Getting Started in Mutual Funds E-Book

Alvin D. Hall

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The Getting Started In Series
• Sprache: Englisch

Seitenzahl: 419

Veröffentlichungsjahr: 2010

Beschreibung

A fresh look at the ever-changing world of mutual funds Like all investment instruments, mutual funds continue to evolve. In the last decade however, there has been plenty of change, including market capitalization, the introduction of new types of funds, and the expansion of the mutual fund model to include investments in commodities. Getting Started in Mutual Funds, Second Edition offers a completely updated look at this popular investment vehicle, including everything from Morningstar's new matrix of evaluating a fund's investment style to implementing mutual funds into long-term investment strategies in retirement plans. Throughout the book, author Alvin Hall also focuses on the basics, like how to read a prospectus, how to evaluate ongoing fees and expenses, and how to gauge a fund's performance. * Acquaints you with the various types of mutual funds and how they are structured * Explains important mutual fund terms and concepts * New chapters include information on exchange-traded funds and how they compare to mutual funds in terms of performance, risk and fees * Reveals how to assess a fund manager's investment style and its impact on your returns Gain a better understanding of mutual funds and maximize your investment returns with Getting Started in Mutual Funds, Second Edition.

Leseprobe

Contents

Cover

Half Title Page

Series

Title Page

Copyright

Dedication

Acknowledgments

Introduction

Benefits of Investing in Mutual Funds

A Brief History of Mutual Funds

Chapter 1: Definition and Structure of a Mutual Fund

Open-End Management Company (aka, Mutual Fund)

Structure of a Mutual Fund

Closed-End Management Company (aka publicly traded fund)

Mutual Funds versus Closed-End Funds

Chapter 2: Investment Objectives and Risks of Stock and Bond Funds

Establishing Your Investment Objectives

Mutual Fund Investment Objectives

Money Market Mutual Funds

Equity or Stock Funds

Bond Funds (aka Fixed Income Funds)

Hybrid Funds

Index Funds

Fund of Funds

Summary

Chapter 3: Fees and Expenses: Load, No-Load, and Pure No-Load Funds

Operating Expenses

Fees, Charges, and Loads

No-Load and Pure No-Load Funds

Classes of Mutual Fund Shares

Expense Ratio

Chapter 4: Buying, Redeeming, and Exchanging Mutual Fund Shares

Forward Pricing

Purchasing Fund Shares

Automatic Reinvestment of Dividends and Capital Gains

Redeeming Mutual Fund Shares

Exchanging Mutual Fund Shares

Deciding Which Shares to Redeem

Chapter 5: Analyzing Mutual Fund Performance

Total Return

Understanding Investment Style and Evaluating Risk

Portfolio Composition

Turnover and Taxes

Summary

Chapter 6: Shareholder Services

Automatic Investing

Check Writing

Dividend Reinvestment

Exchange Privileges

Information Online

Investment Guidance and Asset Allocation Models

Low Initial Investment Amounts

Reinstatement Privileges

Shareholder Reports and Other Documents

Simplified Record Keeping

Systematic Withdrawal

Tax-Deferred Retirement Accounts

Web Sites

Wire Transfers

Chapter 7: Seven Wisdoms of Mutual Fund Investing

Glossary

Index

Getting Started in MUTUAL FUNDS SECOND EDITION

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Copyright © 2011 by Alvin D. Hall. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Hall, Alvin D. Getting started in mutual funds / Alvin D. Hall. – 2nd ed. p. cm. – (Getting started in….. ; 84) Includes index. ISBN 978-0-470-52114-4 (pbk.) 1. Mutual funds. 2. Investments. 3. Mutual funds – United States. 4. Investments – United States. I. Title. HG4530.H335 2010 332.63’27–dc22 2010023266

To John Keefe (Chicago, Illinois), who shares my belief that mutual funds are one of the best ways for individuals to learn about the benefits of long-term investing and wealth building

Acknowledgments

Thanks to Van Morrow of Type-Right, Inc., for diligently and expertly turning my drawings into the illustrations and tables in this book, and for helping me to prepare the manuscript during the time when I was simultaneously traveling (literally around the world) for business and writing this edition. Thanks to my long-time friend, Edward Fleur, for helping me to decipher some of the new mutual fund regulations and practices so that I could explain them clearly in this book. John Keefe’s commitment to reading and commenting on the final manuscript and page proofs was invaluable. His questions and insights helped me to make the book more informative and appropriate to the needs of a wide range of mutual fund investors.

