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Mutual funds
Mutual funds
Authors: TradingDay.com, Jerryseinfeld, AudeVivere, Paul.Paquette, Simon123, MegaHasher
Publisher: TradingDay.com, Version: 1
A mutual fund is a form of collective investment that pools money from many investors and invests the money in stocks, bonds, short-term money market instruments, and/or other securitiesNote. In a mutual fund, the fund manager trades the fund's underlying securities, realizing capital gains or loss, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value (NAV), is calculated daily based on the total value of the fund divided by the number of shares purchased by investors.
Legally known as an "open-end company", a mutual fund is one of three basic types of investment companies available in the United States. The two other basic types are closed-end funds and Unit Investment Trusts (UITs) Note.
Outside of the U.S. (with the exception of Canada which follows the US model), mutual fund is a generic term for various types of collective investment. In the UK and western Europe (including offshore jurisdictions) other forms of collective investment are prevalent including unit trusts, Open-Ended Investment Companies (OEICs), SICAVs and unitized insurance funds.
History
The first open-end mutual fund, Massachusetts Investors Trust was founded on March 21, 1924, and after one year had 200 shareholders and $392,000 in assets. The entire industry, which included a few closed-end funds, represented less than $10 million in 1924.
The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require that a fund be registered with the SEC and provide prospective investors with a prospectus. The SEC helped create the Investment Company Act of 1940 which provides the guidelines that all funds must comply with today.
In 1951, the number of funds surpassed 100 and the number of shareholders exceeded 1 million. Only in 1954 did the stock market finally rise above its 1929 peak and by the end of the fifties there were 155 mutual funds with $15.8 billion in assets. In 1967 funds hit their best year, one quarter earning at least 50% with an average return of 67%, but it was done by cheating using borrowed money, risky options, and pumping up returns with privately traded "letter stock". By the end of the 60's there were 269 funds with a total of $48.3 billion.
With renewed confidence in the stock market, mutual funds began to blossom. By the end of the 1960s there were around 270 funds with $48 billion in assets. The first retail index fund was released in 1976, called the First Index Investment Trust. It is now called the Vanguard 500 Index fund and is one of the largest mutual funds ever with in excess of $100 billion in assets.
One of the largest contributors of mutual fund growth was Individual Retirement Account (IRA) provisions made in 1975, allowing individuals (including those already in corporate pension plans) to contribute $2,000 a year. Mutual funds are now popular in employer-sponsored defined contribution retirement plans (401k), IRAs and Roth IRAs.
As of April 2006, there are 8,606 mutual funds that belong to the Investment Company Institute (ICI), the national association of Investment Companies in the United States, with combined assets of $9.207 trillion USD.
Net asset value
The net asset value, or NAV, is a fund's value of its holdings, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but some funds update their NAV multiple times during the trading day. Open-end funds sell and redeem their shares at the NAV, and so only process orders after the NAV is determined. Closed-end funds may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus.
Turnover
Turnover is a measure of the amount of securities that are bought and sold, usually in a year, and usually expressed as a percentage of net asset value. It shows how actively managed the fund is.
A caveat is that this value is sometimes calculated as the value of all transactions (buying, selling) divided by 2; i.e., the fund counts one security sold and another one bought as one "transaction". This makes the turnover look half as high as would be according to the standard measure.
Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The very process of buying and selling securities also has its own costs, such as brokerage commissions, which are borne by the fund's shareholders.
High turnover can have a negative effect on the return of investors. (see also mutual fund performance)
Mutual funds vs. other investments
Mutual funds offer several advantages over stock investments, including diversification and professional management.
- A mutual fund may hold investments in hundreds or thousands of stocks, thus reducing risk of any particular stock.
- Also, the transaction costs associated with buying individual stocks are also spread around among all the mutual fund shareholders.
- As well, a mutual fund benefits from professional fund managers who can apply their expertise and dedicate time to research investment options.
Mutual funds, however, are not immune to risks. Mutual funds share the same risks associated with the types of investments the fund makes. If the fund mainly invests in stocks, the mutual fund is usually subject to the same ups and downs and risks as the stock market.
Criticism of managed mutual funds
Performance
The primary criticism of actively managed mutual funds comes from the historical fact that, over long periods of time, most have not returned as much as an index fund would.
Fees
There are also other criticisms levied against mutual funds as a consequence of the first criticism. One critique covers the concept of the sales commission, an upfront or deferred fee as high as 8.5 percent of the amount invested in a fund. Critics point out high sales commissions represent a conflict of interest, as high commissions benefits the sales people, but hurt the investors. High commissions can also cause sales people to recommend funds that maximize their income.
Conflict of interest
Mutual funds are also seen by some to have a conflict of interest with regards to their size. Fund companies charge a management fee of anywhere between 0.5-2.5 percent of the funds total assets. Theoretically this could motivate the fund managers, since a well performing fund would cause the amount invested in the fund to rise and increasing the fee earned. It also could motivate the fund company to focus on advertising to attract more and more new investors, as new investors would also cause the fund assets to increase.
Active management
Many analysts believe however that the larger the pool of money one works with, the harder it is to manage actively, and harder to have good performance. Thus a fund company can be focused on attracting new customers, hurting its existing investors' performance. A great deal of the funds costs are flat and fixed costs, such as the salary for the manager. Thus it can be more profitable to the fund to try and allow it to grow as large as possible, instead of limiting its assets.
Market timing
Other practices of mutual funds have been criticized from time to time, such as funds allowing market timing. More recent criticisms have focused on the fund managers accepting extravagant gifts in exchange for trading stocks through certain investment banks, who presumably overcharge the fund compared to what another, non-gifting investment bank would charge.
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This article uses
material from the Wikipedia article "Mutual Fund" (Version
01:13, 21 September 2006 ) . It is licensed under
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