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A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. While there is no legal definition of the term "mutual fund", it is most commonly applied to open-end investment companies, which are collective investment vehicles that are regulated and sold to the general public on a daily basis. They are sometimes referred to as "investment companies" or "registered investment companies". Hedge funds are not mutual funds, primarily because they cannot be sold to the general public. In the United States mutual funds must be registered with the U.S. Securities and Exchange Commission, overseen by a board of directors or board of trustees, and managed by a Registered Investment Advisor. Mutual funds are subject to an extensive and detailed regulatory regime set forth in the Investment Company Act of 1940. Mutual funds are not taxed on their income and profits if they comply with certain requirements under the U.S. Internal Revenue Code.
Mutual funds have both advantages and disadvantages compared to direct investing in individual securities. Today they play an important role in household finances, most notably in retirement planning.
There are three types of U.S. mutual funds: open-end funds, unit investment trusts, and closed-end funds. The most common type, open-end funds, must be willing to buy back shares from investors every business day. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange. Non-exchange-traded open-end funds are most common, but ETFs have been gaining in popularity.
Mutual funds are generally classified by their principal investments. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds, and hybrid funds. Funds may also be categorized as index (or passively managed) or actively managed.
Investors in a mutual fund pay the fund’s expenses, which reduce the fund's returns and performance. There is controversy about the level of these expenses.
In the United States, a mutual fund is registered with the Securities and Exchange Commission (SEC). Open-end and closed-end funds are overseen by a board of directors (if organized as a corporation) or board of trustees (if organized as a trust). The Board is charged with ensuring that the fund is managed in the best interests of the fund's investors and with hiring the fund manager and other service providers to the fund.
The sponsor or fund management company, often referred to as the fund manager, trades (buys and sells) the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment adviser. Funds that are managed by the same company under the same brand are known as a fund family or fund complex.
Mutual funds are not taxed on their income and profits as long as they comply with requirements established in the U.S. Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute most of their income (dividends, interest, and capital gains net of losses) to their investors annually, and earn most of the income by investing in securities and currencies. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors but are retained by the fund to be able to offset future gains.
The characterization of a fund's income is unchanged when it is paid to shareholders. For example, when a mutual fund distributes dividend income to its shareholders, fund investors will report the distribution as dividend income on their tax return. As a result, mutual funds are often called "pass-through" vehicles, because they simply pass on income and related tax liabilities to their investors.
Mutual funds may invest in many kinds of securities. The types of securities that a particular fund may invest in are set forth in the fund's prospectus, a legal document which describes the fund's investment objective, investment approach and permitted investments. The investment objective describes the type of income that the fund seeks. For example, a capital appreciation fund generally looks to earn most of its returns from increases in the prices of the securities it holds, rather than from dividend or interest income. The investment approach describes the criteria that the fund manager uses to select investments for the fund.
Hedge funds are not considered a type of (unregistered) mutual fund. While hedge funds are another type of collective investment vehicle, they are not governed by the Investment Company Act of 1940 and are not required to register with the SEC (though hedge fund managers must register as investment advisers).
Advantages and disadvantagesEdit
According to Pozen and Hamacher, mutual funds have advantages and disadvantages over investing directly in individual securities, namely:
- Increased diversification: A fund normally holds many securities; diversification decreases risk.
- Daily liquidity: Shareholders of open-end funds and unit investment trusts may sell their holdings back to the fund at the close of every trading day at a price equal to the closing net asset value of the fund's holdings.
- Professional investment management: Open-and closed-end funds hire portfolio managers to supervise the fund's investments.
- Ability to participate in investments that may be available only to larger investors. For example, individual investors often find it difficult to invest directly in foreign markets.
- Service and convenience: Funds often provide services such as check writing.
- Government oversight: Mutual funds are regulated by the SEC
- Ease of comparison: All mutual funds are required to report the same information to investors, which makes them easy to compare.