My thanks also go to Bill Falloon, Tiffany Charbonier, and Michael Lisk at John Wiley & Sons. They were forthright, patient, and honest throughout the process of this revision. I truly appreciated their understanding of and dedication to my (and any author’s) desire to produce the best book possible. Their work throughout was supportive and encouraging in all the right and honorable ways.

And finally, my thanks to all of the inquisitive people who have attended my lectures and classes over my more than 25 years of conducting training programs in the financial services industry. All of the questions they have asked, especially those that were complex or difficult to answer, have enabled me to improve continually the way I present the information in my classes and in the books I write. I know that the readers of my books are the true beneficiaries of all the wisdom and practical insights I’ve learned from teaching financial information in front of real people in classes all over the world.

Introduction

I am writing this second edition of Getting Started in Mutual Funds during a worldwide recession and one of the worst bear markets in recent U.S. history. Many of the funds in which we—you and I—invested the money we earned or inherited, set aside for our retirement or our children’s education, or saved hoping to fulfill some lifelong dream, are down in value 25, 35, even 50 percent. Trillions of dollars have disappeared from our collective personal net worth. Many investors have decided they cannot stand to see their life savings being slowly wiped out, so they have sold their mutual funds and other investments, putting the proceeds in money market funds. Others are holding on, feeling it’s too late to sell and take their losses. Instead they hold on to the traditional long-term investment philosophy that the market and the value of their mutual funds will eventually recover—or so they hope and pray.

Regardless of which camp you fall in, we all must admit that this current crisis in the economy and investment markets has made us aware of three important facts. First, each of us must be more knowledgeable about the products in which we invest our money. Second, we must be more conscientious and proactive in reviewing and adjusting to our asset allocations in light of changing market conditions and the need to preserve the money we’ve made. And third, each of us must be much more aware of our real individual tolerance for risk, and not let it be overly influenced, or even blinded, by the optimism of a prolonged bull market.

This second edition of Getting Started in Mutual Funds is revised and expanded with these three facts in mind. My goal is to help you understand what you invest in when you purchase mutual funds and the risks associated with those investments. I want to enable you to have a clearer understanding of your choices when you invest in mutual funds, whether it’s via a 401(k) plan, a 403(b) plan, a 529 college savings plan, an IRA, a SEP (Simplified Employee Pension plan), a personal cash account, or any other type of account. Too often when deciding what to do with our money, we are left essentially on our own—without any guidance, explanation, or reasonable understanding of what we should do and why. This book will be your educational tool, your useful reference guide, and your secret helper, enabling you to make better investment choices for yourself, whether you are a beginning investor or an experienced one wondering what to do in the future.

Despite what has happened in the markets, you most likely know that some of the money you have set aside for retirement, a child’s education, or some future purchase should be invested in the stock market. However, you are apprehensive and gun-shy because of the recent losses you’ve experienced or read about, or you don’t feel you have enough knowledge of investments in general—of mutual funds, specifically. Not only do you want a clearer and more useful understanding of the terminology of mutual funds, you want, perhaps most importantly, to know how to evaluate and select those most appropriate for you from among the group of funds presented to you by your broker, financial advisor, the administrator of the retirement plan at your job, or that you see on web sites, in newsletters and in newspapers you use for research as you make your own investments.

There could be other reasons you need the information in this book. Maybe you are a person who has invested in a fund because “a friend said it was a good one” or because “it was one of the choices in my company’s 401(k) plan.” When asked what fund you own, you say offhandedly, “Oh, Fidelity or Vanguard something-or-other.” Your choice had done well, but now it has dropped in value by a greater percentage than the decline in the major market indices. You now want to be both more knowledgeable and proactive. You want to know about asset allocation, about sector-specific funds, target-date funds, green funds, and about bond funds. In short, you want to be more involved in shaping your financial future, with a renewed understanding of the need to preserve your capital along the way.

Or you have some investment experience but are seeking to understand a particular aspect of mutual funds in more detail—such as the risk associated with a fund, the experience and investment approach of the fund manager, the different classes of mutual fund shares, expense ratios, or turnover ratios. You want to learn about these specific areas quickly and efficiently.

Getting Started in Mutual Funds, Second Edition, is written, like the first edition, to make you smarter and more confident about choosing and monitoring your mutual fund investments. I make two assumptions in this book. First, you are motivated to invest in mutual funds and want to learn more about them. And second, you are looking for a book that will give you a sound understanding of the basic concepts and terms, as well as explain the complexities of evaluating mutual funds in clear, easy-to-follow, and easily readable language. Among the important topics covered in this book are:

The structure and workings of a typical mutual fund.The roles of the various entities involved in operating a fund (i.e., portfolio manager, board of directors, custodian bank, underwriter).How to understand the risk evaluations of a particular fund during bull and bear markets.Investment minimums.Fees and expenses.Measurements (e.g., past performance, expense ratios) to be examined and compared before investing.Common shareholder services.Sources of information about and evaluations of mutual funds.

This book will help you (1) understand what a fund’s return or yield actually means, (2) comprehend the impact of the fund manager’s investment style on your return, and (3) evaluate the ongoing expenses associated with mutual fund investing. The ultimate goal of Getting Started in Mutual Funds, Second Edition is to enable you to choose a mutual fund that will, given your investment objective, risk tolerance, and time horizon, be one of the top performers in its group or sector.

Benefits of Investing in Mutual Funds

Mutual funds are the primary means by which most individuals in the United States invest in the stock and bond markets. Funds offer an opportunity for a group of people with the same investment objective to pool their resources and gain greater buying power. Investors, whether beginning, small, or experienced, are attracted to mutual funds for four widely touted benefits.

Diversification

A mutual fund’s investment portfolio consists of stocks and/or bonds from different companies, usually in many different industries or business sectors. As a result, an investor’s money is somewhat shielded against a decline in any one company, or depending on the fund, any one business sector. Diversification does not mean, as I have heard a beginning investor say, “The value of my money is safe and can only go down a little in value.” If the overall stock market declines sharply, as all of us saw in 2008–2009, then the value of a mutual fund, no matter how well diversified, will also decline. And depending on the types of securities and the business sectors they represent, the mutual fund may decline in value more than the overall market, as measured by indices such as the Standard & Poor’s 500 Index or the Dow Jones Industrial Average. Diversification does not and cannot protect shareholders against adverse moves in the broad investment market. (This is known as market risk.) It protects only against the risk of “putting too many eggs in one basket” (i.e., putting too much money in one stock).

Professional Management

The specific stocks and/or bonds in which the fund invests shareholders’ money are carefully selected by a professional portfolio manager or investment advisor. This may be a single person, or, as is more common today, a team of people. Most have an advanced degree from a business school and have taken additional courses to achieve the Certified Financial Analyst (CFA) designation. Recent business school graduates often work under the guidance of a more experienced or senior portfolio manager before being given primary responsibility for a particular fund. Also, the fund (or its management company) employs or contracts researchers as well as investment analysts and strategists to provide the manager with detailed information, insights, and interpretations about specific companies, sectors, and the overall market that are important considerations when choosing individual stocks and bonds. These data and opinions enable the manager to fulfill the fund’s objective and select those securities that will, hopefully, produce a substantial positive return.

Lower Transaction Costs

Compared with buying individual stocks and bonds to build a diversified portfolio on your own, the costs associated with investing in a mutual fund which contains these financial instruments are lower. A fund’s administrative, operations, and trading expenses are spread over all of the shareholders in the fund. This might be thousands of people. Therefore, the transaction costs per person for every dollar invested are less—some would say minuscule.

This benefit is, however, being challenged by the low-cost order execution services available through deep-discount and on-line brokerage firms. Some services will execute trades for up to 5,000 shares in any stock for a commission as low as $7.00. For the person who buys and holds individual securities over the long term, the trading costs of building his or her own diversified portfolio using these services may be less than the ongoing expenses (explained in Chapter 3) of holding a group of mutual funds. This would most likely be true for a person who buys substantial amounts of securities. However, for the majority of people who invest modest amounts of money, the low cost of mutual fund transactions remains an advantage.

