Mutual fund

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Mutual funds are registered investment companies that pool investors capital for the purpose of investing in securities. Mutual funds are managed by professional money managers. They are a primary funding vehicle for the corporate contributory retirement system in the United States. In 2012, a total of 8,752 U.S. mutual funds held over 13 trillion dollars of assets, owned by forty-four percent of American households and an estimated 92 million individuals. [1]

Mutual fund advantages

Mutual funds have a number of compelling advantages.

  1. Diversification: The first principle of mutual fund investing is broad diversification of securities. Diversification greatly reduces and can even eliminate the specific risk that comes with the ownership of just a few individual stocks and bonds. Until the advent of mutual funds it was impossible for ordinary investors to own enough securities to minimize non-market risk. Now, even a beginning investor with $1,000 can invest in a mutual fund holding thousands of individual securities so that the decline or bankruptcy of a single security will have almost no influence on the portfolio. [2]
  2. Professional management: Managing and holding an investment portfolio entails selecting and supervising the fund's holdings. Managers must do so based on the fund's objectives and policies. Managers of index funds attempt to mimic their benchmark index. Index fund managers make no attempt to select "winning" securities. Managers of managed funds attempt to add value by selecting securities they think will attain above-average performance within the fund's objectives. [3]
  3. Liquidity: Many securities (hedge funds, limited partnerships, real estate, CDs, etc.) cannot be sold quickly and without penalty. However, most mutual fund shares may be acquired or liquidated at a moment's notice at the fund's next determined net asset value per share. Also, mutual funds can easily be converted into cash at a fraction of the cost (a few funds have redemption fees) that would be incurred when selling individual stocks or bonds. This is also true when exchanging mutual funds. [4]
  4. Convenience: Mutual Fund prices and performance are readily available in newspapers, magazines, internet and research organizations such as Morningstar. Purchases can be made through brokers or directly with fund companies. Mutual fund companies provide automatic reinvestment of dividends and capital gains distributions, tax reporting, programs for regular additional investments and for systematic withdrawals, check writing on money market funds, telephone exchanges among different funds within the same family, and on-line account management . [5]

Mutual fund criticism

Invest in Nonprofit Index Funds: Swensen says individuals should invest in nonprofit funds that track market segments, such as the S&P 500. There are a range of index funds that track the U.S. domestic stock market, international markets, emerging markets and the real-estate market. Swensen says mutual funds that are organized on a not-for-profit basis don't have the same conflict of interest as for-profit funds, and they charge lower fees. The fees are even lower with nonprofit index funds, because you're not paying money managers to research stocks and buy and sell them. The fund simply holds all the stocks listed in that index. And because well-structured index funds have low churn (turnover), they are remarkably tax efficient.
David Swenson on NPR, Yale's Money Guru Shares Wisdom with Masses October 5, 2006


According to critics, the advantages that mutual funds may bring to investors are often largely negated by high costs and conflicts of interest between the managers of the funds and the investor fund shareholder.

  1. Costs: Critics such as John Bogle [6], and David Swenson [7] decry the costs of mutual fund investing. According to the Investment Company Institute [8], the average expense ratio for US stock mutual funds in 2012 was 1.40% (weighted average 0.77%), while the average expense ratio for US bond mutual funds was 1.01% (weighted average 0.61%). [9] According to Bogle, while mutual fund assets rose 1,600-fold from 1950-2004, mutual fund expenses rose 2,400 fold. [10] These costs directly reduce investor returns. The expense ratio does not include sales loads or fund transaction costs.
  2. Turnover: Bogle points out that from 1945 to 1965, stock mutual funds maintained an average turnover [11] of 17 percent (an average holding period of six years). Since 1965, turnover has increased to a present day average of 100 percent (average holding period of one year). [12] Increased turnover to such levels leads not only to greater frictional transaction costs for a fund, but also increases the likelihood of realized taxable gains. [13]
  3. Organizational structure: The basic structure of the mutual fund, in which an external management company owns the mutual fund is, according to critics, inherently riddled with conflicts of interest. The external management company's profits to its shareholders must come from mutual fund shareholders. In 2006, the top 30 mutual fund management companies had a corporate structure breakdown that consisted of 19 large conglomerates; 7 publicly owned firms; and 4 privately held firms. In addition, fund acquisitions and mergers have produced little realized value for fund shareholders. Luo and Qiao (2013) find that "acquiring families keep most of the acquired funds intact, and merge a small fraction of the acquired funds with a few of their incumbent funds. Most involved funds, including the acquired funds and the incumbent funds that remain intact, have a performance deterioration. There is little evidence that fund expenses decrease or fund liquidity increases." [14]
Mutual Fund Corporate Structure and Performance [15]
Ownership Structure Number of Firms Average Relative Performance (10 year returns)
Private 4 firms 29% quartile
Public 7 firms 40% quartile
Conglomerate 19 firms 55% quartile