- Less control over timing of recognition of gains
- Less predictable income
- No opportunity to customize
The first mutual funds were established in Europe. One researcher credits a Dutch merchant with creating the first mutual fund in 1774. Mutual funds were introduced to the United States in the 1890s, and they became popular in the 1920s.
These early U.S. funds were generally closed-end funds with a fixed number of shares that often traded at prices above the portfolio value. The first open-end mutual fund, called the Massachusetts Investors Trust (now part of the MFS family of funds), with redeemable shares was established on March 21, 1924. However, closed-end funds remained more popular than open-end funds throughout the 1920s. In 1929, open-end funds accounted for only 5% of the industry's $27 billion in total assets.
After the stock market crash of 1929, Congress passed a series of acts regulating the securities markets in general and mutual funds in particular. The Securities Act of 1933 requires that all investments sold to the public, including mutual funds, be registered with the SEC and that they provide prospective investors with a prospectus that discloses essential facts about the investment. The Securities and Exchange Act of 1934 requires that issuers of securities, including mutual funds, report regularly to their investors; this act also created the Securities and Exchange Commission, which is the principal regulator of mutual funds. The Revenue Act of 1936 established guidelines for the taxation of mutual funds, while the Investment Company Act of 1940 governs their structure.
When confidence in the stock market returned in the 1950s, the mutual fund industry began to grow again. By 1970, there were approximately 360 funds with $48 billion in assets. The introduction of money market funds in the high interest rate environment of the late 1970s boosted industry growth dramatically. The first retail index fund, First Index Investment Trust, was formed in 1976 by The Vanguard Group, headed by John Bogle; it is now called the "Vanguard 500 Index Fund" and is one of the world's largest mutual funds, with more than $220 billion in assets as of November 30, 2015.
Fund industry growth continued into the 1980s and 1990s. According to Pozen and Hamacher, growth was the result of three factors: a bull market for both stocks and bonds, new product introductions (including tax-exempt bond, sector, international and target date funds) and wider distribution of fund shares. Among the new distribution channels were retirement plans. Mutual funds are now the preferred investment option in certain types of fast-growing retirement plans, specifically in 401(k) and other defined contribution plans and in individual retirement accounts (IRAs), all of which surged in popularity in the 1980s. Total mutual fund assets fell in 2008 as a result of the financial crisis of 2007–08.
In 2003, the mutual fund industry was involved in a scandal involving unequal treatment of fund shareholders. Some fund management companies allowed favored investors to engage in late trading, which is illegal, or market timing, which is a practice prohibited by fund policy. The scandal was initially discovered by former New York Attorney General Eliot Spitzer and led to a significant increase in regulation.
At the end of 2015, there were over 15,000 mutual funds in the United States with combined assets of $18.1 trillion, according to the Investment Company Institute (ICI), a trade association of U.S. investment companies. The ICI reports that worldwide mutual fund assets were $33.4 trillion on the same date.
Mutual funds play an important role in U.S. household finances; in mid-2015, 43% of U.S. households held mutual fund. Their role in retirement planning is particularly significant. Roughly half of the assets in individual retirement accounts and in 401(k) and other similar retirement plans were invested in mutual funds. Mutual funds now play a large and decisive role in the valuation of tradeable assets such as stocks and bonds.
As of September 2015, the top ten open-end fund managers in North America were:
There are three principal types of mutual funds in the United States: open-end funds, unit investment trusts (UITs); and closed-end funds. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange; they have gained in popularity recently. ETFs are one type of "exchange-traded product". While the term "mutual fund" may refer to all three types of registered investment companies, it is more commonly used to refer exclusively to the open-and closed-end funds.
Open-end mutual funds must be willing to buy back their shares from their investors at the end of every business day at the net asset value (NAV) computed that day. Most open-end funds also sell shares to the public every day; these shares are also priced at NAV. A professional investment manager oversees the portfolio, buying and selling securities as appropriate. The total investment in the fund will vary based on share purchases, share redemptions and fluctuation in market valuation. There is no legal limit on the number of shares that can be issued.
