Mutual funds have advantages and disadvantages compared to direct investing in individual securities. The primary advantages of mutual funds are that they provide economies of scale, a higher level of diversification, they provide liquidity, and they are managed by professional investors. On the negative side, investors in a mutual fund must pay various fees and expenses.
Primary structures of mutual funds include open-end funds, unit investment trusts, and closed-end funds. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange. Mutual funds are also classified by their principal investments as money market funds, bond or fixed income funds, stock or equity funds, hybrid funds or other. Funds may also be categorized as index funds, which are passively managed funds that match the performance of an index, or actively managed funds. Hedge funds are not mutual funds; hedge funds cannot be sold to the general public and are subject to different government regulations.
The first modern investment funds (the precursor of today's mutual funds) were established in the Dutch Republic. In response to the financial crisis of 1772-1773, Amsterdam-based businessman Abraham (or Adriaan) van Ketwich formed a trust named Eendragt Maakt Magt ("unity creates strength"). His aim was to provide small investors with an opportunity to diversify.
Mutual funds were introduced to the United States in the 1890s. Early U.S. funds were generally closed-end funds with a fixed number of shares that often traded at prices above the portfolio net asset value. The first open-end mutual fund with redeemable shares was established on March 21, 1924 as the Massachusetts Investors Trust (it is still in existence today and is now managed by MFS Investment Management).
In the United States, closed-end funds remained more popular than open-end funds throughout the 1920s. In 1929, open-end funds accounted for only 5% of the industry's $27 billion in total assets.
These new regulations encouraged the development of open-end mutual funds (as opposed to closed-end funds).
Growth in the U.S. mutual fund industry remained limited until the 1950s, when confidence in the stock market returned. By 1970, there were approximately 360 funds with $48 billion in assets.
The introduction of money market funds in the high interest rate environment of the late 1970s boosted industry growth dramatically. The first retail index fund, First Index Investment Trust, was formed in 1976 by The Vanguard Group, headed by John Bogle; it is now called the "Vanguard 500 Index Fund" and is one of the world's largest mutual funds. Fund industry growth continued into the 1980s and 1990s.
According to Pozen and Hamacher, growth was the result of three factors:
In 2003, the mutual fund industry was involved in a scandal involving unequal treatment of fund shareholders. Some fund management companies allowed favored investors to engage in late trading, which is illegal, or market timing, which is a practice prohibited by fund policy. The scandal was initially discovered by former New York Attorney General Eliot Spitzer and led to a significant increase in regulation. In a study about German mutual funds Gomolka (2007) found statistical evidence of illegal time zone arbitrage in trading of German mutual funds . Though reported to regulators BAFIN never commented on these results.
Total mutual fund assets fell in 2008 as a result of the financial crisis of 2007-2008.
In the United States, mutual funds play an important role in U.S. household finances. At the end of 2016, 22% of household financial assets were held in mutual funds. Their role in retirement savings was even more significant, since mutual funds accounted for roughly half of the assets in individual retirement accounts, 401(k)s and other similar retirement plans. In total, mutual funds are large investors in stocks and bonds.
Luxembourg and Ireland are the primary jurisdictions for the registration of UCITS funds. These funds may be sold throughout the European Union and in other countries that have adopted mutual recognition regimes.
Mutual funds have advantages and disadvantages compared to investing directly in individual securities:
Mutual funds have disadvantages as well, which include:
In the United States, the principal laws governing mutual funds are:
Open-end and closed-end funds are overseen by a board of directors, if organized as a corporation, or by a board of trustees, if organized as a trust. The Board must ensure that the fund is managed in the interests of the fund's investors. The board hires the fund manager and other service providers to the fund. The fund sponsors trades (buys and sells) the fund's investments in accordance with the fund's investment objective. Funds that are managed by the same company under the same brand are known as a fund family or fund complex.
The sponsor or fund management company, often referred to as the fund manager, trades (buys and sells) the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment adviser. Funds that are managed by the same company under the same brand are known as a fund family or fund complex.
In the European Union, funds are governed by laws and regulations established by their home country. However, the European Union has established a mutual recognition regime that allows funds regulated in one country to be sold in all other countries in the European Union, but only if they comply with certain requirements. The directive establishing this regime is the Undertakings for Collective Investment in Transferable Securities Directive 2009, and funds that comply with its requirements are known as UCITS funds.