Types of mutual funds

Mutual funds provide access to diversified portfolios of the major asset classes: money markets, bonds, and stocks, as well as providing access to discrete market segments of each market. Funds may be actively managed, where the investment manager attempts to outperform a benchmark index, or indexed, where the investment manager attempts to match a benchmark index return. Mutual funds can be sold with or without a sales commission.

Distribution: load funds

Mutual funds sold by full service brokerages, banks, and commissioned advisors usually impose a sales charge on investors known as a "sales load". The sales load may be paid upfront upon purchase, or deferred until an investor redeems fund shares; this deferred charge is often called a "contingent deferred sales charge (CDSC)". These sales charges are in addition to a fund's expense ratio and any other transaction charges a fund may impose. Sales charges are usually labeled as different share classes of a fund, as follows:

  1. A-shares: A-shares impose a front end charge on initial investment. A fund issuing a-shares might impose a 5% load upon purchase; thus an investor committing a $10,000 investment to the fund would actually invest $9,500 in the fund with $500 going to the sales agent as a commissioned load. A-shares may also assess an additional 0.25% annual charge (known as a 12b-1 fee).
  2. B-shares: B-shares do not charge an upfront load. Instead the shares impose a back end redemption fee combined with a 1% annual charge (12b-1 fee).The redemption fee usually declines each year until it eventually reaches zero. The combination of the annual charge and the redemption fee assures that the full load is eventually paid. The exact rate at which these fees will decline will be disclosed in the fund’s prospectus. Ordinarily, b-shares convert to a-shares (and reduced 12b-1 charges) once the CDSC reaches zero.
  3. C-shares: C-shares do not charge an upfront load. C-shares are sold with a 1% CDSC for the first year, plus a 1% 12b-1 fee. The redemption fee is eliminated during year two. Unlike b-shares, c-shares never convert to a-shares; the investor pays the added 1% 12b-1 fee for as long as the fund is held. [16]

Distribution: no-load funds

A no-load mutual fund distributes its fund shares directly with an investor. Thus a no-load mutual fund does not employ the sales charge fees that load funds impose on shareholders. This is a distinct advantage for the do it yourself investor.

However a no-load fund may impose the following fees in addition to the expense ratio that all funds incur:

  • Transaction fees: Mutual funds incur costs buying and selling securities for the fund (see Mutual funds: additional costs). Some funds cover the costs associated with an individual investor’s transactions by imposing purchase fees and redemption fees directly on the investor at the time of the transactions to cover these costs. Unlike sales charges, these fees are usually paid back into the fund. A redemption fee may also be imposed as a means to deter short term market timing selling of a fund.
  • Maintenance fees: Some funds may charge a separate maintenance fee for low balance fund accounts.
  • 12b-1 fees: A no-load fund is permitted to charge a maximum 0.25% 12b-1 fee and still remain classified as a no-load fund. The main reason that a fund might impose a 0.25% is for purchasing access to a brokerage firm's "fund supermarket". The fee allows the brokerage to offer the fund as a "No Transaction Fee" fund in the supermarket.

The following table and charts show the distribution of long term assets held in load funds, no-load funds, and variable annuity subaccounts [17] over the 2001- 2010 period. Over this period there has been a steady increase in investor no-load fund holdings and a decrease in load fund holdings. (The numerical data is in millions of dollars). [18]

Mutual fund categories

Money market funds

Money funds are regulated under Rule 2a-7 of the 1940 Investment Company Act. Key provisions of the regulations require the following:
  • Maturity: Money funds can only invest in money market instruments maturing under 12 months and must maintain a weighted average maturity of 60 days or less.
  • Diversification: With the exception of federal government securities, money funds may not invest more than 5 percent of their assets in a single issuer.
  • Credit Quality: Money funds must limit their investments to securities that are rated in one of the two highest short-term rating categories by a nationally recognized statistical rating organization (NRSRO). Investment in second-tier securities is limited to 3% of total fund assets, with a limit of 0.5% for any single issuer. Investment in second tier securities is restricted to maturities of 45 days or less. [19]


Money market funds are mutual funds that invest in short term (less than one year) money market instruments. Money market fund investments include treasury bills, commercial paper, bank CD's and banker acceptances. By design, they are meant to maintain stable net asset valuations of 1.00 dollar per share and provide investors with interest dividends. They are thus suitable investments for savings and other short term needs. While money market funds are low risk, they are not zero-risk. In the event that some of the underlying investments default, the fund may not be able to maintain a net asset value of $1.00/share; this failure is colloquially known as breaking the buck. As of November, 2009, there have been only a few cases when this has actually happened. Most notably, two money-market funds of The Reserve Funds broke the buck in September, 2008, after Lehman went bankrupt.

Money funds are characterized by the underlying investments comprising the portfolio. This specialization allows for funds to be differentiated by risk and tax characteristics. Money funds include:

  • General a.k.a. Prime money funds: These funds invest in a large gamut of money fund instruments: treasury bills, CD's, Yankee CD's, Eurodollar CD's, commercial paper, and bankers acceptances. These funds are usually heavily weighted towards the non-treasury instruments. Since these instruments are exposed to credit risks, they provide higher interest coupons than treasuries (this excess interest can be called the default risk premium). The non-treasury component of a General money market fund is taxable income for both federal and state jurisdictions.
  • Treasury money funds: Treasury money funds invest 100% in "full faith and credit" treasury bills and agency instruments. Thus they are not subject to credit risk (since the treasury has monopoly power to print fiat currency.) Treasury interest is exempt from state income taxation.
  • Tax-exempt funds: These funds invest in municipal money market instruments. The interest is generally exempt from federal taxation (although some interest may be subject to the alternative minimum tax). [20] State specific tax exempt funds invest in municipal securities of an individual state and thus provide federal, state, and sometimes local tax exempt interest for state residents. Tax exempt funds are subject to credit risk as well as the risk of tax law change to their exemption status.

If held in a taxable account, one needs to compare the after tax yields of a given money fund to determine whether the fund will yield the highest after tax income (see After-tax yields).

Costs are an important factor in money market fund selection. Since the total return of a money market fund consists of the income payment, the lower the expense ratio of the fund, the higher the net return to the investor. A low cost money fund can hold the highest quality money market instruments and still provide competitive yields.

Bond funds

Bond mutual funds invest in fixed income securities with maturities ranging from one year to thirty (or more) years. Bond funds may hold the following types of bonds:

  • Government bonds
  • Corporate bonds
  • Asset-backed securities
  • Foreign bonds
  • Tax-exempt bonds


Each of these general bond categories contain discrete segments of the bond market. Bond funds may hold an aggregate of the taxable or tax exempt bond markets, or may hold just a specific segment of the market. The segments of the bond market are outlined in the following table.

Bond Funds - Market Sectors (American Investor)
Taxable Tax-Exempt
Government Bonds Corporate Bonds Asset-backed Securities Foreign Bonds Tax-exempt Bonds

Bond funds are distinguished by the types of bonds held in the portfolio, the credit quality of the bonds, and by the average maturity of the bond portfolio. As a general rule, lower quality and longer maturity bonds provide higher interest coupons as compensation for the added risk. Treasury securities have the highest credit quality. Corporate, asset-backed, and tax-exempt bonds are subject to various default and other risks and are rated by rating agencies for credit worthiness. Ratings range from investment grade (the highest rating) to bonds in default.

Figure 1. Morningstar Fixed Income Style Box. Maturity along x-axis; credit quality on y-axis.

Typically, a bond fund in any given segment of the market will be a part of a series of funds providing short, intermediate, and long term maturities. These tiered maturity portfolios allow an investor to match a bond fund to an expected holding period, and to maintain the portfolio's exposure to interest rate risk. Bond funds are usually available in the following maturities:

  • Short term bond funds: maturities between 1 year and 5 years.
  • Intermediate term bond funds: maturities between 5 years and 10 years.
  • Long term bond funds: maturities greater than 10 years.

A fund will have an average maturity based on the proportion of fund assets represented by each bond held in the portfolio.

The two main risk characteristics of a bond fund, credit quality and maturity, are often graphically presented in a Morningstar style box, an example of which is included in Figure 1.

The fact that bond funds distribute income often means that taxable bonds are candidates for tax deferral in tax advantaged accounts (see Principles of tax-efficient fund placement). For taxable accounts, some bonds have tax preferences. Treasury securities are generally exempt from state income tax. Tax exempt bonds are generally exempt from federal taxation and, to the extent that the bond is issued by one's state of residence, may also be exempt from state and local taxation (although some interest may be subject to the alternative minimum tax). [21] These tax preferences often result in lower yields for treasury and municipal bonds in comparison to corporate and other non-preference bonds. One needs to compare the after tax yields of a given fund to determine whether the fund will yield the highest after tax income (see After-tax yields).

Costs are a critical factor in long term bond fund performance. A low cost bond fund can hold higher quality, less risky bonds and still provide higher long term returns than many higher cost funds holding lower quality bonds.

Stock funds

Stock mutual funds are extremely diverse. There are funds that invest in the American stock markets; funds that invest in international markets; funds that invest globally. Within each market, there are funds that invest in the entire market; funds that invest in specific segments of the market; and even funds that specialize in specific industry sectors of the market.

Stocks funds are often classified by the average size of the companies they hold as investments. This is most commonly done by looking at the market capitalization of a firm. Market capitalization is simply a measurement found by taking a stock's current share price and multiplying it by the number of stock shares outstanding.

Figure 2. Morningstar Equity Style Box. Style along x-axis; Market Capitalization along y-axis.

Exact market cap ranges will vary among different financial and rating institutions, but there are three different terms commonly used to describe stocks by their general size.

  • Large capitalization stocks:
    Large cap stocks have a market cap over $10 billion dollars.
  • Mid capitalization stocks:
    Mid cap stocks have a market cap between $2 billion and $10 billion dollars.
  • Small capitalization stocks:
    Small cap stocks have a market cap between $300 million and $2 billion dollars.

While these are the most common market cap references, there are also some less commonly used: mega cap (greater than $200 billion), micro cap ( between $50 million and $300 million), and nano cap (below $50 million). Market cap terms are relative and are constantly changing as companies get bigger and smaller.

Stock funds may also be classified by "style," either Growth, Value, or Blend. Growth stock funds invest in companies that are growing their profits at a very fast rate and are expected to continue to grow at an increasing rate. Value stock funds seek stocks that tend to trade at deep discount relative to their intrinsic value (as defined by profits, book value and other measures). Blend funds tend to hold a mixture of growth and value stocks.

The combination of size and style metrics allows a fund to be classified in a Morningstar Equity style box (see Figure 2.)

In addition to size and style classifications, some international stock funds are specialized by regions. The most common regional fund classifications are:

  • European
  • Pacific
  • Emerging markets

International Developed Market funds usually combine the European and Pacific regions.

