Mutual fund
Encyclopedia
A mutual fund is a professionally managed type of collective investment scheme
that pools money from many investors to buy stock
s, bonds
, short-term money market
instruments, and/or other securities.
(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 fund manager, also known as the fund sponsor or fund management company, trades
(buys and sells) the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment advisor
. Funds that are managed by the same fund manager and that have the same brand name are known as a "fund family" or "fund complex".
The Investment Company Act of 1940
(the 1940 Act) established three types of registered investment companies
or RICs in the United States: open-end fund
s, unit investment trust
s (UITs); and closed-end fund
s. Recently, exchange-traded fund
s (ETFs), which are open-end funds or unit investment trusts that trade on an exchange, have gained in popularity. 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-end type.
Hedge funds are not considered a type of mutual fund. While they are another type of commingled investment scheme, they are not governed by the Investment Company Act of 1940 and are not required to register with the Securities and Exchange Commission (though many hedge fund managers now must register as investment advisors).
Mutual funds are not taxed on their income as long as they comply with certain requirements established in the Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute most of their income to their investors annually, and earn most of the income by investing in securities and currencies. Mutual funds pass taxable income on to their investors. The type of income they earn is unchanged as it passes through to the shareholders. For example, mutual fund distributions of dividend income are reported as dividend income by the investor. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors.
Outside of the United States, mutual fund is used as a generic term for various types of collective investment vehicles available to the general public, such as unit trust
s, open-ended investment companies, unitized insurance funds
, Undertakings for Collective Investment in Transferable Securities, and SICAV
s.
and trades on the London stock exchange.
Mutual funds were introduced into the United States in the 1890s. They became popular during the 1920s. These early funds were generally of the closed-end type with a fixed number of shares which often traded at prices above the value of the portfolio.
The first open-end mutual fund with redeemable shares was established on March 21, 1924. This fund, the Massachusetts Investors Trust, is now part of the MFS family of funds
. However, closed-end funds remained more popular than open-end funds throughout the 1920s. By 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 Securities and Exchange Commission 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 $100 billion in assets as of January 31, 2011.
Fund industry growth continued into the 1980s and 1990s, as a 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 plan
s 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 credit crisis of 2008.
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 then-New York State Attorney General Eliot Spitzer
and resulted in significantly increased regulation of the industry.
At the end of 2010, there were 7,581 mutual funds in the United States with combined assets of $11.8 trillion, according to the Investment Company Institute
(ICI), a national trade association of investment companies in the United States. The ICI reports that worldwide mutual fund assets were $24.7 trillion on the same date.
. 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 net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.
Most ETFs are index funds.
. The types of securities that a particular fund may invest in are set forth in the fund's prospectus, 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.
A mutual fund's investment portfolio
is continually monitored by the fund's portfolio manager
or managers, who are employed by the fund's manager or sponsor.
Mutual funds are classified by their principal investments. The four largest 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 not be inconsistent 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.
Investors often use money market funds as a substitute for bank savings accounts, though money market funds are not government insured, 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.
At the end of 2010, money market funds accounted for 24% of the assets in all U.S. mutual funds.
At the end of 2010, bond funds accounted for 22% of the assets in all U.S. mutual funds.
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 or market cap is the value of a company's stock and equals the number of shares outstanding times the market price of the stock. Market capitalizations are divided into the following categories:
While the specific definitions of each category vary with market conditions, large cap stocks generally have market capitalizations of at least $10 billion, small cap stocks have market capitalizations below $2 billion, and micro cap stocks have market capitalizations below $300 million. Funds are also 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 2010, stock funds accounted for 48% of the assets in all U.S. mutual funds.
. 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. Most fund of funds invest in affiliated funds (meaning mutual funds managed by the same fund sponsor), although some invest in unaffiliated funds (meaning those managed by other fund sponsors) or in a combination of the two.
At the end of 2010, hybrid funds accounted for 6% of the assets in all U.S. mutual funds.
index, while an actively managed fund
seeks to outperform a relevant index through superior security selection.
paid to a broker
by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested (including the front-end load), known as the "public offering price." The front-end load often declines as the amount invested increases, through breakpoints. Front-end loads are deducted from an investor's account and reduce the amount invested.
Typical share classes for funds sold through brokers or other intermediaries are:
No-load funds often have two classes of shares:
Neither class of shares charges a front-end or back-end load.
