Mutual funds belong to a group of financial intermediaries known as investment companies, which are in the business of collecting funds from investors and pooling them for the purpose of building a portfolio of securities according to stated objectives. They are also known as open-end investment companies. Other members of the group are closed-end investment companies (also known as closed-end funds) and unit investment trusts. In the United States, investment companies are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940.
Mutual funds are generally organized as corporations or trusts, and, as such, they have a board of directors or trustees elected by the shareholders. Almost all aspects of their operations are externally managed. They engage a management company to manage the investment for a fee, generally based on a percentage of the fund's average net assets during the year. The management company may be an affiliated organization or an independent contractor. They sell their shares to investors either directly or through other firms such as broker-dealers, financial planners, employees of insurance companies, and banks. Even the day-to-day administration of a fund is carried out by an outsider, which may be the management company or an unaffiliated third party.
The management company is responsible for selecting an investment portfolio that is consistent with the objectives of the fund as stated in its prospectus and managing the portfolio in the best interest of the shareholders. The directors of the fund are responsible for overall governance of the fund; they are expected to establish procedures and review the performance of the management company and others who perform services for the fund.
Mutual funds are known as open-end investment companies because they are required to issue shares and redeem (buy back) outstanding shares upon demand. Closed-end funds, on the other hand, issue a certain number of shares but do not stand ready to buy back their own shares from investors. Their shares are traded on an exchange or in the over-the-counter market. They cannot increase or decrease their outstanding shares easily. A feature common of both mutual funds and closed-end funds is that they are managed investment companies, because they can change the composition of their portfolios by adding and deleting securities and altering the amount invested in each security. Unit investment trusts are not managed investment companies like the mutual funds because their portfolio consists of a fixed set of securities for life. They stand ready, however, to buy back their shares.
TYPES OF MUTUAL FUNDS
There are four basic types of mutual funds: money market, stock (also called equity), bond, and hybrid. This classification is based on the type and the maturity of the securities selected for investment. Money market funds invest in securities that mature in one year or less, such as Treasury bills, commercial paper, and certificates of deposits. They are often referred to as short-term funds. Stock, bond, and hybrid funds invest in long-term securities, and as such are known as long-term funds. Hybrid funds invest in a combination of stocks, bonds, and other securities. According to the Investment Company Institute (ICI), the national association of the U.S. investment company industry, there were 8,044 (7,101 long-term and 943 short-term) mutual funds in the United States and 55,528 outside the country at the end of 2004. The total investment by U.S mutual funds amounted to $6.8 trillion (stock=$4.04 trillion, bond=$808 billion, hybrid=$383 billion, money market=$1.61 trillion) and by non-U.S. funds to $3.5 trillion at the end of 1999. The total assets of U.S. mutual funds are less than the total assets of U.S. depository institutions, which stood at $7.5 trillion at the end of 1999.
Mutual funds also differ in terms of their investment objectives, as outlined in their prospectuses. The ICI classifies mutual funds into thirty-three investment objective categories. The main investment objectives within the stock funds include capital appreciation, total return, and world equity. Within each of these objectives, there are subcategories. There are two groups of bond funds: taxable bond funds and tax-free bond funds. Main categories in taxable bond funds are corporate bond funds, high-yield funds, world bond funds, government bond funds, and strategic income funds. The main tax-free bond fund categories are state municipal bond funds and national municipal bond funds. Among money market funds, there are also taxable money market funds and tax-exempt money market funds. As in the case of stock funds, many subcategories exist within each main category of bond and money market funds. In addition to these, there are specialty or sector funds, which invest in a particular segment of the securities market. Examples include biotechnology funds, small-company growth funds, technology funds, index funds, and social criteria funds.
MUTUAL FUND SHARE PRICING
By law, mutual funds are required to determine the price of their shares each business day. They release their prices the same day for publication in the next day's newspapers. Daily prices of mutual fund shares can also be obtained directly from the fund's offices or Web sites of commercial venders of financial information.