Convenience

Large mutual fund companies and supermarkets offer investors numerous funds, often by different providers, that have different objectives and that concentrate on different industries, markets (e.g., international) or types of securities (stocks, bonds, mortgage-backed securities). They also provide an increasing array of customer services. Investment “help” in screening funds for potential investment, automatic investment plans, online purchases and redemptions, automatic dividend and capital gains reinvestment, and asset allocation models are just a few of the services. (More are discussed in detail in Chapter 6.) The increasing breadth of mutual fund objectives and services afford you, the individual investor, a great deal of flexibility. Competition for your investment dollars has given funds the incentive to make it easy for you to implement your investment decisions, track their performance, and keep accurate records for tax-reporting purposes. In many ways, financial institutions have succeeded in their efforts to make mutual fund investing as convenient as one-stop shopping.

Since the early 1980s, the public has come to understand and believe in the benefits of investing through mutual funds. The result is that, despite the recent distressing downturn, funds remain the investment vehicle of choice for all levels of investors—for the person with as little as $25 per month to invest to the person with hundreds of thousands of dollars. The amount of money Americans poured into mutual funds over the years illustrates this point. In 1990, the public invested $12.8 billion in stock funds for the entire year. In 1996, the public invested $28.9 billion dollars in stock funds in just the first month of the year! In 2000, the amount of money in mutual funds had soared to nearly $4 trillion, and was still growing—up 600 percent during the decade leading up to the millennium. As the long bull market was approaching its peak, at least one new mutual fund was being created every business day. By the end of 2009, mutual funds managed over $11 trillion of assets for nearly 90 million U.S. investors representing 21 percent of all households, according to the Investment Company Institute (ICI). Of these households, the average number of mutual funds owned per household is four.

Today there are around 8,600 mutual funds available from approximately 600 sponsors (mutual fund companies, brokerage firms, banks and other financial institutions). Many industry experts expect the numbers will decrease the longer the bear market lasts. Some mutual funds will merge and some will liquidate, but fewer new funds will be created. Unlike their older brethren, the newer funds created today often have more focused investment objectives and investment strategies. The result: target marketing has become a permanent feature of the mutual fund industry.

Mutual funds are one of the more established products through which small investors have pooled their funds to gain access to the stock and bond markets and to professional management. And as the following brief history and time line reveal, mutual funds have had, like the stock market itself, their ups and downs with the public.

A Brief History of Mutual Funds

1924–1970

In 1924, the Massachusetts Investors Trust and the State Street Investment Trust created the first mutual funds in the United States. Like today’s mutual funds, these trusts enabled investors to purchase shares of a professionally managed portfolio that consisted of a diverse selection of stocks. This product was not immediately popular with individual investors. At that time, people were more interested in owning individual stocks.

FIGURE I.1 Mutual fund timeline: 1924–1970.

FIGURE I.2 Types of investment companies.

Following the Market Crash of 1929 and the Great Depression, individual investors avoided all types of securities, including mutual funds. The entire industry was dubbed “the plague” and stockbrokers “the carriers of the plague.” Beginning in 1933, Congress and the newly created Securities and Exchange Commission (SEC) developed and implemented a series of Acts designed to reform the securities industry. These new laws also sought to protect investors from the fraudulent and manipulative practices that pervaded the market during the Roaring Twenties. One Act, the Investment Company Act of 1940, classified and regulated the various types of pooled investment vehicles. The Act defined three types of investment companies (see Figure I.2) and detailed rules governing the creation, marketing, and operation of these entities and their products. As Figure I.2 shows, a mutual fund is a type of a management company. It is, by its legal name, an open-end management company. At the time the Act was passed, there were only 68 mutual funds in the United States.

From the 1929 crash through World War II, Americans did not invest in the stock markets. The U.S. securities markets were virtually moribund. Recognizing that bringing people back to the markets was essential for their survival, the New York Stock Exchange (NYSE) and its member firms started the Monthly Investment Plan (MIP) in January 1954. Using the tag-line, “Own Your Share of American Business,” this campaign had two purposes: (1) to educate prospective investors about the basic benefits of buying stocks and bonds, and (2) to offer them an opportunity to invest in NYSE-listed stocks with as little as $40 a month. A participant could buy small numbers of shares, including fractional shares computed to three places to the right of the decimal point.

