Mutual funds:Types of international mutual funds, Mutual funds vs. other investments

<< ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR

Mutual Funds:Criticism of managed mutual funds, Money Market Fund >>

Management of Financial Institutions - MGT 604

Lecture 22

Mutual funds

What are mutual funds?

An investment vehicle which is comprised of a pool of funds collected from many investors

for the purpose of investing in securities such as stocks, bonds, money market securities,

and similar assets. Mutual funds are operated by money mangers, who invest the fund's

capital and attempt to produce capital gains and income for the fund's investors. A mutual

fund's portfolio is structured and maintained to match the investment objectives stated in its

prospectus.

In business encyclopedia

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.

History of Mutual Funds

Massachusetts Investors Trust was founded on March 21, 1924, and, after one year, had 200

shareholders and $392,000 in assets. The entire industry, which included a few closed-end

funds, represented less than $10 million in 1924.

Management of Financial Institutions - MGT 604

The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock

market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act

of 1934. These laws require that a fund be registered with the Securities and Exchange

Commission (SEC) and provide prospective investors with a prospectus that contains

required disclosures about the fund, the securities themselves, and fund manager. The SEC

helped draft the Investment Company Act of 1940, which sets forth the guidelines with

which all SEC-registered funds today must comply.

With renewed confidence in the stock market, mutual funds began to blossom. By the end

of the 1960s, there were approximately 270 funds with $48 billion in assets. The first retail

index fund, the First Index Investment Trust, was formed in 1976 and headed by John

Bogle, who conceptualized many of the key tenets of the industry in his 1951 senior thesis

at Princeton University. It is now called the Vanguard 500 Index Fund and is one of the

largest mutual funds ever with in excess of $100 billion in assets.

One of the largest contributors of mutual fund growth was individual retirement account

(IRA) provisions added to the Internal Revenue Code in 1975, allowing individuals

(including those already in corporate pension plans) to contribute $2,000 a year. Mutual

funds are now popular in employer-sponsored defined contribution retirement plans

(401(k)s), IRAs and Roth IRAs.

As of April 2006, there are 8,606 mutual funds that belong to the Investment Company

Institute (ICI), the national association of investment companies in the United States, with

combined assets of $9.207 trillion.

Types of international mutual funds

Open-end fund

The term mutual fund is the common name for an open-end investment company. Being

open-ended means that, at the end of every day, the fund issues new shares to investors, and

buys back shares from investors wishing to leave the fund.

Mutual funds may be legally structured as corporations or business trusts but in either

instance are classed as open-end investment companies by the SEC.

Other funds have a limited number of shares; these are either closed-end funds or unit

investment trusts, neither of which a mutual fund is.

Exchange-traded funds

A relatively new innovation, the exchange traded fund (ETF), is often formulated as an

open-end investment company. ETFs combine characteristics of both mutual funds and

closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares are issued

or redeemed by institutional investors in large blocks (typically of 50,000). Investors

typically purchase shares in small quantities through brokers at a small premium or discount

to the net asset value; this is how the institutional investor makes its profit. Because the

institutional investors handle the majority of trades, ETFs are more efficient than traditional

mutual funds (which are continuously issuing new securities and redeeming old ones,

keeping detailed records of such issuance and redemption transactions, and, to effect such

transactions, continually buying and selling securities and maintaining liquidity position)

and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock

exchange, just like closed-end funds.

Management of Financial Institutions - MGT 604

Exchange traded funds are also valuable for foreign investors who are often able to buy and

sell securities traded on a stock market, but who, for regulatory reasons, are unable to

participate in traditional US mutual funds.

Equity funds

Equity funds, which consist mainly of stock investments, are the most common type of

mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the

United States. Often equity funds focus investments on particular strategies and certain

types of issuers.

Bond funds

Bond funds account for 18% of mutual fund assets. Types of bond funds include term

funds, which have a fixed set of time (short-, medium-, or long-term) before they mature.

Municipal bond funds generally have lower returns, but have tax advantages and lower risk.

High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With

the potential for high yield, these bonds also come with greater risk.

Money market funds

Money market funds hold 26% of mutual fund assets in the United States. Money market

funds entail the least risk, as well as lower rates of return. Unlike certificates of deposit

(CDs), money market shares are liquid and redeemable at any time. The interest rate quoted

by money market funds is known as the 7 Day SEC Yield.