Regulation of mutual funds in Canada is primarily governed by National Instrument 81-102 "Mutual Funds." NI 81-102 is implemented separately in each province or territory. The Canadian Securities Administrator works to harmonize regulation across Canada.
In the Hong Kong market mutual funds are regulated by two authorities:
In Taiwan, mutual funds are regulated by the Financial Supervisory Commission (FSC).
There are three primary structures of mutual funds: open-end funds, unit investment trusts, and closed-end funds. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange.
Open-end mutual funds must be willing to buy back ("redeem") their shares from their investors at the net asset value (NAV) computed that day based upon the prices of the securities owned by the fund. In the United States, open-end funds must be willing to buy back shares at the end of every business day. In other jurisdictions, open-funds may only be required to buy back shares at longer intervals. For example, UCITS funds in Europe are only required to accept redemptions twice each month (though most UCITS accept redemptions daily).
Most open-end funds also sell shares to the public every business day; these shares are priced at NAV.
Most mutual funds are open-end funds. In the United States at the end of 2016, there were 8,066 open-end mutual funds with combined assets of $16.3 trillion, accounting for 86% of the U.S. industry.
Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who want to sell their shares must sell their shares to another investor in the market; they cannot sell their shares back to the fund. The price that investors receive for their shares may be significantly different from NAV; it may be at a "premium" to NAV (i.e., higher than NAV) or, more commonly, at a "discount" to NAV (i.e., lower than NAV).
In the United States, at the end of 2016, there were 530 closed-end mutual funds with combined assets of $300 billion, accounting for 1% of the U.S. industry.
Unit investment trusts (UITs) are issued to the public only once when they are created. UITs generally have a limited life span, established at creation. Investors can redeem shares directly with the fund at any time (similar to an open-end fund) or wait to redeem them upon the trust's termination. Less commonly, they can sell their shares in the open market.
Unlike other types of mutual funds, unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT.
In the United States, at the end of 2016, there were 5,103 UITs with combined assets of less than $0.1 trillion.
Exchange-traded funds (ETFs) are structured as open-end investment companies or UITs. ETFs combine characteristics of both closed-end funds and open-end funds. ETFs are traded throughout the day on a stock exchange. An arbitrage mechanism is used to keep the trading price close to net asset value of the ETF holdings.
In the United States, at the end of 2016, there were 1,716 ETFs in the United States with combined assets of $2.5 trillion, accounting for 13% of the U.S. industry.
Mutual funds are normally classified by their principal investments, as described in the prospectus and investment objective. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds, and hybrid funds. Within these categories, funds may be subclassified by investment objective, investment approach or specific focus.
The types of securities that a particular fund may invest in are set forth in the fund's prospectus, a legal document which describes the fund's investment objective, investment approach and permitted investments. The investment objective describes the type of income that the fund seeks. For example, a capital appreciation fund generally looks to earn most of its returns from increases in the prices of the securities it holds, rather than from dividend or interest income. The investment approach describes the criteria that the fund manager uses to select investments for the fund.
Bond, stock, and hybrid funds may be classified as either index (or passively-managed) funds or actively managed funds.
Money market funds invest in money market instruments, which are fixed income securities with a very short time to maturity and high credit quality. Investors often use money market funds as a substitute for bank savings accounts, though money market funds are not insured by the government, unlike bank savings accounts.
In the United States, money market funds sold to retail investors and those investing in government securities may maintain a stable net asset value of $1 per share, when they comply with certain conditions (alternately, money market funds must compute a net asset value based on the value of the securities held in the funds).
In the United States, at the end of 2016, assets in money market funds were $2.7 trillion, representing 14% of the industry.
Bond funds invest in fixed income or debt securities. Bond funds can be sub-classified according to:
In the United States, at the end of 2016, assets in bond funds were $4.1 trillion, representing 22% of the industry.
Stock, or equity, funds invest in common stocks. Stock funds may focus on a particular area of the stock market, such as
In the United States, at the end of 2016, assets in Stock funds were $10.6 trillion, representing 56% of the industry.
Hybrid funds invest in both bonds and stocks or in convertible securities. Balanced funds, asset allocation funds, target date or target risk funds, and lifecycle or lifestyle funds are all types of hybrid funds.
