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Mutual Funds

This document aggregates information from various sources, and I'm generally satisfied with its breadth and level of detal.

BASICS

A mutual fund is a managed collective investment. Conceptually, it is the equivalent of numerous small investors combining their funds and hiring employees (one or more portfolio managers and supporting staff) to manage their collective portfolio.

Another way of conceptualizing a mutual fund (which is close to reality) is an investment-holding corporation - a company that has no operations of its own, and merely holds investments - in which individual investors own shares.

ADVANTAGES AND DISADVANTAGES

For the individual investor, there are specific advantages and disadvantages to investing in a mutual fund as opposed to managing a private portfolio of securities.

Advantages include:

• Professional management - It is suggested (and debated) that knowledge and experience enables a professional manager to identify investments that will earn a better return than those that a layman or less experienced individual might select.
• Low capital increment - An investor with a very small amount of capital can buy into a mutual fund (generally three thousand dollars), and can increase his investment by small increments.
• Diversification - A mutual fund contains a blend of investments, so the investment in one security (the fund) enables the investor to decrease their overall risk.
• Convenience of Monitoring - It is easier for investors to monitor the performance of a single fund as opposed to numerous individual investments.
• Convenience of Risk Management - An investor who wishes to increase or decrease his level of risk/return can more easily switch mutual funds than rebalance a portfolio of securities.
• Economies of scale - Since a mutual fund purchase large volumes of securities on a more frequent basis, it is presumed to be able to enjoy economies of scale (lower commissions than buying individual securities in small quantities) as well as negotiating discounted commissions on high volume purchases.
• Liquidity - It is easier for the investor to redeem shares in the fund than to sell securities in a private portfolio (and still maintain the same blend of investments).

Disadvantages include:

• Costs - There are overhead expenses to mutual funds (see "fund expenses") that must be paid out of profits.
• Dilution - There is some argument that a pool of assets can become too large to be effectively managed, and that profits are diluted beyond a certain point.
• Taxation - Mutual fund managers do not consider the personal tax situation of each investor when making decisions about investments
• Control - The individual investor has no direct or immediate control over the way in which funds are invested. The fund's management choose the securities.

In general, it is believe that the advantages outweigh the disadvantages for investors whose holdings are modest. Most sources suggest $1 million as the breaking point, where an individual would be better served by having their portfolio managed privately (but even private mangers often place some portion of the portfolio in mutual funds).

CHOOSING FUNDS

Typically, a small investor will begin with a single mutual fund, but will diversity his holdings into multiple funds as the total value of his investment portfolio increases. Whatever the case, the investor must choose fund(s).

There's a considerable amount of advice on this matter, and it seems to be highly subjective, but some of the common considerations are:

• Desired return - The investor's desired return from their investment will guide them to a certain kind of fund.
• Risk Aversion - Investors who wish to preserve the value of their investment may wish to choose a fund whose prices are more stable
• Duration - The length of time that their funds will be invested may lead an investor to accept a fund with slightly greater volatility.
• Investment Strategy - An investor who wishes a fund to provide regular income over time, or experience rapid growth, or minimize the impact of taxation, would be attracted to a fund with similar goals
• Speculation or Expectations - An investor with expectations that a specific market (in global funds) or specific industry sector will outperform others in the future might be drawn to a specific fund.
• Other factors - religious or political views might require or preclude certain investment types. Examples: Muslims cannot own bonds (forbidden to charge interest on loaned money); Mormons might not wish to profit from liquor or tobacco companies; pacifists might not wish to own stock in companies that manufacture munitions; tree huggers may wish to invest only in eco-friendly firms, etc.

Once the investor has decided on the type of fund that best suits their goals and interests, they must then select a specific fund (or mix of funds) in which to invest, considering the following factors

• Expected performance - While past performance is no guarantee of future returns, calculating the average return over time 9and the standard deviation) is one way of estimating (not predicting) the fund's future performance.
• Yield - The fund's yield is the percentage of value paid out as dividends. For those who do not wish to reinvest dividends, but instead take them as a stream of income, may wish to consider this factor.
• Holdings - The specific investments held by a fund might lead an investor to consider one fund over another.
• Management - Because the fund manager is (or at least claims to be) responsible for performance, a change in personnel may lead to a change in performance
• Fees - Where there are multiple funds of a given type, the amount of fees charged by a fund (loads, commissions, and expense ratio) can be a differentiating factor

INVESTING IN FUNDS

The details of mutual fund investment can vary, as each fund may set the terms for investors, but most mutual funds have virtually identical terms, and those that vary from the norm are often given a specific label, such as "exchange traded fund" or "hedge fund." These are discussed separately.

Most mutual funds are intended to be long-term investments. Though they may be bought or sold at will, the expected practice is for an investor to hold the bulk of their shares over a longer period of time.

Buying and Selling Into Funds

An investor typically opens a mutual fund account with a mutual fund, which is a sweeping account that is meant to temporarily warehouse cash until it is invested into a specific mutual fund. Often, the warehoused cash earns a modicum of interest by being invested into a short-term fund (such as a money market fund) while it lies fallow.

It is possible to have a mutual fund account with a company that manages a single fund, but more common to have the account with a parent company that offers an array of funds.

It is also possible to establish an account with a fund "supermarket" that enables the investor to buy and sell shares in mutual funds offered by various companies (though generally, the supermarket charges fees and commissions for its own profit, justified by the convenience to the consumer). Any commercial brokerage can also buy shares in mutual funds, and charge a commission for doing so.

Most individuals purchase mutual funds through an employer's retirement plan, which is in effect a mutual fund account.

Buying and Selling Shares

In most instances, an investor may buy shares by making an initial purchase. A minimum amount is generally required to establish an "account" (most often, three thousand dollars), but after that time, the investor may buy additional shares in any quantity.

The minimum investment requirement may be waived at the fund's discretion, and it is common to do so where there is an expectation of regular investments over a period of time - such as a retirement plan that will be credited with payroll deductions, or a private fund into which the investor agrees to automatic monthly transfers from a bank account.

Funds generally allow investors to buy (and sell) fractions of shares, so they may manage their account in terms of dollars rather than even numbers of shares, such that an investor could add $50 to an fund with a share price of $20 and be credited with 2.5 shares.

Some funds charge sales fees (called a "load") when buying shares, others charge a sales fee when shares are sold, and it's possible for a fund to impose both charges. However, it is most common for a fund to allow investors to buy and sell without paying any penalty.

As to the investor's balance, most funds generally require an investor to maintain a minimum amount invested in the fund, which is generally equal to the minimum initial investment. Fees are charged to investors whose balance drops below this amount as an encouragement to restore the minimum balance or completely divest themselves of the fund.

Various sources have portrayed the restrictions and fees on investors as unscrupulous profiteering, but they are generally intended to encourage stable, long-term investment for the benefit of all shareholders. A fund must keep some amount of its resources in cash (which earns less of a return) in order to cover transactions, so frequent and fluctuating purchases and redemptions of shares require greater liquidity and are detrimental to the performance of the fund.

Share Classes

For the most part, mutual fund shares are non-differentiated, like common stock in a corporation, but funds that charge fees to investors have devised specific classes of shares:

• A Shares - These shares carry a front-end charge (3-6%) when bought, and a 12b-1 fee (0.25%) charged each year
• B Shares - No front-end charge, but a redemption fee. The redemption fee usually is for a specific time (to encourage investors to keep their funds invested for a while), usually six years, and the fee generally decreases each year until it is no longer applicable. The 12b-1 fee also applies each year.
• Charges no load on either end, but does charge the 12b-1 fee each year.

Some funds also have "D Shares," but there is no standard as to what this entails. Generally some mix of the above.

On the 12b-1 fee, The SEC allows funds to charge this fee to cover the costs of distributing shares (generally marketing expenses). Generally, funds that charge this fee charge the full 0.25% (the maximum allowed).

Value of Shares

Determining the per-share value is fairly straightforward: total the present value of all investment holdings (referred to as the "net asset value" or NAV) and divide by the total number of shares outstanding.

This value will change daily, and may be in constant flux during trading hours, but mutual funds generally do not permit investors to buy or sell in real time. Any buy/sell orders will be processed at a specific time (generally, when the markets close and the per-share price is not in flux)

Unlike stocks, shares in a mutual fund generally trade at their actual value - i.e., there is no premium/discount based on future expectations of the fund's growth, as there are with stocks - though it can be said that speculation affects the investments which comprise the fund, so it remains a factor.

Investment Profits

A mutual fund's profit is generated by the securities it holds, and some funds may be structured to favor a specific species of profit.

• Capital Gains (or losses) are earned from the fluctuations in the trading price of the securities it holds. As with any investment, the current value is a paper gain (or loss) until such time as the security is sold.
• Dividends are paid by some securities, and those constitute income (profit) to the fund.
• Interests is earned on securities that make regular interest payments (such as bonds and preferred stocks)

Any investment profit made by the mutual fund is accrued in cash holdings and paid out to shareholders periodically, though it is common for a fund to enable the investor to consent to automatically reinvesting these earnings in the fund (which results in buying additional shares).

Tax Consequences

The mutual fund does not pay the taxes on investment profits: these are taxed to the individual investors as they are dispersed. The fund provides a report (IRS form 1099) to each investor that indicates the profits from each source (capital gains, dividends, and interest).

Taxes apply exactly as they would if the investor held the actual securities in a private portfolio, and some funds specialize in tax-free investments (municipal bonds).

In investor may also pay taxes on the capital gains on the value of shares in the fund itself, as the value of the shares represent an unrealized gain on the investments that would normally be assessed when an investment was sold (selling mutual shares is, in effect, selling off the investments it represents).

TYPES OF MUTUAL FUND

Mutual funds generally categorize themselves (or are categorized by others) into a specific "type" based on the kinds of investment opportunities they pursue. Since they are marketing labels that are not mutually exclusive (a single fund may be described as a sector fund, a green fund, and an equity fund), it can be quite confusing.

One common distinction is based on the type of security they (primarily) seek to hold: stocks, bonds, commercial paper, etc.

Another distinction is based on investment strategy. a "growth" fund seeks companies that will increase in value, an "income" fund seeks investments that make regular payments.

Another distinction is based on the industries in which a fund invests. A fund may seek to invest in companies in the health care, technology, real estate, or other financial sector.

A mutual fund may seek to marry itself to a specific market index, such as the S&P 500 or Dow Jones, by investing in the securities those indices include.

A fund may be structured to accomplish any strategy, even unusual ones. For example, some funds conform to the Muslim standards of investment (Shariah), others may invest only in companies they feel to be ethical or environmentally friendly (green funds), etc.

In all, there are a wide array of funds that enable the investor to choose according to his investment interests and objectives - and if a sufficient number of investors have a common interest, it's almost certain a fund exists (or will be established) to pursue it.

Common Labels

Some of the more common labels for funds include:

• Balanced Fund - A marketing term for a fund that attempts to "balance" security and risk by managing a combination of stocks and bonds.
• Bond Fund - Invests, often exclusively, in bonds rather than stocks.
• Equity Fund - Invests a majority of its holdings in stocks
• Fund of Funds - A fund that purchases shares in other funds (mutual funds or hedge funds)
• Green Fund - Invests in companies that are environmentally friendly
• Growth Fund - Invests in companies that are believed to have the potential for large capital gains
• Income Fund - A bond that seeks to earn a steady rate of return for its investors, generally though low-risk investments (such as bonds)
• Index Fund - A fund that is structured to match the stocks tracked in a specific market index (DJIS, S&P 500, etc.)
• Large-Cap Fund - Invests in large companies (generally those with a market capitalization of $1 billion or more)
• Money Market Fund - Invests in cash, T-Bills, and commercial paper and aims to keep their price stable at $1 per share (distribute hares to investors to balance out the NAV). This preserves value, but minimizes return.
• Municipal Bond Fund - A fund that buys bonds issued by governments (federal, state, city). Income from these funds may be exempt from taxation.
• Sector Funds - Gear their portfolio toward a specific sector (manufacturing, technology, healthcare)
• Small-Cap Fund - Invests in small companies (generally those with a market capitalization of under $10 million)
• Stock Fund - Same as "equity fund" above.
• Value Fund - Invest in companies that are believed to be presently undervalues

MUTUAL FUND OPERATION

A mutual fund operates as a corporate entity. The investors in the fund have voting rights, similar to those of shareholders in any other kind of company, and elect a board to govern the employees and set corporate policies.

