Mutual fund

The Investment Company Act Of 1940 sets the legal framework for four types of registered investment companies in the US: The open-end investment company is by far the most prevalent (in terms of dollars managed) of US regulated companies.
 * Open-end investment companies (mutual funds);
 * Closed-end investment companies ( Closed end funds);
 * Exchange-traded funds (ETFs);
 * Unit investment trusts (UITs).

History
Main article: Mutual Fund History

The history of the mutual fund can be traced to the thriving late 18th century markets in Amsterdam. In July of 1774, an Amsterdam broker by the name of Abraham van Ketwich offered on the market a diversified pooled security specifically designed for citizens of modest means. The security was known as a negotiatie, an instrument very similar to the present day closed-end fund. This first negotiatie, Eendragt Maakt Magt, invested in bonds issued by foreign governments and banks and in plantation loans in the West Indies. The issue was successful and van Ketwich introduced his second negotiatie, Concordia Res Parvae Crescunt in 1779, with more freedom in investment policy. The prospectus stated that the negotiatie would invest in "solid securities and those that based on decline in their price would merit speculation and could be purchased below their intrinsic values..." Concordia Res Parvae Crescunt existed for 114 years; in 1893 it was officially dissolved. During the 1780s and 1790s more that thirty negotiaties emerged to speculate on the future credit of the United States.

When the pooled investment structure crossed over to the English markets in the nineteenth century it evolved into the investment trust, essentially a closed-end fund. The first investment trust, Foreign and Colonial Government Trust, was founded in 1868 in London. The trust invested in foreign government bonds. The most famous of these investment trusts was Robert Fleming's First Scottish American Investment Trust invested in U.S. railroad bonds.

By the 1890s the investment trust had migrated to the American markets. The Boston Personal Property Trust, formed in 1893, was the first closed-end fund in the U.S. The 1920's saw the creation of the first open-end mutual fund, Massachusetts Investors' Trust in Boston, Massachusetts, in 1924. The fund went public in 1928, a year which also saw Scudder, Stevens and Clark launch the first no-load fund and the creation of the Wellington Fund, the first mutual fund to include a balanced fund of stocks and bonds. By 1929 there were 19 open-ended mutual funds competing with nearly 700 closed-end funds. The stock market crash of 1929 wiped out many highly-leveraged closed-end funds; the small open-end funds managed to survive. The ensuing round of 1930's financial legislation laid the groundwork for the contemporary mutual fund industry. The era saw the creation of the Securities and Exchange Commission (SEC), the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. The Investment Company Act of 1940 followed.

Municipal bond funds

Basic Structure


Investment Company Institute's (ICI) 2009 ICI Fact Book

Open-end investment companies (mutual funds)
The open-end investment company (mutual fund) is distinguished by a number of characteristics, here given by the SEC:


 * 1) Investors purchase mutual fund shares from the fund itself (or through a broker for the fund), but are not able to purchase the shares from other investors on a secondary market, such as the New York Stock Exchange or Nasdaq Stock Market. The price investors pay for mutual fund shares is the fund’s approximate per share net asset value (NAV) plus any shareholder fees that the fund imposes at purchase (such as sales loads).
 * 2) Mutual fund shares are "redeemable." This means that when mutual fund investors want to sell their fund shares, they sell them back to the fund (or to a broker acting for the fund) at their approximate per share NAV, minus any fees the fund imposes at that time (such as deferred sales loads or redemption fees).
 * 3) Mutual funds generally sell their shares on a continuous basis, although some funds will stop selling when, for example, they become too large.
 * 4) The investment portfolios of mutual funds typically are managed by separate entities known as "investment advisers" that are registered with the SEC.

Distribution: Load Funds
Main article: Mutual Funds and Fees

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.

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.

Mutual Fund 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) 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) 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) 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.

Mutual Fund Criticism
Main article: Mutual Funds and Fees


 * 1) Cost: Bogle, Swenson
 * 2) Organizational Structure: Bogle

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. Mutual funds are available as open end mutual funds, closed end funds, and exchange traded funds. 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.

Money Market Funds
Main article: Money Markets

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 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 Banker's 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). 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
Main article: Bond Basics

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 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.

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 bonds 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). 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
Main article: Stock Basics

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.

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.)

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 or conservative equity allocations. Balanced funds also include the following types of funds:


 * Asset Allocation Funds
 * Life Cycle Funds
 * Target Retirement Funds

Fund of Funds
Main article 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 retirements 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
Main article Indexing

Advantages:


 * 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%). 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, 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, index funds tend to exhibit greater tax efficiency than actively managed 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.  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 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.

Closed End Funds
Main article Closed End Funds

Exchange Traded Funds
Main article Exchange Traded Funds

Links

 * SECInvest Wisely: An Introduction to Mutual Funds
 * Overview Of The Mutual Fund Industry Richard Loth, Investopedia
 * Investment Company Institute's (ICI) 2009 ICI Fact Book

Mutual Fund Rating Services

 * Lipper
 * Morningstar