The share price represents the net asset value (NAV) per share, which is the current market value of a fund's assets net of its liabilities. The liabilities include securities purchased, but not yet paid for, accrued fees, dividends payable, and other accrued expenses. The NAV per share is obtained by dividing the NAV by the number of shares of the fund outstanding at the end of the day. A buyer of mutual fund shares pays the NAV per share plus any applicable sales load (also known as a front-end load). Sometimes, the sales load is collected when shares are redeemed and is known as a back-end load. Funds that have a sales load are known as load funds and use a sales organization to sell their shares for a fee. Funds that sell shares directly and do not have a sales load are known as no-load funds. The sales load often differs from fund to fund, and it is subject to National Association of Security Dealers (NASD) regulation. When an investor sells a share, it is the NAV that the seller usually receives. Some mutual funds may charge a redemption fee if the shares are held for less than a specified period.
BENEFITS AND COST OF INVESTING IN MUTUAL FUNDS
Mutual funds provide investors with a way to diversify their investment under professional management, which most investors may not be able to obtain on their own. Since the funds operate with a large pool of money, the investors benefit from economies of scale, such as a lower trading cost and a higher yield. Besides delivering attractive yields, many funds provide their investors with such services as check-writing privileges, custody (as a service), and bookkeeping. Investors also benefit from the knowledgeable investment choices of securities and investment objectives that funds offer.
The cost to the shareholder of investing in mutual funds comes in various forms: front-end loads, management fees, cost of maintaining and servicing shareholder accounts (administrative cost), redemption fees, and distribution fees (also known as 12b-1 fees). As mentioned before, a redemption fee is usually levied on shares held for less than a specified period. A distribution fee is a charge on current shareholders to cover the costs of advertising, promotion, selling, and other activities. It is sometimes combined with load charges. All these expenses are aggregated to obtain a single measure of cost to the shareholder. An aggregate measure commonly found in the published data is the expense ratio (expenses as a percent of assets). This measure does not include sales load, if there is one. Rea and Reid (1998) discuss the calculation of an alternative measure of total ownership cost that includes the sales load.
REGULATION AND TAXATION
All U.S. mutual funds are subject to strict regulation by the Securities and Exchange Commission. They are also subject to states's notice filing requirements and anti-fraud statutes. They are required to provide investors a full disclosure of their activities in a written prospectus. They also provide their investors a yearly statement of distribution with the details of the federal tax status of their distribution. Mutual funds in the United States are not subject to corporate income tax, if they meet certain Internal Revenue Code requirements. Instead, mutual fund shareholders are taxed on the distribution of fund's income. For tax purpose, mutual funds distribute their net income to the shareholders in two ways: (1) dividend and interest payments and (2) realized capital gains.
PERFORMANCE AND COMPARISON
The rate of return is widely used for comparing the performance of mutual funds. The rate of return on a mutual fund investment for a period of one year, for example, is calculated by adding the change in the NAV (NAVt–NAVt–1) to income and capital gains distributed during the year and dividing the sum by the NAV at the beginning of the year. The following describes the calculation of return for no-load funds:
where R, i, and c represent rate of return, income, and capital gains, respectively. For load funds, the calculation of return must account for load charges by adding them to the NAV. The performance of a mutual fund is often compared with the performance of a benchmark portfolio that is selected to reflect the investment risk level of the fund's portfolio to see whether the mutual fund had a superior performance.
The rate of return of a mutual fund with a NAV of $15.00 at the beginning of a year and $15.50 at the end of that year, and distributed $0.75 and $0.50 per share as income and capital gain respectively during the year would be:
[($15.50 − $15.00) + $0.75 + $0.50]/$15.00 = 11.67%
ANALYSIS AND REPORTING
Key statistics pertaining to a fund—such as the NAV, offer price, sales charges, expense ratio, and performance measure for various categories of funds—are regularly calculated, analyzed, and published. Two firms well known for their analytical service are the Lipper Analytical Services (Lipperweb.com) and the Morning Star Inc. (Morningstar.com). The Wall Street Journal and Barron's carry the information supplied by Lipper Analytical Services on a regular basis. Investment Company Institute (www.ici.org) also provides a wealth of information on mutual funds, including historical data and Web site addresses of its member funds.
see also Investments
Bogle, John (1994). Bogle on Mutual Funds. Burr Ridge, IL:Irwin.
Crane, Peter G. (1997). Mutual Fund Investing on the Internet. Burlington, MA: AP Professional.
Find the right mutual funds (2005). Hoboken, N.J.: Wiley.