Hybrid funds may be structured as funds of funds, meaning that they invest by buying shares in other mutual funds that invest in securities. Many funds of funds invest in affiliated funds (meaning mutual funds managed by the same fund sponsor), although some invest in unaffiliated funds (i.e., managed by other fund sponsors) or some combination of the two.
In the United States, at the end of 2016, assets in hybrid funds were $1.4 trillion, representing 7% of the industry.
Funds may invest in commodities or other investments.
Investors in a mutual fund pay the fund's expenses. Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value.
These expenses fall into five categories:
The management fee is paid by the fund to the management company or sponsor that organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand to the fund. The fund manager may also provide other administrative services. The management fee often has breakpoints, which means that it declines as assets (in either the specific fund or in the fund family as a whole) increase. The fund's board reviews the management fee annually. Fund shareholders must vote on any proposed increase, but the fund manager or sponsor can agree to waive some or all of the management fee in order to lower the fund's expense ratio.
Index funds generally charge a lower management fee than actively-managed funds.
Distribution charges pay for marketing, distribution of the fund's shares as well as services to investors. There are three types of distribution charges.
Distribution charges generally vary for each share class.
A mutual fund pays expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. These costs are normally positively correlated with turnover.
Shareholders may be required to pay fees for certain transactions, such as buying or selling shares of the fund. For example, a fund may charge a flat fee for maintaining an individual retirement account for an investor. Some funds charge redemption fees when an investor sells fund shares shortly after buying them (usually defined as within 30, 60 or 90 days of purchase). Redemption fees are computed as a percentage of the sale amount. Shareholder transaction fees are not part of the expense ratio.
A mutual fund may pay for other services including:
The fund manager or sponsor may agree to subsidize some of these charges.
The expense ratio equals recurring fees and expenses charged to the fund during the year divided by average net assets. The management fee and fund services charges are ordinarily included in the expense ratio. Front-end and back-end loads, securities transaction fees and shareholder transaction fees are normally excluded.
To facilitate comparisons of expenses, regulators generally require that funds use the same formula to compute the expense ratio and publish the results.
In the United States, a fund that calls itself "no-load" cannot charge a front-end load or back-end load under any circumstances and cannot charge a distribution and services fee greater than 0.25% of fund assets
Critics of the fund industry argue that fund expenses are too high. They believe that the market for mutual funds is not competitive and that there are many hidden fees, so that it is difficult for investors to reduce the fees that they pay. They argue that the most effective way for investors to raise the returns they earn from mutual funds is to invest in funds with low expense ratios.
Fund managers counter that fees are determined by a highly competitive market and, therefore, reflect the value that investors attribute to the service provided. They also note that fees are clearly disclosed.
Mutual funds in the United States are required to report the average annual compounded rates of return for one-, five-and ten year-periods using the following formula:
P(1+T)n = ERV
P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the one-, five-, or ten-year periods at the end of the one-, five-, or ten-year periods (or fractional portion).
Market capitalization equals the number of a company's shares outstanding multiplied by the market price of the stock. Market capitalization is an indication of the size of a company. Typical ranges of market capitalizations are:
A fund's net asset value (NAV) equals the current market value of a fund's holdings minus the fund's liabilities (this figure may also be referred to as the fund's "net assets"). It is usually expressed as a per-share amount, computed by dividing net assets by the number of fund shares outstanding. Funds must compute their net asset value according to the rules set forth in their prospectuses. Most compute their NAV at the end of each business day.
Valuing the securities held in a fund's portfolio is often the most difficult part of calculating net asset value. The fund's board typically oversees security valuation.
A single mutual fund may give investors a choice of different combinations of front-end loads, back-end loads and distribution and services fee, by offering several different types of shares, known as share classes. All of them invest in the same portfolio of securities, but each has different expenses and, therefore, a different net asset value and different performance results. Some of these share classes may be available only to certain types of investors.
Typical share classes for funds sold through brokers or other intermediaries in the United States are:
No-load funds in the United States often have two classes of shares:
Neither class of shares typically charges a front-end or back-end load.
Turnover is a measure of the volume of a fund's securities trading. It is expressed as a percentage of average market value of the portfolio's long-term securities. Turnover is the lesser of a fund's purchases or sales during a given year divided by average long-term securities market value for the same period. If the period is less than a year, turnover is generally annualized.