Open-end funds are the most common type of mutual fund. At the end of 2015, there were 8,116 open-end mutual funds in the United States with combined assets of $15.7 trillion.
Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from NAV. It may be at a "premium" to NAV (i.e., higher than NAV) or, more commonly, at a "discount" to NAV (i.e., lower than NAV). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.
At the end of 2015, there were 558 closed-end funds in the United States with combined assets of $261 billion.
Unit investment trustsEdit
Unit investment trusts (UITs) can only issue to the public once, when they are created. UITs generally have a limited life span, established at creation. Investors can redeem shares directly with the fund at any time (similar to an open-end fund) or wait to redeem them upon the trust's termination. Less commonly, they can sell their shares in the open market. Unit investment trusts do not have a professional investment manager; their portfolio of securities is established at the UIT's creation and does not change.
At the end of 2015, there were 5,188 UITs in the United States with combined assets of $94 billion.
A relatively recent innovation, exchange-traded funds (ETFs) are structured as open-end investment companies or UITs. ETFs are part of a larger category of investment vehicles known as "exchange-traded products" (ETPs), which, other than ETFs, may be structured as a partnership or grantor trust or may take the form of an exchange-traded note. Non-ETF exchange-traded products may be used to provide exposure to currencies and commodities.
ETFs combine characteristics of both closed-end funds and open-end funds. ETFs are traded throughout the day on a stock exchange. An arbitrage mechanism is used to keep the trading price close to net asset value of the ETF holdings.
Most ETFs are passively managed index funds, though actively managed ETFs are becoming more common.
ETFs have been gaining in popularity. At the end of 2015, there were 1,594 ETFs in the United States with combined assets of $2.1 trillion.
Investments and classificationEdit
Mutual funds are normally classified by their principal investments, as described in the prospectus and investment objective. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds, and hybrid funds. Within these categories, funds may be subclassified by investment objective, investment approach or specific focus.
The SEC requires that mutual fund names be consistent with a fund's investments. For example, the "ABC New Jersey Tax-Exempt Bond Fund" would generally have to invest, under normal circumstances, at least 80% of its assets in bonds that are exempt from federal income tax, from the alternative minimum tax and from taxes in the state of New Jersey.
Bond, stock, and hybrid funds may be classified as either index (passively managed) funds or actively managed funds.
Money market fundsEdit
Money market funds invest in money market instruments, which are fixed income securities with a very short time to maturity and high credit quality. Investors often use money market funds as a substitute for bank savings accounts, though money market funds are not insured by the government, unlike bank savings accounts.
Money market funds strive to maintain a $1.00 per share net asset value, meaning that investors earn interest income from the fund but do not experience capital gains or losses. If a fund fails to maintain that $1.00 per share because its securities have declined in value, it is said to "break the buck". Only two money market funds have ever broken the buck—Community Banker's U.S. Government Money Market Fund in 1994 and the Reserve Primary Fund in 2008.
In 2014, the SEC approved significant changes in money market fund regulation. Beginning in October 2016, money market funds that are sold to institutional investors and that invest in non-government securities will no longer be allowed to maintain a stable $1.00 per share net asset value. Instead, these funds will be required to have a floating net asset value.
At the end of 2015, money market funds accounted for 18% of open-end fund assets.
Bond funds invest in fixed income or debt securities. Bond funds can be sub-classified according to the specific types of bonds owned (such as high-yield or junk bonds, investment-grade corporate bonds, government bonds or municipal bonds) and by the maturity of the bonds held (short-, intermediate- or long-term). Bond funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds).
At the end of 2015, bond funds accounted for 22% of open-end fund assets.
Stock, or equity, funds invest in common stocks which represent an ownership share (or equity) in corporations. Stock funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds). They may focus on a specific industry or sector.
A stock fund may be subclassified along two dimensions: (1) market capitalization and (2) investment style (i.e., growth vs. blend/core vs. value). The two dimensions are often displayed in a grid known as a "style box".
Market capitalization ("cap") indicates the size of the companies in which a fund invests, based on the value of the company's stock. Each company's market capitalization equals the number of shares outstanding times the market price of the stock. Market capitalizations are typically divided into the following categories, with approximate market capitalizations in parentheses:
- Micro cap (below $300 million, 30 crore)
- Small cap (below $2 billion, 200 crore)
- Mid cap
- Large cap (at least $10 billion,1000 crore)
Funds can also be classified in these categories based on the market caps of the stocks that it holds.
Stock funds are also subclassified according to their investment style: growth, value, or blend (or core). Growth funds seek to invest in stocks of fast-growing companies. Value funds seek to invest in stocks that appear cheaply priced. Blend funds are not biased toward either growth or value.
At the end of 2015, stock funds accounted for 52% of the assets in all U.S. mutual funds.
Hybrid funds invest in both bonds and stocks or in convertible securities. Balanced funds, asset allocation funds, target date or target risk funds and lifecycle or lifestyle funds are all types of hybrid funds.
Hybrid funds may be structured as funds of funds, meaning that they invest by buying shares in other mutual funds that invest in securities. Many fund of funds invest in affiliated funds (meaning mutual funds managed by the same fund sponsor), although some invest in unaffiliated funds (i.e., managed by other fund sponsors) or some combination of the two.
At the end of 2015, hybrid funds accounted for 9% of the assets in all U.S. mutual funds.
Index (passively managed) versus actively managedEdit
An index fund or passively managed fund seeks to match the performance of a market index, such as the S&P 500 index, while an actively managed fund seeks to outperform a relevant index through superior security selection.
Investors in a mutual fund pay the fund's expenses. These expenses fall into five categories: distribution charges (sales loads and 12b-1 fees), the management fee, securities transaction fees, shareholder transaction fees and fund services charges. Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value.
Recurring fees and expenses—specifically the 12b-1 fee, the management fee and other fund expenses—are included in a fund's total expense ratio (TER), often referred to simply the "expense ratio". Because all funds must compute an expense ratio using the same method, investors may compare costs across funds.
There is considerable controversy about the level of mutual fund expenses.
The management fee is paid to the management company or sponsor that organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand to the fund. The fund manager may also provide other administrative services. The management fee often has breakpoints, which means that it declines as assets (in either the specific fund or in the fund family as a whole) increase. The management fee is paid by the fund and is included in the expense ratio.
The fund's board reviews the management fee annually. Fund shareholders must vote on any proposed increase, but the fund manager or sponsor can agree to waive some or all of the management fee in order to lower the fund's expense ratio.
Distribution charges pay for marketing, distribution of the fund's shares as well as services to investors. There are three types of distribution charges:
- Front-end load or sales charge. A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested or the "public offering price", which equals the net asset value plus the front-end load per share. The front-end load often declines as the amount invested increases, through breakpoints. The front-end load is paid by the shareholder; it is deducted from the amount invested.
- Back-end load. Some funds have a back-end load, which is paid by the investor when shares are redeemed. If the back-end load declines the longer the investor holds shares, it is called a contingent deferred sales charges (CDSC). Like the front-end load, the back-end load is paid by the shareholder; it is deducted from the redemption proceeds.
- 12b-1 fees. Some funds charge an annual fee to compensate the distributor of fund shares for providing ongoing services to fund shareholders. This fee is called a 12b-1 fee, after the SEC rule authorizing it. The 12b-1 fee is paid by the fund and reduces net asset value.
A no-load fund does not charge a front-end load or back-end load under any circumstances and does not charge a 12b-1 fee greater than 0.25% of fund assets.
Securities transaction feesEdit
A mutual fund pays expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. Securities transaction fees increase the cost basis of investments purchased and reduce the proceeds from their sale. They do not flow through a fund's income statement and are not included in its expense ratio. Instead, purchases and sells of assets are recorded net of the transaction costs. There is no easy way to identify a fund's total transaction costs from publicly available data.
That said, an investor can get some idea of the size of these fees in a fund in two ways. First, the amount of securities transaction fees paid by a fund is normally positively correlated with its trading volume or "turnover", which is required to be reported by the SEC. The second way is to examine the size of the brokerage fees paid by the fund sponsor by looking at SEC Form N-SAR.
Shareholders may be required to pay fees for certain transactions. For example, a fund may charge a flat fee for maintaining an individual retirement account for an investor. Some funds charge redemption fees when an investor sells fund shares shortly after buying them (usually defined as within 30, 60 or 90 days of purchase); redemption fees are computed as a percentage of the sale amount. Shareholder transaction fees are not part of the expense ratio.
Fund services chargesEdit
A mutual fund may pay for other services including:
- Board of directors or trustees fees and expenses
- Custody fee: paid to a custodian bank for holding the fund's portfolio in safekeeping and collecting income owed on the securities
- Fund administration fee: for overseeing all administrative affairs such as preparing financial statements and shareholder reports, SEC filings, monitoring compliance, computing total returns and other performance information, preparing/filing tax returns and all expenses of maintaining compliance with state blue sky laws
- Fund accounting fee: for performing investment or securities accounting services and computing the net asset value (usually every day the New York Stock Exchange is open)
- Professional services fees: legal and auditing fees
- Registration fees: paid to the SEC and state securities regulators
- Shareholder communications expenses: printing and mailing required documents to shareholders such as shareholder reports and prospectuses
- Transfer agent service fees and expenses: for keeping shareholder records, providing statements and tax forms to investors and providing telephone, internet and or other investor support and servicing
- Other/miscellaneous fees
The fund manager or sponsor may agree to subsidize some of these other expenses in order to lower the fund's expense ratio (called a fee waiver).
Critics of the fund industry argue that fund expenses are too high. They believe that the market for mutual funds is not competitive and that there are many hidden fees, so that it is difficult for investors to reduce the fees that they pay. They argue that the most effective way for investors to raise the returns they earn from mutual funds is to invest in funds with low expense ratios.
Fund managers counter that fees are determined by a highly competitive market and, therefore, reflect the value that investors attribute to the service provided. They also note that fees are clearly disclosed.
An additional critique of mutual funds is their potential role in herd behavior during asset bubbles. Australian researchers Preston Teeter and Jorgen Sandberg argue that the explosive growth of mutual funds during the 1990s resulted in a large number of rookie mutual fund managers, many of whom were quick to follow industry trends as opposed to carving out their own unique investment strategies. As a result, funds started to closely mimic one another, and stock prices, particularly of internet companies, quickly surpassed fundamental valuations.
A single mutual fund may give investors a choice of different combinations of front-end loads, back-end loads and 12b-1 fees, by offering several different types of shares, known as share classes. All of them invest in the same portfolio of securities, but each has different expenses and, therefore, a different net asset value and different performance results. Some of these share classes may be available only to certain types of investors.
Funds offering multiple classes often identify them with letters, though they may also use names such as "Investor Class", "Service Class", "Institutional Class", etc., to identify the type of investor for which the class is intended. The SEC does not regulate the names of share classes, so that specifics of a share class with the same name may vary from fund family to fund family.
Typical share classes for funds sold through brokers or other intermediaries are as follows:
- Class A shares usually charge a front-end sales load together with a small 12b-1 fee.
- Class B shares usually do not have a front-end sales load; rather, they have a high contingent deferred sales charge (CDSC) that gradually declines over several years, combined with a high 12b-1 fee. Class B shares usually convert automatically to Class A shares after they have been held for a certain period.
- Class C shares usually have a high 12b-1 fee and a modest contingent deferred sales charge that is discontinued after one or two years. Class C shares usually do not convert to another class. They are often called "level load" shares.
- Class I are usually subject to very high minimum investment requirements and are, therefore, known as "institutional" shares. They are no-load shares.
- Class R are usually for use in retirement plans such as 401(k) plans. They typically do not charge loads, but do charge a small 12b-1 fee.