Henriques, Diana B. (1995). Fidelity's World: The Secret Life and Public Power of the Mutual Fund Giant. New York: Scribner.
Investment Company Institute website. http://www.ici.org/index.html. Accessed December 1, 2005.
Lavine, Alan, and Liberman, Gail (2001). The Complete Idiot's Guide to Making Money with Mutual Funds. Indianapolis, IN: Alpha.
Levy, Haim (1999). Introduction to Investments. Cincinnati, OH: South-Western College Publishing.
Rea, John D., and Reid, Brian K. (1998, November). "Trends in the Ownership Cost of Equity Mutual Funds." ICI Perspective, 41(3), 2-15.
Sharpe, William F., Alexander, Gordon J., and Bailey, Jeffrey V. (1999). Investments. 6th ed., Upper Saddle River, NJ: Prentice Hall.
Anand G. Shetty
What It Means
A mutual fund is a form of investment that involves pooling the money of many people and using it to buy numerous stocks, bonds, or other securities. Stocks are shares of company ownership that generally gain value when the company prospers and lose value when the company struggles. Bonds are a way of lending money to the government or a company; the holder of a bond is paid interest (a fee for the use of borrowed money) by the government or company. Stocks and bonds are two among numerous kinds of securities. A security is any contract that can be assigned value, bought, and sold. Securities are traded on various financial markets, the places or computer systems that allow buyers and sellers to come together and make exchanges.
If you believe that Coca-Cola is going to experience great success in the next several years, you might take your money out of the bank and buy Coca-Cola stock through the New York Stock Exchange (the financial market where Coca-Cola stock is traded), hoping that your savings will grow as a result. If Coca-Cola stock does not increase in value, however, you lose money. Because even the most knowledgeable investors cannot perfectly predict the future, it is generally advisable to buy more than one form of security at a time to insure yourself against inevitable losses. For example, in addition to Coca-Cola, you might buy stock in Microsoft, Nike, and General Motors, hoping that if any of the stocks lose value, the other stocks will gain value and balance out your losses. You might additionally buy bonds from the U.S. government, since the government guarantees you regular payments of interest. Thus, you would have ways of earning money in the financial markets even if some of your investment decisions turned out to be bad ones. Ideally you would spread your money among dozens, hundreds, or even thousands of investments that work together to ensure you of profits while protecting you from losses. This is called diversifying your investments.
Mutual funds are an easy, effective way of diversifying. The average person interested in investing may lack the in-depth knowledge of the financial world that the most successful investors have, and he or she may be uncertain about choosing individual stocks, let alone figuring out how to choose and balance dozens of them in order to minimize risk while still making a sizable profit. In such a case mutual funds can be a sensible alternative. Mutual funds are managed by experts who have thorough knowledge of financial markets and who decide how best to allocate their investors’ pooled money. Rather than researching financial markets for years and spending hours, days, and weeks buying and selling individual stocks and bonds yourself, you can easily diversify your money by purchasing shares of a mutual fund. A share of a mutual fund gains or loses value in proportion to the gains or losses of all of the different securities that the fund owns.
When Did It Begin
The first mutual fund in the United States was the Massachusetts Investors Trust, founded in 1924 with a pool of $50,000. By the end of its first year of operation, the fund had approximately 200 shareholders and $392,000. But this promising start for the industry was derailed by the Great Depression, the severe economic crisis that gripped the world economy in the 1930s.
In response to the Depression, with the intent of preventing future economic crises, numerous new financial regulations were passed at the national level. Among these laws, the Securities Acts of 1933 and 1934 specified some of the basic guidelines that mutual funds would be required to follow, and the Investment Company Act of 1940 more fully established the ground rules for the industry. The mutual funds of today are still governed by those 1940 guidelines.
By the 1960s the mutual-fund industry, composed of around 270 funds, had become a vibrant part of the overall economy. The popularity of mutual funds grew greatly as a result of changes to the U.S. tax code implemented in 1975. The changes made it possible for people to make tax-free investments for their retirement, thereby encouraging millions of people to invest money in stocks, bonds, and other securities. Since mutual funds allow easy diversification and are accessible to ordinary people, they became one of the most popular ways of investing for retirement during this time. Retirement investing remains at the heart of the mutual-fund industry.
