Lesson 3: Understanding the Mutual Fund

I.        Introduction
A mutual fund is a company that is in the business of making investments (an investment company).  Purchasing shares of a mutual fund is comparable to buying stock in a corporation.  When you invest in a mutual fund you are buying shares of the investment company just like buying stock in a corporation.  Mutual funds use the money invested in them by shareholders to purchase securities (stocks, bonds, money-market instruments, etc.) to meet the investment objectives established in the fund’s prospectus (a document published by the fund and updated on a routine basis disclosing detailed information about the fund).  The value of the mutual fund is determined by the value of the underlying securities it holds in its investment portfolio.  The share price of a mutual fund is called the Net Asset Value or NAV.  The NAV of a fund is normally calculated at the end of each business day by adding the day’s closing value of all of it securities and cash together, subtracting any liabilities and then dividing that resulting value by the number of shares outstanding that day. 

Before investing in any mutual fund it is important to read the fund’s prospectus as it contains information about the fund’s investment objectives, risks, management, historical performance, fees, etc.  You should always fully understand what you are investing in before you buy and a mutual fund prospectus is the source for the fundamental information you need to know about the fund before you invest in it.  Mutual funds also produce quarterly reports to shareholders that provide details about current performance and current assets held by the funds.  The fund, brokers, brokerages and other investment publications and rating agencies will also provide this information (generally for free) to non-shareholders.

One of the main advantages of investing in mutual funds over buying individual securities is leveraged diversification.  Mutual funds normally invest in many different securities (often over 100 different securities in a single fund).  Buying shares of the fund provides you with exposure to (although not direct ownership in) all of the underlying securities held by the fund.  Therefore, as an individual investor with limited funds you can get significantly more diversification buying shares of a mutual fund than you can buying individual securities.  For example, an investment in a mutual fund holding 100 blue chip company stocks will give you exposure to all 100 of those companies.  To buy individual shares in each of those 100 blue chip company would cost a significant amount of money.  If, for instance, each of those blue chip company stocks cost $50 per share then to buy only 1 share of all 100 different companies would cost $5,000.  To buy 10 shares of all 100 companies would cost $50,000!  On the other hand, most mutual funds have a minimum investment requirement of around $1,000 (some are $500 or less).  Therefore, for as little as $500-$1,000 you could get the same amount of diversification as the $5,000 or $50,000 portfolio.

The main advantage of diversification is the spreading of risk.  The risk of any single company failing or going out of business is significantly higher than 100 companies failing.  By investing in mutual funds you are spreading your risk across all of the securities held by the fund.  Further, by investing in several different mutual funds that are focused in different sectors of the economy (financial, industrial, retail, etc.) you can further spread your risk across many different sectors of the economy.  To get this same level of diversification buying individual securities would be impossible to all but the wealthiest individuals.

Another advantage of mutual funds is the economy of scale (cost savings associated with operating a large organization).  Investment companies work hard to hire and retain experienced, talented personnel to oversee their holdings and can spread the cost of this talent over a large asset pool.  Additionally, the fund managers, unlike most individual investors, are dedicated full-time to portfolio management and will, within the limits set by the fund’s investment objectives, quickly make the changes necessary to protect the fund from losses and generate the highest return for the investor.  However, one down side to the economy of scale is that if a fund grows too large it can become a prisoner to its size and not be able to move as quickly to adjust to changing economic conditions.  For example, a fund that has $50 million in assets can easily move a large percentage of its assets from one security to another, if it sees an advantage in doing so, without significantly affecting the securities being bought or sold.  However, a fund that has $50 billion in assets cannot easily move large percentages of its assets without potentially affecting the very market conditions it is trying to take advantage of.

II.        Types of Mutual Funds
There are thousands of different mutual funds available in the U.S. with hundreds of different investment objectives.  However, all of these funds fall into three different types as defined by the Securities and Exchange Commission (SEC):

1.       Open-end Funds

The most common type of Investment Company (mutual fund) is the open-end fund.  An open-end fund can issue new shares without limit.  An open-end fund will also buy back shares without limit.  An open-end fund’s share price (NAV) changes daily based on the value of the securities it owns and the number of shares outstanding.  When you buy shares in an open-end fund you receive new, previously unissued stock.  Your investment increases the number of shares outstanding for the fund.  When you sell share of an open-end fund the shares are purchased by the fund and cancelled thus reducing the number of shares outstanding for the fund.  Open-end fund shares are bought and sold only once a day, at the end of the business day after the NAV for the fund is calculated.  Because of the fluid nature of the open-end fund the SEC requires all open-end funds to publish a new prospectus at least every 16 months. 

2.        Close-end Funds

Close-end funds issue a specific number of shares all at once in their initial public offering.  After the initial public offering the shares are traded on stock exchanges and the price moves up and down as determined by the market.  If demand for the shares is high the price will rise while if demand for the shares is low the price will drop.  When you buy shares of a close-end fund (after the initial public offering) you are buying them from other investors and not from the mutual fund.  When you sell shares of a close-end fund you sell them to other investors and not to the mutual fund.  Therefore, the share price of a close-end fund can change independently from its NAV.  If demand for the close-end fund is high its shares can sell at a significant premium to the fund’s NAV.  Conversely, if demand for the close-end fund is low its shares can sell at a significant discount to the fund’s NAV.

3.       Unit Investment Trusts (UITs)

UITs are like close-end funds in that they too issue a specific number of shares all at one time in an initial public offering. However, unlike close-end funds UITs are normally set up as an unmanaged fund for a specific purpose with a limited life span. UITs are also like open-end funds in that investors can redeem shares directly with the fund at any time.  Upon termination of the trust all outstanding shares are redeemed by the fund and the fund is closed.  Some UITs may allow investors to sell their shares on the open market.  UITs do not have a professional investment manager. The portfolio of securities held by the UIT is set by the creators of the trust and that portfolio remains unchanged throughout the life of the fund.

III.        Categories of Mutual Funds
The three different types of mutual funds discussed in Section II above can further be categorized based on the investment objectives or focus of the fund.  There are many different ways to categorizes mutual funds.  However, most funds can be broadly organized into three major categories based on the type of securities the fund focuses on:

1.        Stock Funds

As the name implies stock (or equity) funds invest in the common stock of corporations.  There is a myriad of different stock funds available in the U.S.  It is important to read a stock fund’s prospectus in order to understand what types of stocks the fund invests in.  The fund may invest in only U.S. corporations (domestic fund) or it may only invest in international corporations (foreign fund) or it may invest in both domestic and foreign corporations (global fund).  It may focus on a specific industry or sector, or it may be more broadly market based.  Stock funds are often subcategorized into a 3x3 matrix according to two primary factors: 

a.       The size of corporation (market capitalization or “cap” for short) the fund focuses on.  A corporation's “cap” is calculated by multiplying the number of shares it has on the market by the price per share.  The three common stock fund “cap” subcategories are small-cap, mid-cap, and large-cap.  As market valuations are always fluctuating the exact definition of what size a corporation fits into these three subcategories is always a bit nebulous, but for current market conditions large-cap stocks generally have market capitalizations of at least $10 billion, small-cap stocks have market capitalizations below $2 billion, and mid-cap stocks fit somewhere in between.  A fourth category, micro-cap, is also often used to identify corporations with a market capitalization of less than $300 million.

b.      The investment style the fund employs in picking its stocks.  The three investment styles are growth, value, and blend.  Growth funds seek to invest in stocks of fast-growing companies. Value funds seek to invest in stocks that appear to the fund manager to be undervalued (cheaply priced). Blend funds try to hit a middle ground between the other two styles by investing for both growth and value.

Often when reading reviews or reports on a stock fund you will see the following 3x3 matrix used to identify the fund’s subcategory:

	Large-cap	Mid-cap	Small-cap
Growth	X
Blend
Value

This example indicates that the fund under review is a large-cap growth fund.

2.        Bond Funds

Again, as the name implies bond funds invest in bonds or other fixed income or debt securities. Bond funds are also often subcategorized according to two primary factors:

a.       The credit rating or type of bonds targeted for purchase by the fund (e.g. high-yield or junk bonds, investment-grade corporate bonds, government bonds or municipal bonds).

b.      The maturity of the bonds held (short-, intermediate- or long-term).  Bond funds tend to have a target maturity range (such as five to ten years) that they strive to stay within.  Therefore, once established, a bond fund must constantly sell older bonds as they mature out of the target range and buy new bonds in order to stay in the target maturity range. Thus, most bond funds will never "mature" or expire like a specific bond would.

As with stock funds, bond funds may be domestic, global, or international funds depending on where in the world they focus their bond purchases.

3.        Money market Funds

Most money market funds invest primarily in short term IOUs issued by banks and the nation’s strongest, most creditworthy corporations.  Others may invest in the short-term bonds of the U.S. government or state and local governments.  There focus is always on low-risk capital preservation with high liquidity.  These funds are attractive to those who are seeking marginally better returns on their cash than what they would get from a normal bank or credit union account.

IV.        Management style

The different categorizes of Mutual funds can further be classified according to their management style:

1.        Passively Managed

Also known as “fully invested” or “index” funds.  A passively managed fund will generally be at least 80% invested in the securities of the index, sector or other investment vehicle it is following regardless of what is happening to the underlying securities.  Index funds arrange their portfolio of securities to match, as closely as possible, a market index such as the S&P 500 (a broad based index of 500 large U.S. corporations chosen by the Standard & Poor’s selection committee). Passively managed funds only buy or sell securities as needed to maintain the composition of the fund’s portfolio with the composition of the selected index or other target. This passive management style generally results in a passively managed fund having lower management and other fees than actively managed funds.

2.        Actively Managed

Also known as “fully managed” funds, an actively managed fund can exercise more discretion in buying and selling assets, within the limits set in the fund prospectus, to try to protect the fund from losses and maximize returns.  As mentioned above this active management style generally results in higher management and other fees which the investor hopes is more than off-set by better returns from the managed fund relative to the index fund.

V.        Fees

One of the main disadvantages to investing in mutual funds as compared to investing in individual securities is the myriad of fees that can be associated with buying, selling and holding mutual fund shares.  Again, it is important to carefully read a fund’s prospectus before investing to understand the types of fees associated with that fund.

1.         Sales fee (front-end load)

Some funds charge a sales fee or commission on shares purchased.  This fee is often adjusted up or down depending upon the number of shares purchased.  Generally the more share purchased, the lower the fee.

2.        Redemption fee (back-end load)

Some funds charge a redemption fee when shares are sold.  Often the redemption fee is reduced or eliminated the longer the shares are held.

3.        12b-1 fee

Paragraph 12b-1 of the SEC mutual fund rules allows funds to charge up to 1.25% annually to cover expenses related to advertising and other services provided by the fund.  Not all funds charge this fee so it is important to check the fund prospectus to see if this fee is imposed by a fund you are interested in.

4.        Operating Expenses (Management fee)

Expenses related to operating and managing the fund are paid directly out of the fund’s assets.  Management fees can vary greatly from fund to fund and can be listed directly in the fund’s prospectus, or included in the expense ratio.

5.        Other fees

There is a litany of other fees potentially charged by mutual funds.  Some examples include exit fees, exchange fees, automatic reinvestment fees, trustee fees, custody fees, fund administration fees, fund accounting fees, professional service fees, registration fees, etc.

VI.        Electronically Traded Funds (ETFs)

ETFs are a relatively new class of Investment Company that combines characteristics of both close-end and open-end funds. Like close-end funds ETFs are traded throughout the day on stock exchanges at prices that may be more or less than the NAV of the ETF assets.  Like open-end funds ETF shares can often be bought or sold at the end of each trading day at NAV.    ETFs traditionally have been index funds, but in 2008 the SEC began authorizing the creation of actively managed ETFs.  ETFs tend to have low fees due to their electronic format and propensity to be passively managed.