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© 2014
© 2014
Chapter Ten
Mutual funds
A mutual fund is commonly defined as “a company that brings together money from many people and invests it in stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings” (SEC, 2009). Mutual funds are professionally managed by fund managers that trade the pooled money on a regular basis to meet the funds’ objectives. The net gains and losses are then distributed to the investors annually. Investors may sell their shares typically at the Net Asset Value (NAV) that are computed daily after the market close, although some mutual funds may update their NAV many times during the trading day. The public offering price (POP), or asking price, is the NAV plus a sales charge.
For investors who don't or don't want to know anything about the stock market, this is definitely the way to go. Although money management doesn't come cheap and investing into mutual funds has a price to pay but at least the investor will have peace of mind by letting professionals to worry about the ups and downs of the stock market.
Mutual funds are structured in such a way that the small investor can invest incremental amounts of money, sometimes as low as a $100 per month and may see its egg-nest growing as time goes by. Also, there is a host of mutual funds to choose, some are very aggressive such as equity funds that invest into small companies and could possibly have very high returns. The opposite is also true because high rewards involve high risks and the investor can see his wealth diminishing dramatically when the market turns sour. On the other hand, a "risk apprehensive" investor may choose to put his money into bonds or fixed-income funds which invest solely into graded bonds in order to preserve capitals. In middle, there are balanced funds that invest into bonds and stocks.
History
Mutual funds emerged as early as the 18th century in the Netherlands with the creation of a trust named “Eendragt Maakt Magt” by Abraham van Ketwich in 1774. Van Ketwich’s aim was to provide small investors an opportunity to diversify and spread risks by investing in Austria, Germany, Denmark, Spain, Sweden, Russia and a host of colonial plantations in Central and South America.
The first mutual fund in the United States was probably the Massachusetts Investors Trust, now the MFS Investment Management, founded on March 21, 1924. The next year, the fund had 200 shareholders and $292,000 in assets. The entire industry at that time, which comprised a few closed-end funds, represented less than $10 million in total assets. Following the stock market crash in 1929, Congress passed a series of Acts, such as the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940 to regulate the stock market activities.
Those regulations helped tremendously investors to regain confidence in the stock market and fostered the growth of mutual funds. Cautious investors were looking for less risky investments and found them in mutual funds. By the end of the 1960s, the number of mutual funds jumped to 270 with a total asset of $48 billion. The first index fund, called First Index Investment Trust, was founded in 1976 by John Bogle. The fund is now called the Vanguard 500 Index Fund and is most likely the world’s largest mutual funds with a total asset of more than $100 billion.
As of 2007, more than 8 thousands mutual funds have been registered in the USA with a combined assets value of more than $12 trillion. In early 2008, the value of all mutual funds worldwide totals more than $26 trillion.
Types of mutual funds
Mutual funds can be categorized in many ways, depending on structure or objectives.
Open-end funds. Most actual mutual funds in the USA are open-ended, meaning that they are open to the public and investors may buy or sell shares at any time. After the close of a trading day, the fund issues new shares to investors and redeems shares for investors who wish to leave the fund.
Unit Investment Trusts (UTIs). UTI is structured as a trust with a definite time life with a fixed portfolio that will not be sold or new ones bought until the end of its terminating date, on which the assets will be liquidated and the NAV distributed to shareholders.
Closed-end funds. As opposed to open-end funds, closed-end funds shares are rarely issued or redeemed once the fund is launched. Investors may still acquire closed-end funds through secondary market, meaning from a broker or market maker, but not from the fund’s management itself. Hedge funds are considered a type of closed-end fund, not open to the public.
Equity or Stock funds. These funds seek long term growth by investing in stocks of companies. Equity funds are called aggressive growth funds when they are invested in small and mid-sized companies. Stocks of these companies may have greater potential than the market in general but bear also a greater risk. The funds are called conservative growth funds if they are invested in stocks of large caps, which are typically less volatile but do not offer as much growth potential.
Bonds of Fixed Income funds. These funds seek capital preservation and a steady stream of income by investing in bonds or other income securities. They are typically less risky than equity funds but the return is limited to the current interest rate.
Balanced, combined or hybrid funds. These funds seek a more balanced return and risk by investing in both equity and income funds.
Money market or cash equivalent funds. They are mutual funds that invest in money market securities such as Treasury Bills, Certificates of Deposit, and Commercial Papers. Money market funds are considered cash equivalent, relatively very safe and having a high level of liquidity. However, the rate of return is very low and suitable only for companies and financial institutions to “park” their idle cash.
Load and expenses
Front-end load, or sales charges is a broker’s commission paid upfront when mutual fund’s shares are purchased, usually taken as a percentage of funds invested. According to actual regulations, this charge cannot exceed 8.5% of the initial investment (SEC, 2009).
Back-end load is a type of sales charges but taken only when the shares are redeemed. The investor pays no charge when purchasing the mutual fund’s shares and commission’s fees will be charged out of the proceeds when the investor cashes out his shares.
Level-load is another derivative structure similar to back-end load, in which the investor pays no charge when buying the fund, but a back-end load may be charged if the investor sells his shares within a year.
No-load fund. As the name implies, this type of fund does not charge sales load fee. Index funds with low maintenance are among those funds. However a no-load fund may charge fees that are not sales charges, such as redemption fees, exchange fees, or account fees.
Some remarks about mutual funds
Mutual funds have become very popular over the last decades and according to some studies, about one half of the US households are investing into mutual fund through individual and retirement accounts with a staggering number of trillions of dollars. Investing in mutual funds offers many advantages for the small investor, such as:
- Professional management. In theory, the small investor does not have the time and resources to study and manage his investments, therefore, a mutual fund is a relatively inexpensive way to “hire” a professional manager to make financial decisions and to monitor investments.
- Diversification. The small investor’s risk can be spread out over a basket of positions instead of owning individual stocks or bonds. Typically, a large mutual fund may have hundreds of different stocks in divers industries, a feature that a small investor cannot have with a small amount of money.
- Economies of scales. Transactions’ costs can be kept at a lowest level because a mutual fund buys and sells large amount of securities at a time.
- Liquidity. Investing in mutual funds allows the investor to redeem his shares and convert them into cash at any time.
- Simplicity. Buying shares of mutual funds is practically simple. Any bank or financial institution has its own line of mutual funds and the minimum investment is relatively affordable for everyone. Many mutual funds have their own automatic purchase program and the small investor can buy directly from them with a monthly commitment as low as $100.
However, investing in mutual funds has its own disadvantages, markedly:
- Professional management. This could be a controversy over the professional management of mutual funds. According to many surveys, more than 80% mutual funds lag behind the market, illustrated by the S&P 500 index. The reasons can be attributed to management costs and fund managers still taking their cuts even if the fund is losing money.
- Costs. The simple truth is that the mutual fund industry exists because of profits generated by managing other people money (OPM). Like it or not, costs eat up return of investments and they are the main reason why the majority of mutual fund end up with sub-par performance compared with the overall market. What's rather disturbing is that the mutual fund industry is hiding costs through layers of complexity and jargon. Even a so-called no-load fund can have other substantial management costs. Those costs can be revealed by the expense ratio which is typically from 0.5 to 2 % annually. In other words, from the investor’s perspective, mutual funds have already an initial disadvantage at the start.
- Dilution. Mutual funds offer the advantage of diversification but also the disadvantage of dilution because too much diversification limits performance. Especially when the mutual fund is becoming successful, more investors pour in money and the fund manager often has difficulties to find a good investment for all the new money.
- Taxes. Every year, fund managers turn over their positions and trigger capital gains tax liabilities for shareholders, even though the investor does not redeem his shares yet. Dividends paid out to investors also have tax liabilities.
A good alternative to mutual funds is to invest into Exchange Traded Funds or ETFs. This concept will be explained further in the next chapter.
Mutual funds
A mutual fund is commonly defined as “a company that brings together money from many people and invests it in stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings” (SEC, 2009). Mutual funds are professionally managed by fund managers that trade the pooled money on a regular basis to meet the funds’ objectives. The net gains and losses are then distributed to the investors annually. Investors may sell their shares typically at the Net Asset Value (NAV) that are computed daily after the market close, although some mutual funds may update their NAV many times during the trading day. The public offering price (POP), or asking price, is the NAV plus a sales charge.
For investors who don't or don't want to know anything about the stock market, this is definitely the way to go. Although money management doesn't come cheap and investing into mutual funds has a price to pay but at least the investor will have peace of mind by letting professionals to worry about the ups and downs of the stock market.
Mutual funds are structured in such a way that the small investor can invest incremental amounts of money, sometimes as low as a $100 per month and may see its egg-nest growing as time goes by. Also, there is a host of mutual funds to choose, some are very aggressive such as equity funds that invest into small companies and could possibly have very high returns. The opposite is also true because high rewards involve high risks and the investor can see his wealth diminishing dramatically when the market turns sour. On the other hand, a "risk apprehensive" investor may choose to put his money into bonds or fixed-income funds which invest solely into graded bonds in order to preserve capitals. In middle, there are balanced funds that invest into bonds and stocks.
History
Mutual funds emerged as early as the 18th century in the Netherlands with the creation of a trust named “Eendragt Maakt Magt” by Abraham van Ketwich in 1774. Van Ketwich’s aim was to provide small investors an opportunity to diversify and spread risks by investing in Austria, Germany, Denmark, Spain, Sweden, Russia and a host of colonial plantations in Central and South America.
The first mutual fund in the United States was probably the Massachusetts Investors Trust, now the MFS Investment Management, founded on March 21, 1924. The next year, the fund had 200 shareholders and $292,000 in assets. The entire industry at that time, which comprised a few closed-end funds, represented less than $10 million in total assets. Following the stock market crash in 1929, Congress passed a series of Acts, such as the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940 to regulate the stock market activities.
Those regulations helped tremendously investors to regain confidence in the stock market and fostered the growth of mutual funds. Cautious investors were looking for less risky investments and found them in mutual funds. By the end of the 1960s, the number of mutual funds jumped to 270 with a total asset of $48 billion. The first index fund, called First Index Investment Trust, was founded in 1976 by John Bogle. The fund is now called the Vanguard 500 Index Fund and is most likely the world’s largest mutual funds with a total asset of more than $100 billion.
As of 2007, more than 8 thousands mutual funds have been registered in the USA with a combined assets value of more than $12 trillion. In early 2008, the value of all mutual funds worldwide totals more than $26 trillion.
Types of mutual funds
Mutual funds can be categorized in many ways, depending on structure or objectives.
Open-end funds. Most actual mutual funds in the USA are open-ended, meaning that they are open to the public and investors may buy or sell shares at any time. After the close of a trading day, the fund issues new shares to investors and redeems shares for investors who wish to leave the fund.
Unit Investment Trusts (UTIs). UTI is structured as a trust with a definite time life with a fixed portfolio that will not be sold or new ones bought until the end of its terminating date, on which the assets will be liquidated and the NAV distributed to shareholders.
Closed-end funds. As opposed to open-end funds, closed-end funds shares are rarely issued or redeemed once the fund is launched. Investors may still acquire closed-end funds through secondary market, meaning from a broker or market maker, but not from the fund’s management itself. Hedge funds are considered a type of closed-end fund, not open to the public.
Equity or Stock funds. These funds seek long term growth by investing in stocks of companies. Equity funds are called aggressive growth funds when they are invested in small and mid-sized companies. Stocks of these companies may have greater potential than the market in general but bear also a greater risk. The funds are called conservative growth funds if they are invested in stocks of large caps, which are typically less volatile but do not offer as much growth potential.
Bonds of Fixed Income funds. These funds seek capital preservation and a steady stream of income by investing in bonds or other income securities. They are typically less risky than equity funds but the return is limited to the current interest rate.
Balanced, combined or hybrid funds. These funds seek a more balanced return and risk by investing in both equity and income funds.
Money market or cash equivalent funds. They are mutual funds that invest in money market securities such as Treasury Bills, Certificates of Deposit, and Commercial Papers. Money market funds are considered cash equivalent, relatively very safe and having a high level of liquidity. However, the rate of return is very low and suitable only for companies and financial institutions to “park” their idle cash.
Load and expenses
Front-end load, or sales charges is a broker’s commission paid upfront when mutual fund’s shares are purchased, usually taken as a percentage of funds invested. According to actual regulations, this charge cannot exceed 8.5% of the initial investment (SEC, 2009).
Back-end load is a type of sales charges but taken only when the shares are redeemed. The investor pays no charge when purchasing the mutual fund’s shares and commission’s fees will be charged out of the proceeds when the investor cashes out his shares.
Level-load is another derivative structure similar to back-end load, in which the investor pays no charge when buying the fund, but a back-end load may be charged if the investor sells his shares within a year.
No-load fund. As the name implies, this type of fund does not charge sales load fee. Index funds with low maintenance are among those funds. However a no-load fund may charge fees that are not sales charges, such as redemption fees, exchange fees, or account fees.
Some remarks about mutual funds
Mutual funds have become very popular over the last decades and according to some studies, about one half of the US households are investing into mutual fund through individual and retirement accounts with a staggering number of trillions of dollars. Investing in mutual funds offers many advantages for the small investor, such as:
- Professional management. In theory, the small investor does not have the time and resources to study and manage his investments, therefore, a mutual fund is a relatively inexpensive way to “hire” a professional manager to make financial decisions and to monitor investments.
- Diversification. The small investor’s risk can be spread out over a basket of positions instead of owning individual stocks or bonds. Typically, a large mutual fund may have hundreds of different stocks in divers industries, a feature that a small investor cannot have with a small amount of money.
- Economies of scales. Transactions’ costs can be kept at a lowest level because a mutual fund buys and sells large amount of securities at a time.
- Liquidity. Investing in mutual funds allows the investor to redeem his shares and convert them into cash at any time.
- Simplicity. Buying shares of mutual funds is practically simple. Any bank or financial institution has its own line of mutual funds and the minimum investment is relatively affordable for everyone. Many mutual funds have their own automatic purchase program and the small investor can buy directly from them with a monthly commitment as low as $100.
However, investing in mutual funds has its own disadvantages, markedly:
- Professional management. This could be a controversy over the professional management of mutual funds. According to many surveys, more than 80% mutual funds lag behind the market, illustrated by the S&P 500 index. The reasons can be attributed to management costs and fund managers still taking their cuts even if the fund is losing money.
- Costs. The simple truth is that the mutual fund industry exists because of profits generated by managing other people money (OPM). Like it or not, costs eat up return of investments and they are the main reason why the majority of mutual fund end up with sub-par performance compared with the overall market. What's rather disturbing is that the mutual fund industry is hiding costs through layers of complexity and jargon. Even a so-called no-load fund can have other substantial management costs. Those costs can be revealed by the expense ratio which is typically from 0.5 to 2 % annually. In other words, from the investor’s perspective, mutual funds have already an initial disadvantage at the start.
- Dilution. Mutual funds offer the advantage of diversification but also the disadvantage of dilution because too much diversification limits performance. Especially when the mutual fund is becoming successful, more investors pour in money and the fund manager often has difficulties to find a good investment for all the new money.
- Taxes. Every year, fund managers turn over their positions and trigger capital gains tax liabilities for shareholders, even though the investor does not redeem his shares yet. Dividends paid out to investors also have tax liabilities.
A good alternative to mutual funds is to invest into Exchange Traded Funds or ETFs. This concept will be explained further in the next chapter.
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