Mutual funds are registered investment companies that pool investors' capital to invest in securities. Professional money managers manage mutual funds, and the corporate contributory retirement system in the U.S. uses them extensively. As of 2017, a total of 9,356 U.S. mutual funds held over 18 trillion dollars of assets, owned by forty-five percent of American households and an estimated 101.9 million individuals.
Mutual funds offer you diversification, professional management, liquidity, and convenience. These advantages are offset by factors such as costs, fund turnover, and the consequences of organizational structure. You can buy mutual funds through brokers with commissions, or through firms that sell directly to investors without commissions. Funds may be actively managed, or they may use passive indexing. Funds give you access to money markets, domestic and international bonds, and domestic and international stocks.
Mutual fund advantages
Mutual funds have a number of compelling advantages.
- Diversification. The first principle of mutual fund investing is broad diversification of securities. Diversification greatly reduces and can even eliminate the risks of owning just a few individual stocks and bonds. Before 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 their portfolio.
- Professional management. Managing and holding an investment portfolio means selecting and supervising the fund's holdings. Managers must do this based on the fund's objectives and policies. Index fund managers aim to mimic their benchmark index, and make no attempt to select "winning" securities. By contrast, active fund managers try to add value by selecting securities they think will perform above the average, within the fund's objectives.
- Liquidity. Many securities (hedge funds, limited partnerships, real estate, CDs, etc.) cannot be sold quickly and without penalty. However, you can acquire or sell most mutual fund shares at a moment's notice, at the fund's next determined net asset value per share. Also, you can easily convert mutual funds into cash at a fraction of the cost (a few funds have redemption fees) that you would pay to sell individual stocks or bonds. This is also true when exchanging mutual funds.
- Convenience. Mutual fund prices and performance are readily available in newspapers, magazines, internet and research organizations such as Morningstar. You can purchase them 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
|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 (October 5, 2006). "Yale's Money Guru Shares Wisdom with Masses". NPR.|
According to critics, high costs, and conflicts of interest between the managers of the funds and the investor, often negate the advantages of mutual funds.
- Costs. Experts such as John Bogle and David Swenson criticise the costs of mutual fund investing. According to the Investment Company Institute, the average expense ratio for US stock mutual funds in 2014 was 1.33% (weighted average 0.70%), while the average expense ratio for US bond mutual funds was 0.98% (weighted average 0.57%). According to John Bogle, while mutual fund assets rose 1,600-fold from 1950-2004, mutual fund expenses rose 2,400 fold. These costs directly reduce investor returns. The expense ratio does not include sales loads or fund transaction costs.
- Turnover. John Bogle points out that from 1945 to 1965, stock mutual funds maintained an average turnover 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). Increased turnover to these levels creates greater frictional transaction costs for a fund, and also increases the likelihood of realized taxable gains.
- Organizational structure. According to critics, the basic structure of the mutual fund, where an external management company owns the mutual fund is 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 thirty mutual fund management companies had a corporate structure breakdown that consisted of nineteen large conglomerates; seven publicly owned firms; and four 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."
|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
Funds may be actively managed, where the investment manager tries to outperform a benchmark index, or indexed, where the investment manager aims to match a benchmark index return. Mutual funds may or may not have a sales commission.
Mutual funds sold by full service brokerages, banks, and commissioned advisors usually impose a sales charge on investors known as a "sales load". You might pay the sales load upfront upon purchase, or deferred until you sell fund shares; this deferred charge is often called a "contingent deferred sales charge (CDSC)". These sales charges are on top of the fund's expense ratio, and any other transaction charges the fund may impose. Different share classes usually indicate sales charges, as follows:
- A-shares. A-shares have a front end charge on initial investment. A fund issuing A-shares might have a 5% load upon purchase, so that if you commit $10,000 to the fund, you would actually invest $9,500 in the fund, with $500 going to the sales agent as a commissioned load. A-shares may also have an additional 0.25% annual charge (known as a 12b-1 fee).