Balanced funds

Balanced funds (sometimes also referred to as hybrid funds) invest in a portfolio that includes stocks and bonds, and sometimes cash and commodities. Usually these type funds have a fixed asset allocation mix, generally with moderate (60 percent stock/40 percent bond) or conservative (40 percent stock/60 percent bond) equity allocations. Balanced funds also include the following types of funds:

  • Asset allocation funds: These funds can be designed to hold a fixed asset allocation of asset classes, but are commonly funds which allow a fund manager to shift allocations according to a tactical asset allocation strategy.
  • Life cycle funds: These funds usually offer portfolios that hold a static asset allocation, usually labeled as growth, moderate, conservative, and income portfolios. These funds are often designed as fund of funds (see below).
  • Target retirement funds: These funds are designed primarily for retirement plans. They are usually designed as fund of funds (see below).

Balanced funds offer the advantage of a simplified investment program. The portfolios include multiple asset classes and are self-balancing. However, investors whose portfolios are divided between taxable accounts and tax deferred/tax free accounts often eschew balanced funds in favor of separate asset class funds, allocated across accounts using principles of tax-efficient fund placement.

Fund of funds

A fund of funds differs from most mutual funds in that the fund invests in mutual funds as opposed to investing in individual securities. Fund of funds are primarily designed for retirement plans and education savings plans. Fund of funds have two basic forms:

  1. Static portfolios: These portfolios hold a steady predetermined allocation mix of stock funds, bond funds, or a balanced mix of stock and bond funds. A variation on this type fund allows a manager to shift the stock/bond/cash allocation according to a tactical asset allocation strategy.
  2. Target date portfolios: These fund of funds hold a targeted asset allocation that over time grows more heavily weighted towards bonds as the target date (for retirement or college matriculation) approaches. These funds are commonly used in corporate retirement plans and in the 529 plan market.

Fund of funds may use funds from the same advisory firm, or the fund manager (usually with an added management fee) may select funds from different advisors.

Fund of funds have what is known as an acquired fund fee, a measure which includes the weighted expense ratio of the underlying funds as well as any additional expense ratio imposed by the investment manager.

Index funds

Indexing is an investment management strategy that attempts to replicate the investment performance of a market index. An index is a statistical measure of a market's value and performance and serves as a benchmark against which an investment manager's performance is judged. [22] . Today, a large number of index providers, including ,S&P, Dow Jones, MSCI, Russell, FTSE, CRSP and Morningstar, provide a wide range of indexes covering US and international stocks, bonds, and commodities. A well managed, low cost index fund offers investors an excellent, if not optimal, investment vehicle for investing in the overall stock market, in discrete market segments, in the bond markets, and in the commodity markets.

Advantages:

Figure 3: Investment growth of both a low-cost and high-cost fund [23]
  • Low costs: According to the Investment Company Institute, the average expense ratio for US stock mutual funds in 2008 was 1.46% (weighted average 0.84%}, while the average expense ratio for US bond mutual funds was 1.07% (weighted average 0.63%). [24] Index funds are available to investors for expense ratios of 0.20% and lower from firms such as Vanguard, Fidelity, Schwab , and many exchange-traded funds . These low expenses mean that a greater portion of market returns accrue to the mutual fund shareholder where they can continue to compound, as opposed to being siphoned off through intermediaries. As figure 3. demonstrates, indexing's cost advantage builds steadily over long holding periods. In addition to low expense ratios, index funds can provide low transaction costs, which include brokerage commission costs [25], bid/ask spreads, and market impact costs (institutional purchases and sales can drive the price of a security up or down before the order is filled.)
  • Tax efficiency: Due to lower fund turnover and longer holding periods, stock index funds tend to exhibit greater tax efficiency than actively managed stock funds. This is especially true for total market index funds, large cap index funds, and large growth index funds. These funds rarely realize and distribute a capital gain (and any small capital gains distributions are usually long term gains taxed at reduced tax rates.) The deferral of capital gains tax liabilities results in a tax-efficient index fund providing higher after tax returns to investors. [26] In addition, since the advent of the tax regime for qualified dividends in 2004, well-managed total market and large cap indexes have been successful in providing investors with 100% qualified dividends, which are taxed at lower tax rates
  • Asset class style consistency: Index funds are designed to provide the returns of the asset class they are tracking. This allows an investor to control the asset allocation decision.
  • Reduced manager risk: Actively managed funds expose investors to two manager risks.
  1. The risk that the manager will under perform the benchmark return,
  2. The risk that the manager will leave the fund. For taxable investors, selling a stock fund after a manager change could result in a large capital gains tax.

