Mutual Funds & ETF’s
A mutual fund is a type of professionally managed collective investment scheme that pools money from many investors to purchase securities. While there is no legal definition of the term mutual fund, it is most commonly applied only to those collective investment vehicles that are regulated and sold to the general public. They are sometimes referred to as “investment companies” or “registered investment companies”. Most mutual funds are open-ended, meaning stockholders can buy or sell shares of the fund at any time by redeeming them from the fund itself, rather than on an exchange. Hedge funds are not considered a type of mutual fund, primarily because they are not sold publicly.
In the United States, mutual funds must be registered with the Securities and Exchange Commission, overseen by a board of directors (or board of trustees if organized as a trust rather than a corporation or partnership) and managed by a registered investment adviser. Mutual funds, like other registered investment companies, are also subject to an extensive and detailed regulatory regime set forth in the Investment Company Act of 1940. Mutual funds are not taxed on their income and profits if they comply with certain requirements under the U.S. Internal Revenue Code.
There are 3 types of U.S. mutual funds: open-end, unit investment trust, and closed-end. The most common type, the open-end fund, must be willing to buy back shares from investors every business day. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange. Open-end funds are most common, but exchange-traded funds have been gaining in popularity.
Mutual funds are generally classified by their principal investments. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds and hybrid funds. Funds may also be categorized as index or actively managed.
Investors in a mutual fund pay the fund’s expenses, which reduce the fund’s returns and performance. A single mutual fund may give investors a choice of different combinations of expenses (which may include sales commissions or loads) by offering several different types of share classes.
In the US, a mutual fund is registered with the Securities and Exchange Commission (SEC) and is overseen by a board of directors (if organized as a corporation) or board of trustees (if organized as a trust). The board is charged with ensuring that the fund is managed in the best interests of the fund’s investors and with hiring the fund manager and other service providers to the fund.
The 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.
Mutual funds are not taxed on their income and profits as long as they comply with requirements established in the U.S. Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute a high percentage of their income and capital gains (net of capital losses) 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 by paying out dividends and capital gains at least annually. The characterization of that income is unchanged as it passes through to the shareholders. For example, mutualfund 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 but are retained by the fund to be able to offset future gains.
Mutual funds may invest in many kinds of securities. The types of securities that a particular fund may invest in are set forth in the fund’s prospectus, 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.
Hedge funds are not considered a type of (unregistered) mutual fund. While they are another type of collective investment vehicle, they are not governed by the Investment Company Act of 1940 and are not required to register with the Securities and Exchange Commission (though many hedge fund managers must register as investment advisers).
Advantages and disadvantages
Mutual funds may have advantages compared to direct investing in individual securities.These include:
- Increased diversification: A fund must hold many securities. Diversifying reduces risks compared to holding a single stock, bond, other available instruments.
- Daily liquidity: This concept applies only to open-end funds. Shareholders may trade their holdings with the fund manager at the close of a trading day based on the closing net asset value of the fund’s holdings. However, there may be fees and restrictions as stated in the fund prospectus. For holders of individual stocks, bonds, closed-end funds, ETFs, and other available instruments, there may not be a buyer/seller for that instrument every day, making such investments less liquid.
- Professional investment management: A highly variable aspect of a fund discussed in the prospectus. Actively managed funds may have large staffs of analysts who actively trade the fund holdings. Management of an index fund may just passively re-balance holdings to match a market index like the Standard and Poors 500 Index.
- Ability to participate in investments that may be available only to larger investors: Foreign markets, in particular, are rarely open and affordable for individual investors. Moreover, the research required to make sensible foreign investments may require knowledge of another language and the rules of regulations of other markets.
- Service and convenience: This is not a feature of a mutual fund, but rather a feature of the fund management company. Increasingly in recent years, there are funds, notably Exchange Traded Funds (ETFs) that are purely investment instruments without any additional services from the fund management company.
- Government oversight: Largely, the US government’s role with mutual funds is to require the publication of a prospectus describing the fund. No such document is required for stock, bonds, currencies, and other investment instruments. There is no governmental oversight of a fund’s investment success/failure.
- Ease of comparison: Since mutual funds are available from many providers, it is generally easy to find similar funds and compare features such as expenses.
Mutual funds may have disadvantages as well, which include:
- Less control over timing of recognition of gains
- Less predictable income
- No opportunity to customize
Types of Mutual Funds
There are 3 principal types of mutual funds in the United States: open-end funds, unit investment trusts (UITs); and closed-end funds.
Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange; they have gained in popularity recently. 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.
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.
Open-end funds are the most common type of mutual fund.
Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from 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. UITs generally have a limited life span, established at creation. Investors can redeem shares directly with the fund at any time (as with an open-end fund) or wait to redeem upon termination of the trust. Less commonly, they can sell their shares in the open market.
Unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT and does not change.
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). Most ETFs are index funds that combine characteristics of both closed-end funds and open-end funds. Ideally, ETFs are traded throughout the day on a stock exchange at a price that is close to net asset value of the ETF holdings. ETF shares may be created or liquidated during the trading day by the fund manager working with specialist and institutions that profit from arbitrage trading the slight differences between the ETF trading price and the price of the ETF holdings. This arbitrage is supposed to keep the ETF market price close to net asset value of its holdings, but there is no guarantee especially with thinly traded ETFs.
Investments and classification
Mutual funds are normally classified by their principal investments, as described in the prospectus and investment objective. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds and hybrid funds. Within these categories, funds may be subclassified by investment objective, investment approach or specific focus. The SEC requires that mutual fund names 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”.
Bond funds invest in fixed income or debt 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).
Stock or equity funds
Stock or equity funds invest in common stocks which represent an ownership share (or equity) in corporations. Stock funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds). They may focus on a specific industry or sector.
A stock fund may be subclassified along two dimensions: (1) market capitalization and (2) investment style (i.e., growth vs. blend/core vs. value). The two dimensions are often displayed in a grid known as a “style box”.
Market capitalization (“cap”) indicates the size of the companies in which a fund invests, based on the value of the company’s stock. Each company’s market capitalization equals the number of shares outstanding times the market price of the stock. Market capitalizations are typically divided into the following categories:
- 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.
Hybrid funds invest in both bonds and stocks or in convertible securities. Balanced funds, asset allocation funds, target date or target risk funds and lifecycle or lifestyle funds are all types of hybrid funds.
Hybrid funds may be structured as funds of funds, meaning that they invest by buying shares in other mutual funds that invest in securities. 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.
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 500 index, while an actively managed fund seeks to outperform a relevant index through superior security selection.
Investors in a mutual fund pay the fund’s expenses. These expenses fall into five categories: distribution charges (sales loads and 12b-1 fees), the management fee, 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 fees and expenses—specifically the 12b-1 fee, the management fee and other fund expenses—are included in a fund’s total expense ratio, or simply the “expense ratio”. Because all funds must compute an expense ratio using the same method, it allows investors to compare costs across funds.
Distribution charges pay for marketing, distribution of the fund’s shares as well as services to investors.
Front-end load or sales charge
A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested or the “public offering price”, which equals the net asset value plus the front-end load per share. The front-end load often declines as the amount invested increases, through breakpoints. The front-end load is paid by the shareholder; it is deducted from the amount invested.
Some funds have a back-end load, which is paid by the investor when shares are redeemed. If the back-end load declines the longer the investor holds shares, it is called a contingent deferred sales charges (or CDSC). Like the front-end load, the back-end load is paid by the shareholder; it is deducted from the redemption proceeds.
Some funds charge an annual fee to compensate the distributor of fund shares for providing ongoing services to fund shareholders. This fee is called a 12b-1 fee, after the SEC rule authorizing it. The 12b-1 fee is paid by the fund and reduces net asset value.
A no-load fund does not charge a front-end load 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.
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.
The fund’s board of directors reviews the management fee annually. Fund shareholders must vote on any proposed increase in the management. However, the fund manager or sponsor may agree to waive all or a portion of the management fee in order to lower the fund’s expense ratio.
Other fund expenses
A mutual fund may pay for other services including:
- Board of directors or trustees fees and expenses
- Custody fee – paid to a custodian bank for holding the fund’s portfolio in safekeeping and collecting income owed on the securities
- Fund administration fee – for overseeing all administrative affairs of the fund such as preparing financial statements and shareholder reports, preparing and filing myriad SEC filings required of registered investment companies, monitoring compliance with investment restrictions, computing total returns and other fund performance information, preparing/filing tax returns and all expenses of maintaining compliance with state “blue sky” laws
- Fund accounting fee – for performing investment or securities accounting services and computing the net asset value (usually each day the New York Stock Exchange is open)
- Professional services fees – legal and auditing fees
- Registration fees – for 24F-2 fees owed to the SEC for net sales of registered fund shares and state blue sky fees owed for selling shares to residents of states in the US and jurisdictions such as Puerto Rico and Guam
- Shareholder communications expenses – printing and mailing required documents to shareholders such as shareholder reports and prospectuses
- Transfer agent service fees and expenses – for keeping shareholder records, providing statements and tax forms to investors and providing telephone, internet and or other investor support and servicing
- Other/miscellaneous fees
The fund manager or sponsor may agree to subsidize some of these other expenses in order to lower the fund’s expense ratio.
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 expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. Securities transaction fees increase the cost basis of investments purchased and reduce the proceeds from their sale. They do not flow through a fund’s income statement and are not included in its expense ratio. The amount of securities transaction fees paid by a fund is normally positively correlated with its trading volume or “turnover”.
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.
Funds offering multiple classes often identify them with letters, though they may also use names such as “Investor Class”, “Service Class”, “Institutional Class”, etc., to identify the type of investor for which the class is intended. The SEC does not regulate the names of share classes, so that specifics of a share class with the same name may vary from fund family to fund family.
Typical share classes for funds sold through brokers or other intermediaries are as follows:
- Class A shares usually charge a front-end sales load together with a small 12b-1 fee.
- Class B shares usually 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 usually have a high 12b-1 fee and a modest contingent deferred sales charge that is discontinued after one or two years. Class C shares usually do not convert to another class. They are often called “level load” shares.
- Class I are usually subject to very high minimum investment requirements and are, therefore, known as “institutional” shares. They are no-load shares.
- Class R are usually for use in retirement plans such as 401(k) plans. They typically do not charge loads, but do charge a small 12b-1 fee.
No-load funds often have two classes of shares:
- Class I shares do not charge a 12b-1 fee.
- Class N shares charge a 12b-1 fee of no more than 0.25% of fund assets.
Neither class of shares typically charges a front-end or back-end load.
- 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 net assets by the number of fund shares outstanding. Funds must compute their net asset value according to the rules set forth in their prospectuses. Funds compute their NAV at the end of each day that the New York Stock Exchange is open, though some funds compute their NAV more than once daily.
- Valuing the securities held in a fund’s portfolio is often the most difficult part of calculating net asset value. The fund’s board typically oversees security valuation.
- 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 daily net assets. The expense ratio is sometimes referred to as the “total expense ratio” or TER.
- 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).
- P(1+T)n = ERV where:
- Turnover – A measure of the volume of a fund’s securities trading. It is expressed as a percentage of average market value of the portfolio’s long-term securities. Turnover is the lesser of a fund’s purchases or sales during a given year divided by average long-term securities market value for the same period. If the period is less than a year, turnover is generally annualized.