A mutual fund generally does not seek to generate a profit from customers, as the investors are both the firm's "customers" and its "owners" - hence any profit made from an investor would be returned to him in the value of his shares.

Mutual funds incur expenses for their operations, which detract from their returns. These include:

• Management expenses are the fees paid to the firm that manages the fund. It is generally a flat rate, but may be structured according to various factors. This is generally reported as the "management expense ratio" or MER.
• Non-management expenses are largely similar to SG&A in any business: the costs of support personnel required for tasks not related to managing the portfolio.
• Marketing expenses are another non-management expense, but are of ten categorized as "12b-1" fees

Funds are required to report their expenses as a ratio, which is generally taken as an indication of efficiency. Also, since expenses detract from profits, funds with lower expense ratios are preferred. One source suggests that a reasonable expense ratio will range from 0.5% to 2%, with 1.45% being about average.

To cover expenses, mutual funds may divert funds from the investment portfolio, either as a percentage of the total value of the portfolio or as a (higher) percentage charged on any profits made from investing.

The fund may also charge fees for buying/selling shares or failure to maintain a minimum balance, and these fees are applied to the expenses of the company. (This is generally justified by the fact that the expenses are increased by the behavior of individuals upon whom the fees are applied.)

SPECIES OF MUTUAL FUND

Each mutual fund sets its own policies and practices. The information in this document pertains to the most common type of mutual fund, but there are other species of fund with significant differences.

Closed-End Funds

A closed-end fund is a joint investment with a limited number of shares. Typically, such a fund is created when a number of investors pool their funds, and the number of shares is created at that time (and no new shares are issued afterward).

In order to buy into a closed-end fund, an investor must be able to purchase shares from an individual who currently holds them; and to sell out, an investor must find a buyer for his shares; though some funds will buy and sell shares out of treasury.

This is slightly different from a fund that is called a "closed" fund, which has merely decided that it will stop selling shares to new investors at the current time.

Exchange-Traded Funds

An exchange-traded fund (ETF) is registered with a public exchange, and investors buy and sell individual shares on the open market, much as they would purchase shares of any other company.

This better facilitates liquidity for the small investor (there is no minimum purchase amount, not any company-imposed restrictions on buying or selling shares), but the key disadvantages are that investment is made in whole shares (rather than dollar amounts that may include fractional shares) and the value of the fund will be affected by second-degree speculation (not only do the value of the fund's holdings fluctuate, but the value of fund shares may fluctuate due to expectations of future performance).

Hedge Funds

A "hedge" fund trades in a wider array of investment opportunities, such as stock options, commodities, and even partnership in private firms. They generally require investment in large amounts (hundreds of thousands or millions) and have greater restrictions on the purchase or sale of shares.

Hedge funds have traditionally been subject to less regulatory control, though recent scandals in the industry may precipitate greater legislative restriction. There are also additional legal restrictions on hedge funds, such as a prohibition against certain kinds of marketing.

Hedge fund managers are generally paid based on performance: they take a cut, and often quite a large one, of the profit they generate rather than being paid a salary or a percentage of the fund's overall value.

Real Estate Investment Trust (REIT)

A REIT invests in real estate only, typically buying properties that generate an income through rentals (apartment buildings, office buildings, shopping malls), or through developing real estate (buying land, constructing buildings, then selling them off), or through real-estate related holdings (buying mortgage loans or other mortgage-backed securities).

A REIT is subject to specific and persnickety legislation - but from an investor's perspective, the value in a REIT is in the tendency (or requirement) of the trust to pay dividends on a regular and frequent basis.