No-load funds often have two classes of shares:
- Class I shares do not charge a 12b-1 fee
- Class N shares charge a 12b-1 fee of no more than 0.25% of fund assets
Neither class of shares typically charges a front-end or back-end load
Definitions of key terms.
Net asset valueEdit
A fund's net asset value (NAV) equals the current market value of a fund's holdings minus the fund's liabilities (sometimes referred to as "net assets"). It is usually expressed as a per-share amount, computed by dividing net assets by the number of fund shares outstanding. Funds must compute their net asset value according to the rules set forth in their prospectuses. Funds compute their NAV at the end of each day that the New York Stock Exchange is open, though some funds compute NAVs more than once daily.
Valuing the securities held in a fund's portfolio is often the most difficult part of calculating net asset value. The fund's board typically oversees security valuation.
The expense ratio allows investors to compare expenses across funds. The expense ratio equals the 12b-1 fee plus the management fee plus the other fund expenses divided by average daily net assets. The expense ratio is sometimes referred to as the total expense ratio (TER).
Average annual total returnEdit
The SEC requires that mutual funds report the average annual compounded rates of return for one-, five-and ten year-periods using the following formula:
- P(1+T)n = ERV
- P = a hypothetical initial payment of $1,000
- T = average annual total return
- n = number of years
- ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the one-, five-, or ten-year periods at the end of the one-, five-, or ten-year periods (or fractional portion)
Turnover is a measure of the volume of a fund's securities trading. It is expressed as a percentage of average market value of the portfolio's long-term securities. Turnover is the lesser of a fund's purchases or sales during a given year divided by average long-term securities market value for the same period. If the period is less than a year, turnover is generally annualized.
- Fund derivative
- Global assets under management
- Lipper average
- List of mutual-fund families in Canada
- List of mutual-fund families in the United States
- List of U.S. mutual funds by assets under management
- Money fund
- Mutual funds in India
- Mutual-fund scandal (2003)
- Operation Perfect Hedge
- Retirement plans in the United States
- Separately managed account
- Value investing
- "26 U.S. Code § 851 – Definition of regulated investment company". Legal Information Institute. Cornell University Law School. Retrieved 9 March 2015.
851(b)(2) and (3)
- Pozen, Robert; Hamacher, Theresa (2014). The Fund Industry: How Your Money is Managed (Second Edition). John Wiley & Sons. pp. 4–5.
- K. Geert Rouwenhorst (December 12, 2004), "The Origins of Mutual Funds", Yale ICF Working Paper No. 04-48.
- Fink, Matthew P. (2008). The Rise of Mutual Funds. Oxford University Press.
- Fink (2008), p. 63.
- "Vanguard – 500 Index Fund Investor Shares". The Vanguard Group. Retrieved 2016-01-10.
- Pozen and Hamacher (2014), pp. 10–14.
- 2016 Investment Company Fact Book. Investment Company Institute. Retrieved 11 September 2016.
- Teeter, Preston; Sandberg, Jorgen (2017). "Cracking the enigma of asset bubbles with narratives". Strategic Organization. 15 (1): 91–99. doi:10.1177/1476127016629880.
- EY Global Fund Distribution
- 17 CFR 270.35d-1
- "Final Rule: Registration Form Used by Open-End Management Investment Companies: Sample Form and instructions". U.S. Securities and Exchange Commission (SEC). Retrieved 2008-09-25.
- Matthew P. Fink (2011). The Rise of Mutual Funds: An Insider's View (2nd ed.). Oxford University Press. ISBN 978-0199753505.
- Thomas P. Lemke; Gerald T. Lins; A. Thomas Smith (2016). Regulation of Investment Companies. Matthew Bender. ISBN 978-0-8205-2005-6.
- Thomas P. Lemke; Gerald T. Lins; W. John McGuire (2015). Regulation of Exchange-Traded Funds. Matthew Bender. ISBN 978-0-7698-9131-6.
- Robert Pozen; Theresa Hamacher (2015). The Fund Industry: How Your Money is Managed (2nd ed.). Hoboken, NJ: Wiley Finance. ISBN 978-1118929940.