Funds of funds

Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds (i.e.,

they are funds comprised of other funds). The funds at the underlying level are typically

funds which an investor can invest in individually. A fund of funds will typically charge a

management fee which is smaller than that of a normal fund because it is considered a fee

charged for asset allocation services. The fees charged at the underlying fund level do not

pass through the statement of operations, but are usually disclosed in the fund's annual

report, prospectus, or statement of additional information. The fund should be evaluated on

the combination of the fund-level expenses and underlying fund expenses, as these both

reduce the return to the investor.

Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor),

although some invest in funds managed by other (unaffiliated) advisors. The cost associated

with investing in an unaffiliated underlying fund is most often higher than investing in an

affiliated underlying because of the investment management research involved in investing

in fund advised by a different advisor. Recently, FoFs have been classified into those that

are actively managed (in which the investment advisor reallocates frequently among the

underlying funds in order to adjust to changing market conditions) and those that are

passively managed (the investment advisor allocates assets on the basis of on an allocation

model which is rebalanced on a regular basis).

The design of FoFs is structured in such a way as to provide a ready mix of mutual funds for

investors who are unable to or unwilling to determine their own asset allocation model.

Fund companies such as TIAA-CREF, Vanguard, and Fidelity have also entered this market

to provide investors with these options and take the "guess work" out of selecting funds.

Management of Financial Institutions - MGT 604

The allocation mixes usually vary by the time the investor would like to retire: 2020, 2030,

2050, etc. The more distant the target retirement date, the more aggressive the asset mix.

Hedge funds

Hedge funds in the United States are pooled investment funds with loose SEC regulation

and should not be confused with mutual funds. Certain hedge funds are required to register

with SEC as investment advisers under the Investment Advisers Act. The Act does not

require an adviser to follow or avoid any particular investment strategies, nor does it require

or prohibit specific investments. Hedge funds typically charge a management fee of 1% or

more, plus a "performance fee" of 20% of the hedge fund's profit. There may be a "lock-

up" period, during which an investor cannot cash in shares.

Usage of Mutual Funds

Mutual funds can invest in many different kinds of securities. The most common are cash,

stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can

invest primarily in the shares of a particular industry, such as technology or utilities. These

are known as sector funds. Bond funds can vary according to risk (e.g., high-yield or junk

bonds, investment-grade corporate bonds), type of issuers (e.g., government agencies,

corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock

and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and

foreign securities (global funds), or primarily foreign securities (international funds).

Most mutual funds' investment portfolios are continually adjusted under the supervision of a

professional manager, who forecasts the future performance of investments appropriate for

the fund and chooses those which he or she believes will most closely match the fund's

stated investment objective. A mutual fund is administered through a parent management

company, which may hire or fire fund managers.

Mutual funds are liable to a special set of regulatory, accounting, and tax rules. Unlike most

other types of business entities, they are not taxed on their income as long as they distribute

substantially all of it to their shareholders. Also, the type of income they earn is often

unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free

municipal bond income are also tax-free to the shareholder. Taxable distributions can be

either ordinary income or capital gains, depending on how the fund earned those

distributions.

Mutual funds vs. other investments

Mutual funds offer several advantages over investing in individual stocks. For example, the

transaction costs are divided among all the mutual fund shareholders, who also benefit by

having a third party (professional fund managers) apply their expertise, dedicate their time

to manage and research investment options. However, despite the professional management,

mutual funds are not immune to risks. They share the same risks associated with the

investments made. If the fund invests primarily in stocks, it is usually subject to the same

ups and downs and risks as the stock market.

Share classes

Many mutual funds offer more than one class of shares. For example, you may have seen a

fund that offers "Class A" and "Class B" shares. Each class will invest in the same pool (or

investment portfolio) of securities and will have the same investment objectives and

Management of Financial Institutions - MGT 604

policies. But each class will have different shareholder services and/or distribution

arrangements with different fees and expenses. These differences are supposed to reflect

different costs involved in servicing investors in various classes; for example, one class may

be sold through brokers with a front-end load, and another class may be sold direct to the

public with no load but a "12b-1 fee" included in the class's expenses (sometimes referred to

as "Class C" shares). Still a third class might have a minimum investment of $10,000,000

and be available only to financial institutions (a so-called "institutional" share class). In

some cases, by aggregating regular investments made by many individuals, a retirement

plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the

benefit of their typically lower expense ratios) even though no members of the plan would

qualify individually. As a result, each class will likely have different performance results.

A multi-class structure offers investors the ability to select a fee and expense structure that

is most appropriate for their investment goals (including the length of time that they expect

to remain invested in the fund).

Table of Contents: