakpoints, which are only available for Class A shares.
Class B Shares do not have a front-end sales load, but have a 12b-1 fee and a contingent deferred sales load—a sales charge assessed when the shares are redeemed. This charge typically declines to 0 over a period of 6 to 8 years, then is automatically converted to Class A shares with a lower 12b-1 fee.
Class C Shares — Class C shares might have a 12b-1 fee, other annual expenses, and either a front- or back-end sales load. But the front- or back-end load for Class C shares tends to be lower than for Class A or Class B shares, respectively. Unlike Class B shares, Class C shares generally do not convert to another class. Class C shares tend to have higher annual expenses than either Class A or Class B shares. These shares would be more attractive to a short-term investor.
Here's an example of share classes from an actual prospectus:
Operating expenses, such as management fees, 12b-1 fees, and administrative fees, but not including transaction costs in the buying and selling of securities or fund shares (sales loads), can be summarized by the expense ratio:
| Mutual Fund Expense Ratio Formula | |
| Total Operating Expenses (doesn't include shareholder costs) Average Net Asset Value | = Expense Ratio (.18% < Typical Range < 2%) |
The expense ratio is an important metric when comparing funds, because it can make a significant difference over time. Any money paid for expenses is money that is not invested and earns no profit. High expenses are not proportional to better management. In fact, frequently, high-expense funds underperform index funds, which are minimally managed and have very low expense ratios. A fund's managers can become rich through the charge of expenses even as the fund's NAV declines!
All fees must be disclosed in the prospectus as a fee table. Here is a sample:
Investment Tips:
A mutual fund can be measured in various ways. Three common metrics are:
Net Asset Value (NAV) change. The NAV is the share price of the fund, obtained by dividing the value of the fund's holdings by the number of outstanding shares. The share price is what you would have to pay to buy into the mutual fund, plus any fees. The change in NAV, reported at the end of every market day, reflects the increase or decrease in the value per share.| Net Asset Value (NAV) Formula | |
| value of fund number of shares | = Net Asset Value (NAV) |
| Net Asset Value (NAV) Example | |
| $100,000,000 total fund value 10,000,000 shares | = $10 per share |
| Mutual Fund Yield Formula | |
| income distribution per share price per share | = Yield % |
| Mutual Fund Yield Example | |
| $.60 income per share $10 per share | = 6% yield |
| Mutual Fund Total Return Formula | |
| Current Value of Shares + Cash Distributions - Initial Investment | = Total Profit or Loss |
| Mutual Fund Total Return Example | |
| $12,000 current value of shares + $3,000 total cash distributions - $6,000 initial investment | = $9,000 Profit |
An investor has a choice of buying shares of the mutual fund directly, or through a financial agent, such as a broker or a bank. Buying through an agent will generally cost more, and oftentimes, an agent will push funds that his company sponsors or offers the highest commission for the agent rather than what’s best for the client. There are, however, good tools on the Web for finding funds that satisfy certain criteria.
A mutual fund earns money from dividends and interest, and by selling securities. Profits are paid to investors through distributions. Income distributions are based on profits from dividends and interest, while capital distributions are from profits from the sale of securities. The schedule of payouts differ according to company. Typically, income is distributed quarterly, while capital distributions are paid out once a year, usually in December.
Instead of receiving distributions, profits can be reinvested, but investors must pay tax on profits, whether it is distributed or reinvested. Income distributions are taxed as ordinary income, while capital distributions are taxed as capital gains.
An investor can also profit by selling shares back to the fund—redeeming the shares. Such sales are taxed as capital gains in the year they are sold. Depending on the mutual fund and the share class, there may be a deferred sales load on the redemption.
The Securities and Exchange Commission (SEC — http://www.sec.gov/) monitors and regulates all mutual fund companies, which are registered under the Investment Company Act of 1940. Mutual fund companies are also regulated by the National Association of Securities Dealers (NASD — http://www.nasd.com/). Each state also has security regulations that may apply to mutual fund companies doing business in that state.
Most mutual funds are also regulated investment companies that comply with Sub-Chapter M of the Internal Revenue Code, which requires that the company must distribute at least 90% of its net investment income and 90% of its net capital gains to its shareholders to avoid corporate taxation of the distributions. Investment companies do, however, have to pay tax on undistributed income.
If a mutual fund is also a diversified management company, which most are, then at least 75% of its portfolio must consist of securities where no individual issue composes more than 5% of the fund's total assets, and that does not compose more than 10% of the voting stock of any single issuer. The other 25% of the fund is not so restricted.
If you are going to buy a large number of shares from a fund with a front-end sales load, then know if you can take advantage of breakpoints to lower the sales load percentage.
No-load funds do not charge a sales load, which is technically a sales commission to a broker for selling the shares, and therefore the no-load category may include fees that are not technically sales loads, such as purchase fees, redemption fees, exchange fees, and account fees. No-load funds will also have operating expenses.
Small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858 — an 18% difference.
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