- 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 fund's prospectus will show the exact rate at which these fees will decline. Ordinarily, B-shares convert to A-shares (and reduced 12b-1 charges) once the CDSC reaches zero.
- 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; holders pay the added 1% 12b-1 fee for as long as they hold the fund.
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, on top of the expense ratio that all funds have:
- Transaction fees. Mutual funds incur costs buying and selling securities for the fund; for more, see: Mutual funds: additional costs. Some funds cover the costs associated with an individual investor’s transactions by charging purchase fees and redemption fees directly to the investor at the time of the transactions to cover these costs. Unlike sales charges, these fees are usually paid back into the fund. Funds may also charge a redemption fee to deter short term market timing selling of the 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.[note 1]
Mutual fund categories
Money market funds
|Money funds are regulated under Rule 2a-7 of the Investment Company Act of 1940. Key provisions of the regulations require the following:
Under the 2014 SEC final rules, money funds are divided into three classes: institutional, retail, and government. Institutional money funds must have a floating NAV based on market values. The rules also provide for liquidity (redemption) fees and gates (suspended redemption) during periods of market distress. In summary:
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 therefore suitable investments for savings and other short term needs.
Although money market funds are low risk, they are not zero-risk. If 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 funds to differentiate by risk and tax characteristics. Money funds include:
- General (Prime) money funds. These funds invest in a large range 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 at both federal and state levels.
- Treasury money funds. Treasury money funds invest 100% in "full faith and credit" treasury bills and agency instruments. As a result, they are not subject to credit risk (because 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 so 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 you hold these in a taxable account, you need to compare the after tax yields of a given money fund to determine whether the fund will yield the highest after tax income. For more, see: After-tax yields.
Costs are an important factor in money market fund selection. Because the total return of a money market fund is the income payment, the lower the expense ratio of the fund, the higher your net return. A low cost money fund can hold the highest quality money market instruments and still provide competitive yields.
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 they may hold just a specific segment of the market. The following table outlines the segments of the bond market.
|Government bonds||Corporate bonds||Asset-backed securities||Foreign bonds||Tax-exempt bonds|
Bond funds distinguish 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, to compensate 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 you to match a bond fund to an expected holding period, and to maintain your portfolio's exposure to interest rate risk. You can usually find bond funds with 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. See Figure 1 for an example.
Because bond funds distribute income, taxable bonds are often candidates for placement in tax advantaged accounts (see 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 your 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. You need 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 mutual funds are extremely diverse. There are funds that invest in the American stock markets, funds that invest in international markets, and 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 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 common terms that 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 common ones: 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 change constantly 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 hold 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).
As well as size and style classifications, some international stock funds are specialized by regions. The most common regional fund classifications are:
- Emerging markets
International Developed Market funds usually combine the European and Pacific regions.
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. They 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 deliberately avoid balanced funds in favor of separate asset class funds, allocated across accounts using tax-efficient fund placement.
Fund of funds
A fund of funds differs from most mutual funds, in that the fund invests in mutual funds rather than individual securities. Fund of funds are primarily designed for retirement plans and education savings plans. Fund of funds have two basic forms:
- 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.
- Target date portfolios. These fund of funds hold a targeted asset allocation that grows more heavily weighted towards bonds as the target date (for retirement or entry into college) 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.
Indexing is an investment management strategy that aims 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. 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 is 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.
- Low costs. According to the Investment Company Institute, the average expense ratio for US stock mutual funds in 2014 was 1.33% (weighted average 0.70%), while the average expense ratio for US bond mutual funds was 0.98% (weighted average 0.57%). 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,[note 3] 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. Because of lower fund turnover and longer holding periods, stock index funds tend to be more tax efficient 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.) Deferring capital gains tax liabilities means higher after tax returns. In addition, since the introduction of the tax regime for qualified dividends in 2004, well-managed total market and large cap indexes have been able to provide investors with 100% qualified dividends, 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.