These expenses are included in the expense ratio.
Many researchers have suggested that the most effective way for investors to raise the returns they earn from mutual funds is to reduce the fees that they pay. They suggest that investors look for no-load funds with low expense ratios.
Valuing the securities held in a fund's portfolio is often the most difficult part of calculating net asset value. The fund's board of directors (or board of trustees) oversees security valuation.
Where:
ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).
Collective investment scheme
A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
that pools money from many investors to buy stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, short-term money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
instruments, and/or other securities.
Overview
In the United States, a mutual fund is registered with the Securities and Exchange Commission (SEC) and is overseen by a board of directorsBoard of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
(if organized as a corporation) or board of trustees
Trustee
Trustee is a legal term which, in its broadest sense, can refer to any person who holds property, authority, or a position of trust or responsibility for the benefit of another...
(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 fund manager, also known as the fund sponsor or fund management company, trades
Trade (financial instrument)
In finance, a trade is an exchange of a security for "cash", typically a short-dated promise to pay in the currency of the country where the 'exchange' is located...
(buys and sells) the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment advisor
Registered Investment Advisor
The term Registered Investment Adviser is used to describe an Investment Adviser who is registered with the Securities and Exchange Commission or a state's securities agency. The term has been popularized due to its use within the Investment Advisers Act of 1940 and its association to the term...
. Funds that are managed by the same fund manager and that have the same brand name are known as a "fund family" or "fund complex".
The Investment Company Act of 1940
Investment Company Act of 1940
The Investment Company Act of 1940 is an act of Congress. It was passed as a United States Public Law on August 22, 1940, and is codified at through . Along with the Securities Exchange Act of 1934 and Investment Advisers Act of 1940, and extensive rules issued by the Securities and Exchange...
(the 1940 Act) established three types of registered investment companies
Investment company
An investment company is a company whose main business is holding securities of other companies purely for investment purposes. The investment company invests money on behalf of its shareholders who in turn share in the profits and losses....
or RICs in the United States: open-end fund
Open-end fund
An open-end fund is a collective investment scheme which can issue and redeem shares at any time. An investor will generally purchase shares in the fund directly from the fund itself rather than from the existing shareholders...
s, unit investment trust
Unit Investment Trust
A Unit Investment Trust is a US investment company offering a fixed portfolio of securities having a definite life. UITs are assembled by a sponsor and sold through brokers to investors.-Types:...
s (UITs); and closed-end fund
Closed-end fund
A closed-end fund is a collective investment scheme with a limited number of shares. It is called a closed-end fund because new shares are rarely issued once the fund has launched, and because shares are not normally redeemable for cash or securities until the fund liquidates.Typically an...
s. Recently, exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s (ETFs), which are open-end funds or unit investment trusts that trade on an exchange, have gained in popularity. 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-end type.
Hedge funds are not considered a type of mutual fund. While they are another type of commingled investment scheme, they are not governed by the Investment Company Act of 1940 and are not required to register with the Securities and Exchange Commission (though many hedge fund managers now must register as investment advisors).
Mutual funds are not taxed on their income as long as they comply with certain requirements established in the Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute most of their income to their investors annually, and earn most of the income by investing in securities and currencies. Mutual funds pass taxable income on to their investors. The type of income they earn is unchanged as it passes through to the shareholders. For example, mutual fund distributions of dividend income are reported as dividend income by the investor. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors.
Outside of the United States, mutual fund is used as a generic term for various types of collective investment vehicles available to the general public, such as unit trust
Unit trust
A unit trust is a form of collective investment constituted under a trust deed.Found in Australia, Ireland, the Isle of Man, Jersey, New Zealand, South Africa, Singapore, Malaysia and the UK, unit trusts offer access to a wide range of securities....
s, open-ended investment companies, unitized insurance funds
Unitised insurance fund
Unitised insurance funds or unit-linked insurance funds are a form of collective investment offered through life assurance policies.An insurance company's contract may offer a choice of unit-linked funds to invest in. Insurers that offer these contracts are mainly found in the UK and British Isles...
, Undertakings for Collective Investment in Transferable Securities, and SICAV
SICAV
A SICAV is an open-ended collective investment scheme common in Western Europe, especially Luxembourg, Switzerland, Italy, Spain, Belgium and France...
s.