Index funds greatly mitigate these risks:

  1. The risk of under performing a benchmark return is greatly reduced.
  2. Index funds are managed by an investment team. The departure of a fund manager does not affect the management of the fund.
  • Simplicity: The low cost, high tax efficiency, and long term consistency of performance advantages of indexing greatly simplify the task of fund selection and fund monitoring in an investment plan.

See also

References

  1. 2013 Investment Company Fact Book, pp 9,12,70.
  2. John Bogle, Bogle on Mutual Funds, p.52
  3. John Bogle, Bogle on Mutual Funds, p.53
  4. John Bogle, Bogle on Mutual Funds, p.53
  5. John Bogle, Bogle on Mutual Funds, p.54
  6. The Relentless Rules of Humble Arithmetic John Bogle, Financial Analysts Journal; November/December 2005 CFA Institute's "Bold Thinking on Investment Management: The FAJ 60th Anniversary Anthology", 2005
  7. David Swenson on NPR, Yale's Money Guru Shares Wisdom with Masses October 5, 2006
  8. Investment Company Institute
  9. ICI 2013 Mutual Fund Factbook p.80
  10. John Bogle (2005), The Battle for the Soul of Capitalism, Yale University Press, p.154. IBSN 0-300-10990-3
  11. turnover
  12. John Bogle (2005), The Battle for the Soul of Capitalism, Yale University Press, p.184. IBSN 0-300-10990-3
  13. The Arithmetic of Mutual Fund Investing is More Important Than Ever John Bogle, American Association of Individual Investors Philadelphia Chapter, May 24, 2005, Valley Forge, PA
  14. Luo, Jiang and Qiao, Zheng, [http://ssrn.com/abstract=2251726 On the Mergers and Acquisitions of Mutual Fund Families: The Determinants and Subsequent Impact on Fund Performance (April 9, 2013). Available at SSRN.
  15. Mutual Funds: How a Profession with Elements of a Business Became a Business with Elements of a Profession John Bogle, At Boston Security Analysts Society Boston, Massachusetts,February 24, 2006
  16. SEC Invest Wisely: An Introduction to Mutual Funds
  17. Variable annuity subaccounts, while not technically organized as a mutual fund, are diversified investment funds used by insurance companies. Some employer provided plans use variable annuity subaccounts as funding vehicles. Subaccounts are also available in variable annuities. In addition to fund management charges, a subaccount will usually have additional insurance related charges.
  18. ICI 2011 Mutual Fund Fact Book, pp. 76-77. Retrieved 26 April 2006
  19. Rule 2a-7
  20. alternative minimum tax
  21. alternative minimum tax, investopedia
  22. Richard A. Ferri, All About Index Funds, pp. 10-11.ISBN 0-07-148492-2
  23. Both funds assume an initial $10,000 investment and an identical 8% annual growth. The time period is 30 years. The low-cost fund is no-load and has expenses of 0.2% per year. The high-cost fund has an initial 5.75% sales load, expenses of 2.0% per year, and a 0.25% 12b-1 fee.
  24. ICI 2009 Mutual Fund Factbook p.65
  25. See Vanguard Passive Fund Brokerage Commissions for data
  26. Robert H. Jeffrey and Robert D. Arnott, Is Your Alpha Big Enough To Cover Its Taxes?, 1993 • First Quadrant Corporation • No. 2

External links

Mutual fund rating services

Mutual fund information sources

Investment Company Institute fact books