Corporations

The line between a corporation and a mutual fund becomes blurry at times. When a corporation's value is determined by its assets and sale of products or services, it is generally not considered to be a mutual fund (though it could be argued that it is an investment firm that has a 100% stake in its own operations, that's a bit of a stretch).

When a corporation begins to purchase subsidiaries or wrap its operations into separate corporate entities (e.g., a parent corporation that owns a 100% stake in two or three separate corporations), the lines begin to blur.

When the corporation does not own a controlling share of the companies in which invests, does not take an active part in the management of their operations, and expresses its assets in terms of its shares of ownership in other organizations, it has crossed the line.

But exactly where the "line" exists, and what practices differentiate a "normal" corporation from an investment corporation, and an investment corporation from a true mutual fund, is subject to debate.

RANDOM TOPICS

In my research, I gathered information that doesn't seem to fit neatly into the material above. Here are the odds and ends:

Cost Averaging

A few sources have gone into detail about the benefits of buying and selling small amounts of mutual fund shares at a set interval rather than buying a large chunk all at once. In general, this mitigates the risk of daily market fluctuations and achieves a return that is closer to the advertised rate of return.

There is some debate over whether this practice reduces risk in a way that is of value to the investor, or whether it is merely done so that the investor's return will more closely match the general return rate of the fund (such that the fund does not need to deal with cranky investors who feel they have been short-changed because their personal rate of return is not equal to what the company is advertising).

Turnover

Turnover is discussed as a method of gauging the level of transactions in which a mutual fund engages. It's the total amount of transactions (absolute value of purchase and sales, divided by two) divided by the total holdings of the fund.

In theory, a firm that has a 100% turnover rate has sold off everything it owns and bought new investments during the same period of time. Though in truth, it may be that the firm held 90% of its securities steadily, but trade the other 10% ten times.

It's not clear whether turnover is desirable or undesirable - an aggressive fund may engage in a number of short-term deals in order to pursue rapid growth, or it may hold stocks of companies that are undergoing significant expansion over a longer period of time.

A lower turnover rate would result in a lower tax impact (a security that is held for a long period of time generates no taxable income), and it would likewise be desirable if the firm pays a significant commission on trades.

Beyond that, it's not clear that turnover is indicative of anything specific, or anything worth considering.

History

Mutual funds are not particularly new: investors have pooled money into portfolios (or to form investment companies, which did no business but held securities of other companies) for ages. Following the market crash of the 1930's, the SEC drafted an Investment Company Act, passed in 1940, which provides regulations dictating practices and procedures for this kind of operation, standardizing the industry.

Growth of funds has been rampant since. By the end of the 1960's, there were less than 300 such funds in existence. As of October 2007, there are over 8,000 such funds. It is estimated that half of U.S. households invest in mutual funds (mostly, through 401K, IRA, and similar retirement plans) and that private individuals stake in mutual funds is over $6 trillion.

Governance

In the United States, a mutual fund is regulated by the Investment Company Act of 1940. Fundamentally, a fund is an investment corporation in which the investors hold shares. Mutual fund companies are generally owned by parent companies (financial services firms), but are subject to their own articles of incorporation.

Mutual funds are subject to a special set of regulatory, accounting, and tax ruels and procedures.

Generally speaking, mutual funds are not taxed on their earnings. Any profit or income generated is passed along to the shareholders, who pay the taxes upon selling their shares. The sale of shares generates a blend of ordinary income (the portion of profit from interest, dividends, and the like) and capital gains (the portion of profit from the sale of securities themselves).

Reporting

Mutual funds are required to report their performance in a certain standard format, and will often take some of these statistics out of context to promote their fund to new investors.

Statistics reported include

• The high and low price over the past 52 weeks
• The latest quarterly and annual returns
• Returns for 1, 3, and 5 years
• Daily fluctuations in price and volume

This is historical data, and like all investments, does not guarantee future returns, though companies seem to rely on the fact that investors often assume that they represent "trends" that will continue.