Advantages of mutual funds
Mutual funds have advantages compared to direct investing in individual securities. These include:- Increased diversification
- Daily liquidity
- Professional investment management
- Ability to participate in investments that may be available only to larger investors
- Service and convenience
- Government oversight
- Ease of comparison
Disadvantages of mutual funds
Mutual funds have disadvantages as well, which include:- Fees
- Less control over timing of recognition of gains
- Less predictable income
- No opportunity to customize
History
The first mutual funds were established in Europe. One researcher credits a Dutch merchant with creating the first mutual fund in 1774. The first mutual fund outside the Netherlands was the Foreign & Colonial Government Trust, which was established in London in 1868. It is now the Foreign & Colonial Investment TrustForeign & Colonial Investment Trust
Foreign & Colonial Investment Trust is a publicly-traded investment trust. It is listed on the London Stock Exchange and is a constituent of the FTSE 250 Index.-History:...
and trades on the London stock exchange.
Mutual funds were introduced into the United States in the 1890s. They became popular during the 1920s. These early funds were generally of the closed-end type with a fixed number of shares which often traded at prices above the value of the portfolio.
The first open-end mutual fund with redeemable shares was established on March 21, 1924. This fund, the Massachusetts Investors Trust, is now part of the MFS family of funds
MFS Investment Management
MFS Investment Management is an American-based global asset manager, formerly known as Massachusetts Financial Services. It is owned by Sun Life Financial of Canada, with subsidiary headquarters in Boston, Massachusetts and offices worldwide. MFS was founded in 1924 and is one of the oldest asset...
. However, closed-end funds remained more popular than open-end funds throughout the 1920s. By 1929, open-end funds accounted for only 5% of the industry's $27 billion in total assets.
After the stock market crash of 1929
Wall Street Crash of 1929
The Wall Street Crash of 1929 , also known as the Great Crash, and the Stock Market Crash of 1929, was the most devastating stock market crash in the history of the United States, taking into consideration the full extent and duration of its fallout...
, Congress passed a series of acts regulating the securities markets in general and mutual funds in particular. The Securities Act of 1933
Securities Act of 1933
Congress enacted the Securities Act of 1933 , in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression...
requires that all investments sold to the public, including mutual funds, be registered with the Securities and Exchange Commission and that they provide prospective investors with a prospectus
Prospectus (finance)
In finance, a prospectus is a document that describes a financial security for potential buyers. A prospectus commonly provides investors with material information about mutual funds, stocks, bonds and other investments, such as a description of the company's business, financial statements,...
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
Revenue Act of 1936
The Revenue Act of 1936, , established an "undistributed profits tax" on corporations in the United States .It was signed into law by President Franklin D...
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
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
, First Index Investment Trust, was formed in 1976 by The Vanguard Group
The Vanguard Group
The Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $1.6 trillion in assets. It offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. Founder...
, headed by John Bogle
John Bogle
John Clifton "Jack" Bogle is the founder and retired CEO of The Vanguard Group. He is known for his 1999 book Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, which became a bestseller and is considered a classic.-Early life and education:Bogle was born in in Verona, New...
; it is now called the Vanguard 500 Index Fund and is one of the world's largest mutual funds, with more than $100 billion in assets as of January 31, 2011.
Fund industry growth continued into the 1980s and 1990s, as a result of three factors: a bull market for both stocks and bonds, new product introductions (including tax-exempt bond
Municipal bond
A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any...
, 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)
401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
and other defined contribution plan
Defined contribution plan
In economics, a defined contribution plan is a type of retirement plan in which the amount of the employer's annual contribution is specified. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money...
s 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 credit crisis of 2008.
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
Late trading
Late trading is trading executed after the standard local national exchanges have closed. This is distinct from after-hours trading, as they have in context specific meanings, the former may be illegal while the latter is legal.-Mutual funds:...
, which is illegal, or market timing
Market timing
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...
, which is a practice prohibited by fund policy. The scandal was initially discovered by then-New York State Attorney General Eliot Spitzer
Eliot Spitzer
Eliot Laurence Spitzer is an American lawyer, former Democratic Party politician, and political commentator. He was the co-host of In the Arena, a talk-show and punditry forum broadcast on CNN until CNN cancelled his show in July of 2011...
and resulted in significantly increased regulation of the industry.
At the end of 2010, there were 7,581 mutual funds in the United States with combined assets of $11.8 trillion, according to the Investment Company Institute
Investment Company Institute
The Investment Company Institute is the national association of U.S. investment companies. ICI encourages adherence to high ethical standards, promotes public understanding of funds and investing, and advances the interests of investment funds and their shareholders, directors, and advisers.As of...
(ICI), a national trade association of investment companies in the United States. The ICI reports that worldwide mutual fund assets were $24.7 trillion on the same date.
Leading mutual fund complexes
At the end of 2010, the top 10 mutual fund complexes in the United States were:- Vanguard
- Fidelity
- American Funds (Capital Group)
- PIMCO
- JPMorgan Chase
- Franklin Templeton
- BlackRock
- Federated
- T. Rowe Price
- BNY Mellon
Types of mutual funds
There are three basic types of registered investment companies defined in the Investment Company Act of 1940: open-end funds, unit investment trusts, and closed-end funds. Exchange-traded funds are open-end funds or unit investment trusts that trade on an exchange.Open-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 computed that day. Most open-end funds also sell shares to the public every business day; these shares are also priced at net asset value. 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.Closed-end funds
Closed-end funds generally issue shares to the public only once, when they are created through an initial public offeringInitial public offering
An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...
. Their shares are then listed for trading on a stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
. 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 net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.
Unit investment trusts
Unit investment trusts or UITs issue shares to the public only once, when they are created. Investors can redeem shares directly with the fund (as with an open-end fund) or they may also be able to sell their shares in the market. Unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT and does not change. UITs generally have a limited life span, established at creation.Exchange-traded funds
A relatively recent innovation, the exchange-traded fund or ETF is often structured as an open-end investment company, though ETFs may also be structured as unit investment trusts, partnerships, investments trust, grantor trusts or bonds (as an exchange-traded note). ETFs combine characteristics of both closed-end funds and open-end funds. Like closed-end funds, ETFs are traded throughout the day on a stock exchange at a price determined by the market. However, as with open-end funds, investors normally receive a price that is close to net asset value. To keep the market price close to net asset value, ETFs issue and redeem large blocks of their shares with institutional investors.Most ETFs are index funds.
Investments and classification
Mutual funds may invest in many kinds of securitiesSecurity (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
. The types of securities that a particular fund may invest in are set forth in the fund's prospectus, 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.
A mutual fund's investment portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
is continually monitored by the fund's portfolio manager
Portfolio manager
A portfolio manager is either a person who makes investment decisions using money other people have placed under his or her control or a person who manages a financial institution's asset and liability portfolios....
or managers, who are employed by the fund's manager or sponsor.
Mutual funds are classified by their principal investments. The four largest 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 not be inconsistent 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 funds
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 government insured, 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.
At the end of 2010, money market funds accounted for 24% of the assets in all U.S. mutual funds.
Bond funds
Bond funds invest in fixed income securities. Bond funds can be subclassified according to the specific types of bonds owned (such as high-yield or junk bonds, investment-grade corporate bonds, government bonds or municipal bonds) or 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 2010, bond funds accounted for 22% of the assets in all U.S. mutual funds.
Stock or equity funds
Stock or equity funds invest in common stocks. 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 or market cap is the value of a company's stock and equals the number of shares outstanding times the market price of the stock. Market capitalizations are divided into the following categories:
- Micro cap
- Small cap
- Mid cap
- Large cap
While the specific definitions of each category vary with market conditions, large cap stocks generally have market capitalizations of at least $10 billion, small cap stocks have market capitalizations below $2 billion, and micro cap stocks have market capitalizations below $300 million. Funds are also 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 2010, stock funds accounted for 48% of the assets in all U.S. mutual funds.
Hybrid funds
Hybrid funds invest in both bonds and stocks or in convertible securitiesConvertible security
A convertible security is a security that can be converted into another security. Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined...
. 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. Most fund of funds invest in affiliated funds (meaning mutual funds managed by the same fund sponsor), although some invest in unaffiliated funds (meaning those managed by other fund sponsors) or in a combination of the two.
At the end of 2010, hybrid funds accounted for 6% of the assets in all U.S. mutual funds.
Index (passively-managed) versus actively-managed
An index fund or passively-managed fund seeks to match the performance of a market index, such as the S&P 500S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
index, while an actively managed fund
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
seeks to outperform a relevant index through superior security selection.
Mutual fund expenses
Investors in mutual funds pay fees. These fall into four categories: distribution charges (sales loads and 12b-1 fees), the management fee, other fund expenses, shareholder transaction fees and securities transaction fees. Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value. Recurring expenses are included in a fund's expense ratio.Distribution charges
Distribution charges pay for marketing and distribution of the fund's shares to investors.Front-end load or sales charge
A front-end load or sales charge is a commissionCommission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
paid to a broker
Stock broker
A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors...
by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested (including the front-end load), known as the "public offering price." The front-end load often declines as the amount invested increases, through breakpoints. Front-end loads are deducted from an investor's account and reduce the amount invested.
Back-end load
Some funds have a back-end load, which is paid by the investor when shares are redeemed depending on how long they are held. The back-end loads may decline the longer the investor holds shares. Back-end loads with this structure are called contingent deferred sales charges (or CDSCs). Like front-end loads, back-end loads are deducted from an investor's account.12b-1 fees
A mutual fund may charge an annual fee, known as a 12b-1 fee, for marketing and distribution services. This fee is computed as a percentage of a fund's assets, subject to a maximum of 1% of assets. The 12b-1 fee is included in the expense ratio.No-load funds
A no-load fund does not charge a front-end load under any circumstances, does not charge a back-end load under any circumstances and does not charge a 12b-1 fee greater than 0.25% of fund assets.Share classes
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 the shares classes 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.Typical share classes for funds sold through brokers or other intermediaries are:
- Class A shares usually charge a front-end sales load together with a small 12b-1 fee.
- Class B shares don't have a front-end sales load. Instead they, have a high contingent deferred sales charge, or CDSC that declines gradually 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 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 subject to very high minimum investment requirements and are, therefore, known as "institutional" shares. They are no-load shares.
- Class R are for use in retirement plans such as 401(k) plans. They 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 charges a front-end or back-end load.
Management fee
The management fee is paid to the fund manager or sponsor who organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand name 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.Other fund expenses
A mutual fund pays for other services including:- Board of directors' (or board of trustees') fees and expenses
- Custody fee: paid to a bank for holding the fund's portfolio in safekeeping
- Fund accounting fee: for computing the net asset value daily
- Professional services fees: legal and accounting fees
- Registration fees: when making filings with regulatory agencies
- Shareholder communications expenses: printing and mailing required documents to shareholders
- Transfer agent services fee: keeping shareholder records and responding to customer inquiries
These expenses are included in the expense ratio.
Shareholder transaction fees
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.Securities transaction fees
A mutual fund pays any 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 the investments. They do not flow through the income statement and are not included in the expense ratio. The amount of securities transaction fees paid by a fund is normally positively correlated with its trading volume or "turnover".Expense ratio
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 net assets. The expense ratio is sometimes referred to as the "total expense ratio" or TER.Controversy
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.Many researchers have suggested that the most effective way for investors to raise the returns they earn from mutual funds is to reduce the fees that they pay. They suggest that investors look for no-load funds with low expense ratios.
Net asset value or NAV
A fund's net asset value or 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 by the number of fund shares outstanding. Funds must compute their net asset value every day the New York Stock Exchange is open.Valuing the securities held in a fund's portfolio is often the most difficult part of calculating net asset value. The fund's board of directors (or board of trustees) oversees security valuation.
Average annual total return
The SEC requires that mutual funds report the average annual compounded rates of return for 1-year, 5-year and 10-year periods using the following formula:- P(1+T)n = ERV
Where:
- 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 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).
Turnover
Turnover is a measure of the volume of a fund's securities trading. It is expressed as a percentage of net asset value and is normally annualized. Turnover equals the lesser of a fund's purchases or sales during a given period (of no more than a year) divided by average net assets. If the period is less than a year, the turnover figure is annualized.See also
- Fund derivative
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- Lipper averageLipper averageLipper Analytical Services provides a series of indices that establish benchmarks to measure the performance of a portfolio, or of various mutual funds and Exchange Traded Funds. They allow an investor, a portfolio manager, or an institutional investor to compare the performance of his/her...
- List of mutual fund companies in Canada
- List of mutual-fund families in the United States
- List of US mutual funds by assets under management
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