Mutual fund

The Investment Company Act Of 1940 sets the legal framework for four types of registered investment companies in the US: open-end investment companies (mutual funds), closed-end investment companies ( closed end funds), exchange-traded funds (ETFs), and unit investment trusts (UITs). The open-end investment company is by far the most prevalent (in terms of dollars managed) of US regulated companies.

History
See Mutual Fund History

Basic Structure


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

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
See 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.

Money Market Funds
See 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
See 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
See 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.)

Fund of Funds
See 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 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
see 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
See Closed End Funds

Exchange Traded Funds
See 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