- The risk that the manager will under perform the benchmark return,
- 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 reduce these manager risks.
- The risk of under performing a benchmark return is lower (although not eliminated, due to sampling and tracking errors.)
- An investment team manages index funds. One fund manager leaving does not materially affect the management of the fund.
- Simplicity. The low cost, high tax efficiency, and long term consistency of performance advantages of indexing all help to simplify how you select and monitor funds for your investment plan.
- The following table and charts show the distribution of long term assets held in load funds, no-load funds, and variable annuity sub-accounts. Variable annuity sub-accounts, while not technically organized as a mutual fund, are diversified investment funds used by insurance companies. Some employer provided plans use variable annuity sub-accounts as funding vehicles. Sub-accounts are also available in variable annuities. In addition to fund management charges, a sub-account will usually have additional insurance related charges. Over the period measured there has been a steady increase in investor no-load fund holdings and a decrease in load fund holdings. (The numerical data is in billions of dollars.) Source: "Mutual Fund Fact Books". Investment Company Institute. Retrieved June 5, 2023..
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- 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.
- See Vanguard Passive Fund Brokerage Commissions[dead link] for data.
- Closed-end funds
- Exchange-traded funds
- Mutual fund history
- Mutual fund share split
- Mutual fund structure
- Unit investment trusts
- "Mutual Funds". Investor.gov (SEC). Retrieved June 5, 2023.
- "2018 ICI Mutual Fund Fact Book" (PDF). Investment Company Institute. Retrieved June 5, 2023.
- John Bogle (1993). Bogle on Mutual Funds: New Perspectives for the Intelligent Investor. McGraw-Hill. pp. 52–54. ISBN 1-55623-860-6.
- John Bogle (2005). "The Relentless Rules of Humble Arithmetic" (PDF). Financial Analysts Journal. Retrieved June 5, 2023.
- David Swenson (October 5, 2006). "Yale's Money Guru Shares Wisdom with Masses". NPR.
- "ICI 2015 Mutual Fund Fact Book (chapter five)" (PDF). Investment Company Institute. Retrieved June 5, 2023.
- John Bogle (2005). The Battle for the Soul of Capitalism. Yale University Press. pp. 154, 184. ISBN 0-300-10990-3.
- John Bogle (May 24, 2005). "The Arithmetic of Mutual Fund Investing is More Important Than Ever" (PDF). American Association of Individual Investor, Philadelphia Chapter. Retrieved June 5, 2023.
- Luo, Jiang; Qiao, Zheng (April 9, 2013). "On the Mergers and Acquisitions of Mutual Fund Families: The Determinants and Subsequent Impact on Fund Performance". Retrieved June 5, 2023. Available at SSRN.
- John Bogle (February 24, 2006). "Mutual Funds: How a Profession with Elements of a Business Became a Business with Elements of a Profession" (PDF). Boston Security Analysts Society Boston, Massachusetts. Retrieved June 5, 2023.
- "Mutual Funds and Exchange-Traded Funds (ETFs) – A Guide for Investors". SEC. Retrieved June 5, 2023.
- Rick Ferri. All About Index Funds: The Easy Way to Get Started. pp. 10–11. ISBN 978-0-07-148492-3.
- Robert H. Jeffrey; Robert D. Arnott (1993). "Is Your Alpha Big Enough To Cover Its Taxes?" (PDF). First Quadrant Corporation. Archived from the original (PDF) on November 2, 2022. Retrieved June 3, 2023.
- Mutual Funds and Exchange-Traded Funds (ETFs) – A Guide for Investors, from SEC
- Overview Of The Mutual Fund Industry Guide to Mutual Funds, from Investopedia
- Bogleheads forum topic: , tutorial on the various share classes
Mutual fund rating services
Mutual fund information sources
Investment Company Institute fact books
PDF documents, by year: