Mutual funds are equity claims against pre-specified assets held by investment companies (firms that professionally manage pools of assets). Thus, a share of a mutual fund is an equity claim, typically held by an individual, against a professionally managed pool of assets.
Mutual funds provide four benefits to individual investors. First, since most mutual funds are well diversified, these funds allow individuals with limited capital to hold diversified portfolios. Second, since mutual funds are professionally managed, an individual investor can obtain the benefits of professional asset management at a fraction of the cost of privately retaining a professional manager. Third, mutual funds can provide superior liquidity both during the holding period of the fund and at liquidation. Since transaction costs are not typically proportional to order dollar values, mutual funds can rebalance portfolios at a lower proportional cost than an individual investment can. Furthermore, to liquidate a portfolio, mutual funds require the sale of only a sing le security (the fund). Finally, mutual funds reduce topic-keeping and clerical costs by automatically reinvesting dividends or coupons and by providing quarterly performance rep orts and annual consolidated statements for investors’ tax purposes.
Mutual funds carry several costs for investors . Management fees, charged daily against the net asset value of the fund, are summarized, aggregated and reported quarterly. Load funds charge a one-time fee to the investor whenever shares are purchased (a “front-end” load) and/or sold (a “back-end load”). Some back-end load fees are contingent on the holding period. For example, a back-end load fee of (5 percent – 1 percent x years held) means that an investor can escape the back-end load fee if the shares are held for five years or more. Such contingent back-end fees are often called “contingent deferred sales loads.” Finally, investment companies may charge mutual fund holders “12b-1 fees” to reimburse the investment company for marketing, advertising, reporting, and maintaining investor relations.
The most important dichotomy in the analysis of mutual funds is the distinction between open-end and closed-end funds. In an “open end fund,” purchases and sales of shares in the fund can be made through the investment company at any time. Thus, the number of shares outstanding and the amount of capital under management vary constantly. Further, such transactions occur at the stated net asset value (NAV). The NAV, which is calculated at least daily, is the current market value of the fund’s assets divided by shares outstanding.
In contrast, shares of a “closed-end fund” are issued by the investment company only once and are fixed thereafter. As a result, individuals wishing to buy or sell shares of an established closed-end fund must identify a counterparty willing to take the other side of the transaction. This is why closed-end funds, but not open end funds, are listed on stock exchanges. Often, secondary market transactions of a closed-end fund occur at prices that differ from the fund’s NAV. Funds with market prices above their NAV trade at a premium; funds with market prices below their NAV trade at a discount. Closed-end funds do not charge an explicit front-end load fee. Instead, this fee is charged implicitly, through the difference between the higher purchase price and the NAV of the fund.
A second important distinction between mutual funds is their investment “style.” Some funds are “passively” managed; that is, holdings of the mutual fund are rarely altered and the fund mimics a benchmark index such as the Standard and Poor’s 500 Index. However, the vast majority of mutual funds are “actively” managed, with portfolio holdings frequently altered according to management discretion. One example of an actively managed style is “market timing,” where a manager dynamically alters a fund’s weights in stocks, bonds, and short-term debt in anticipation of future moves.
Actively managed funds are classified by the type of assets they hold. For example, some funds invest only in tax-exempt municipal bonds, while others invest only in mortgage-backed debt obligations. Equity funds are normally classified as growth funds (containing speculative stocks with low dividend yields), income funds (containing less volatile, higher yield stocks, and sometimes bonds), or balanced funds (containing elements of both growth and income funds).
Furthermore, some equity funds consider only foreign issues, while others, called “country funds,” invest only in equities in one particular foreign country. Since many countries restrict foreign investment, a closed-end fund may be the only viable avenue for investing in a particular country. Thus, a foreign country closed-end fund is likely to trade at a premium.
In the USA, mutual funds, and the investment companies that manage them, are regulated under the Investment Company Act of 1940. Under this Act, the Securities and Exchange Commission is granted authority to regulate mutual funds. Investment companies, like the equity market, are regulated by disclosure, rather than merit, regulation. Consequently, mutual fund regulation focuses on mandatory disclosure of information, including the filing of a prospectus at the time of issue as well as quarterly and annual reports. To prevent potential conflicts of interest, regulation limits the holdings of brokers and underwriters in a mutual fund.