More Detailed Information
Though mutual funds simplify investing in some important ways, the process of choosing a mutual fund can be complicated. By 2006 there were more than 8,000 mutual funds in the United States (worldwide, there were more than 60,000). This means that there were roughly as many mutual funds as there were stocks available for purchase in the United States. Additionally, there are numerous different types of mutual funds, each of which has a distinct purpose and approach to investing.
Most mutual funds are focused on the stock market and consist of hundreds of different stocks. Stock funds, also called equity funds, can be classified in a number of ways. One way they can be classified is according to their strategy: as growth funds, value funds, or blend funds. Growth funds are mutual funds that own stock in companies expected to grow quickly and produce large gains in stock value. This is the riskiest class of mutual funds. Value funds invest in older, established companies, especially those whose value may not be fully reflected by their stock prices (in other words, those whose stock prices are lower than they should be, given the company’s potential for future growth). Value funds are not as risky as growth funds, but they also do not offer the chance for the big profits that growth funds sometimes generate. Blend funds mix aspects of growth and value funds.
Mutual funds can also be classified according to the value of the companies on which they are focused. Large-cap funds invest in so-called “blue-chip” companies whose value (as measured by the number of stock shares in that company times the value of each share) is at the top range among all companies. Mid-cap funds allocate their money to the stock of companies valued in the middle range of all companies, and small-cap funds focus on newer, up-and-coming companies that have the potential for large growth.
Sector funds are another prominent form of mutual fund. Sector funds are stock funds that focus at least 25 percent of their investments on a particular sector of the economy. For example, there are sector funds that invest in technology companies, utility companies, food companies, and automotive companies, among many others.
Index funds, meanwhile, attempt to match one of the many prominent indices used to measure the performance of the stock market. The S&P 500, for example, is an index (a measure of the value of representative companies) that tracks the performance of 500 of the largest corporations in the world. There are dozens of indices that track American companies and hundreds of indices that track different groups of companies around the world. An index fund focuses on one such index and attempts to match its performance. Thus, an S&P 500 index fund would mirror the gains or losses of those 500 companies in the index.
There are also numerous international funds. Global funds are mutual funds that invest in the stock of U.S. companies as well as the stock of companies in other countries. Foreign funds focus on the stock of companies outside the United States. A country specific fund invests in one particular country. Emerging markets funds invest in countries that are only beginning to develop economically.
In addition to all of the above, which represent only some of the total variety of stock funds, investors can choose bond funds. Bond funds are safe investments that offer a consistent, but fairly low, level of growth. Among bond funds, there are municipal bond funds, which specialize in the bonds of state and local governments; U.S. government bond funds, which specialize in the bonds of the national government; corporate bond funds, which specialize in the bonds of corporations; and mortgage-backed securities funds, which specialize in securities that are related to the loans people take out to purchase homes.
Another mutual fund variety that is considered an extremely safe vehicle for investing is the money-market fund. Money-market funds invest in what are called short-term debt instruments: securities that represent shares of debt that must be repaid within 13 months. Examples of short-term debt instruments are Certificates of Deposit (CDs), a form of investment that gains value but can only be redeemed on a certain date, and repurchase agreements, a form of investment that involves the sale of securities with an agreement to repurchase them at a set price on a particular day. The least risky of all mutual funds, money market funds typically offer the most modest gains.
As of 2006 U.S. mutual funds managed around $10 trillion, up from $135 billion in 1980. To understand the magnitude of this amount of money, consider that in 2006 the entire U.S. Gross Domestic Product (GDP), the total value of all goods and services produced in the country, was around $12 trillion. More than half of the $10 trillion invested in mutual funds was in stock funds at that time. All in all, the mutual-fund industry was an enormous force in U.S. financial markets.
Some investors, however, were beginning to turn away from mutual funds and toward a new form of investment fund called an exchange-traded fund (ETF). ETFs, first created in 1990, combine the diversifying aspect of mutual-fund investing with the characteristics of stocks: while they are composed of many different stock holdings, ETFs can be bought and sold on stock markets like ordinary stocks (mutual fund shares are purchased directly from the mutual-fund company; they are not bought and sold on financial markets, even though they are composed of securities that are bought and sold on financial markets). Because of the way ETFs were structured, they could be managed at a lower cost than mutual funds, and their presence on stock markets made them attractive both to the ordinary investors who often bought mutual-fund shares and to more sophisticated investors. In 2006 the number of ETFs grew from under 100 to more than 400, and some observers were beginning to wonder whether they might not eclipse mutual funds at some point in the future.
A fund, in the form of an investment company, in which shareholders combine their money to invest in a variety of stocks, bonds, and money-market investments such as U.S. Treasury bills and bank certificates of deposit.
Mutual funds provide a form of investment that is both relatively safe and relatively lucrative. Mutual funds offer investors the advantages of professional management of invested money and diversification of that investment. Mutual fund managers assume the responsibility of investigating and researching financial markets and selecting the combination of stocks, bonds, and other investment vehicles to be bought and sold. Thus, consumers purchase shares in a mutual fund and rely on the expertise of the mutual fund manager, whose job is to provide them with the highest possible return on their investments.
Investing in a mutual fund is not as safe as investing in a bank or a savings and loan association. The federal government normally insures money deposited in banks or savings and loan associations; if one of those institutions fails, each of its deposits of up to $100,000 generally is guaranteed. This is not true of other investment vehicles such as stocks and bonds, which by their nature rise and fall in value and offer no guarantees. But investing in a mutual fund usually is considered to be safer than investing in individual stocks and bonds. Mutual fund managers observe the financial markets and take advantage of trends that affect the fund by buying and selling various components of the fund. And because a mutual fund is diverse—comprised perhaps of a hundred or more different kinds of stocks, bonds, or other investments—even the complete failure of one stock will make a relatively small impact on the fund's overall success.
There are two general types of mutual funds. An investor in an open-end fund may request at any time that the fund buy back, or redeem, that investor's shares. The price of shares in an open-end fund is based on the market value of the fund's portfolio of investments. Investors in open-end funds may be charged additional fees known as loads. Front-end loads are charged when the investor purchases shares in a mutual fund; back-end loads are subtracted from the redemption price. Open-end funds are sold by securities dealers and brokers and financial planners, or they are sold directly to the investor by the fund's sales staff.
Closed-end funds are traded on stock exchanges or the over-the-counter market. Unlike open-end funds, closed-end funds usually have a fixed number of shares, which are purchased and redeemed at their market price plus a commission.
Mutual funds are broadly classified according to three types of investment objectives: growth of capital, stability of capital, or current income. Most funds are geared toward one or two of these objectives. For example, money-market funds invest in instruments like U.S. Treasury bills, which are relatively safe and generally stable. Therefore many investors view money-market funds as a good alternative to a bank account. Other funds seek stability of capital by investing in blue-chip stocks and high-quality bonds. Some funds are potentially more lucrative, but far riskier. Growth funds are somewhat aggressive, investing in speculative securities that show promise over time for slow but steady long-term return. Income funds also tend to be speculative, often investing in high-risk, high-yield securities with the goal of greater short-term return.
Within the three broad categories of mutual funds are numerous subcategories. Funds that seek both growth and income are known as balanced funds. Sector funds invest in certain types of businesses, such as the computer industry. Some funds strive to fulfill a political agenda, such as investing in environmentally responsible companies or companies that actively promote women and minorities. Precious metals funds, municipal bond funds, and international stock funds are other examples of mutual fund categories. Other funds are far less specialized and allow the fund manager free reign to compile and alter the fund's portfolio.
Mutual fund shareholders receive periodic investment income, or dividends, which comes from dividends and interest earned by the various securities that make up the fund's portfolio. Shareholders often elect to have these dividends reinvested into the mutual fund. Investors in mutual funds may choose to make monthly payments into the fund or have a specified amount automatically withdrawn from a bank account or savings and loan association account each month. Some companies offer a variety of open-end mutual funds with different investment objectives and allow investors a simple way to switch their money from one fund to another as their savings goals change.
Securities laws, both state and federal, govern mutual funds. Some statutes regulate the organization of investment companies and the sale of securities by brokers and dealers. Federal securities laws that regulate mutual funds include the Securities Act of 1933 (15 U.S.C.A. § 77a et seq.), the Securities Exchange Act of 1934 (15 U.S.C.A. § 78a et seq.), and the Investment Company Act of 1940 (15 U.S.C.A. § 80a–1 et seq.).
Baer, Gregory, and Gary Gensler. 2002. The Great Mutual Fund Trap: An Investment Recovery Plan. New York: Broadway Books.
Blake, Erica. 2000."A Review and Analysis of the Monitoring of Personal Investment Transactions and the Implementation of Codes of Ethics." Annual Review of Banking Law 19 (annual): 637–53.
A mutual fund is a large, diverse group of stocks and/or bonds in which an individual may invest. There are three basic types of mutual funds. Money market funds invest in certificates of deposit, U.S. Treasury bills, and other low-risk, short-term securities that provide a safe, low-return alternative to checking accounts. The medium-risk bond and income funds invest in both stocks and corporate and government debt, with the goal of invest exclusively in the stock of corporations. The higher risk equity fund invests in the stocks of corporations and comes in all shapes and sizes. Mutual funds are also classified as "closed-end" (a fixed number of shares are sold to the public) and "open-end" (shares are sold to as many people as want them).
Low, medium, and high risk mutual funds each have many options for investment. One class of higher-risk funds is the aggressive growth equity fund, which may be suitable for an individual looking for a quick return on an investment. A less risky kind of mutual fund, the index equity fund, takes the process of picking stocks out of the hands of mutual fund managers and instead invests in companies listed in such stock market indices as the Standard and Poor's 500. Sector equity funds specialize in specific segments of the economy, such as telecommunications, biotechnology, or Internet stocks. While many opportunities exist for domestic investment, an individual can also look to the foreign markets as a place to invest money. International equity funds focus on the stocks of non-U.S. companies and may be region specific, such as an Asia or Latin America fund.
Mutual funds first appeared in Europe in the nineteenth century and were well established in the United States by 1900. Not until 1924, however, did the first modern open-end mutual fund appear—it boasted forty-five stocks and $50,000 in assets. The stock market crash of 1929 soured an entire generation on stock investing, however, and it took new government safeguards and the post-World War II (1939–1945) economic boom to convince U.S. citizens to return to stock investing. In the 1940s there were only about 80 mutual funds with assets of $500 million. In 1948 one of the first sector funds, Television Funds, Inc., was launched; it was followed in 1953 by the first international mutual fund. The number of funds edged up to 100 in the 1950s, but by 1952 still only onequarter of one percent of the U.S. population owned stocks. The first aggressive growth mutual fund appeared in the 1960s, and in the 1970s money market funds and bond and income funds became more common. Fueled by the beginning of one of the longest bull markets in U.S. history in 1982, the number of funds grew fivefold in the 1980s. By the late 1990s, the nation's 6,700 mutual funds owned 22 percent of the entire U.S. stock market and held assets of more than $4.5 trillion.
See also: Bond, Investment, Standard and Poor's, Stock, Stock Market
mutual fund, in finance, investment company or trust that has a very fluid capital stock. It is unique in that at any time it can sell or redeem any of its outstanding shares at net asset value (i.e., the price of a share equals total assets minus liabilities divided by the total number of shares). A mutual fund, also called an open-end investment company, owns the securities of several corporations and receives dividends on the shares that it holds. A closed-end investment company differs from an open-end company in that the number of shares is limited and the price of the shares may fluctuate above and below the net asset value. The earnings of a mutual fund are distributed to the holders of its shares. It is hoped that a loss on one holding will be made up by a gain on another. The holders of mutual-fund shares thus gain the advantage of diversification, which might ordinarily be beyond their means. Common mutual funds, which often provide skilled management for security holdings, include stock, bond, balanced, index, and money-market funds. Stock funds mainly invest in common shares, and bond funds in bonds; such funds may specialize in a particular category of stocks or bonds (such as Internet stocks or municipal bonds). A balanced fund might invest in preferred stocks and bonds in addition to common stocks. Index funds invest in a portfolio that mimics a given index, such as the stocks that make up the S&P 500. The forerunner of the modern mutual fund was established in Belgium in 1822, and the use of these closed-end investment companies soon spread to Great Britain and France. They became popular in the United States in the 1920s, but from the 1930s the open-end mutual fund became more popular. Mutual funds experienced a period of tremendous growth after World War II, especially in the 1980s and 90s.
See M. Useem, Investor Capitalism: How Money Managers Are Changing the Face of Corporate America (1996).