MIP gave small investors hands-on experience with three important investment-related concepts. The first was payroll deduction. MIP participants could elect to invest the quarterly amount either through payroll deduction plans or by making the deposit themselves. The second was dividend reinvestment. Virtually all MIP participants signed up for automatic reinvestment of dividends. And the third, dollar-cost averaging, is one of the keystones to successful mutual fund investing. It involves investing modest amounts of money into a stock or mutual fund at regular intervals. The ease of this strategy, combined with the rise in the stock market, contributed to the success of MIP. It introduced a new generation to the advantages of investing in stocks.

The increase in share ownership MIP created, however, did not extend to mutual funds. There were only 161 mutual funds available to investors in 1960. Even as late as 1970, the total was only 361. (Forty-six of these were bond and income funds.) Few stockbrokers had ever written an order ticket for a mutual fund.

The severe bear market of 1973–1974 made mutual funds even less attractive (see Figure I.3). The Dow declined nearly 50 percent during that two-year period. Many funds shares dropped more than 40 percent in value and the resulting deluge of investor redemptions contributed to even further declines. Among stockbrokers and the few mutual fund investors, the cynical view about mutual funds is captured in what was then an oft-repeated statement: “I can lose my money just as easily as a professional fund manager can.”

FIGURE I.3 Mutual fund timeline: 1970–1980.

1970–1980: The Disenfranchisement of the Small Investor

During the mid-1970s, two events made investing directly in stock and bonds more difficult for people with small amounts of money and consequently spurred the growth of mutual funds. First, the Federal Reserve Board (FRB) increased the minimum investment for Treasury bills. Interest rates on six-month Treasury bills had risen to more than 16 percent. This increase, combined with the prolonged bear market, caused investors to flee the stock market and begin purchasing large amounts of U.S. Treasury bills.

To stem the demand, the FRB raised the minimum purchase amount for Treasury bills from $1,000 to $10,000. (The minimum purchase has been reduced over the past decade and is currently $100.) This increase effectively placed T-bills out of the reach of small investors. The high interest rates associated with T-Bills could only be accessed through investment in the then-newly-created product called the “money market mutual fund.” One of the first of these, The Fidelity Daily Income Trust, was offered to the public in 1974. Like today’s money market mutual funds, it sought to maintain its net asset value at $1.00 and offered check-writing privileges. The yields on money funds closely tracked that of the six-month T-bill rate.

The second blow to the smaller investor came on May 1, 1975, when commissions on securities transactions became negotiable. This resulted in small investors becoming less attractive to full-service brokerage firms. The reason was simple: the commissions to be earned from their small trades were relatively insignificant. Most brokerage firms therefore chose to focus their efforts and attention on the institutional clients, who bought and sold large quantities of shares.

1980–Today: Mutual Funds Attract More Investors—Small and Large

The elimination of fixed commissions was good news for mutual funds and a newly created type of investment firm: the discount brokerage firm. These companies saw opportunity—and profit—in the small investors’ periodic purchases of modest quantities of stocks and bonds and set out to attract those who would regularly invest in the securities market, either indirectly (i.e., through investment in mutual funds) or directly (i.e., by purchasing stocks and bonds). In doing so, they would capture an ongoing stream of fees and commissions. If the number of investors was large enough, these fees could provide substantial income for the company.

As a customer retention strategy, mutual fund companies began offering small investors a variety of products and services. Many of the services and benefits were tied to the amount of money invested. The more money you invested, the more benefits (usually discounts) you received—thereby lowering the overall cost of your holdings. This strategy helped mutual fund companies capture a larger percentage of each person’s investment dollars.

During the bull market of the 1980s (see Figure I.4), the number of mutual fund investors and the amount of money flowing into mutual funds increased rapidly. This growth was spurred by the creation of Individual Retirement Accounts (IRAs) under the Tax Act of 1981 and, as mentioned at the beginning of this introduction, the public’s increasing awareness of the benefits of mutual fund investing. The movement of companies away from defined benefit plans, replacing them with defined contribution plans, also helped the growth of mutual funds. Most defined contribution plans—of which a 401(k) plan is one example—offer employees a group of mutual funds in which they can invest money for their retirement. Mutual fund companies began aggressive campaigns to attract new investors. The aim was—and remains—to convert people who “saved” for retirement into people who “invest” for retirement.

FIGURE I.4 Mutual fund timeline: 1980–2000.

FIGURE I.5 Mutual fund timeline: 2000–today.

The Market Break of 1987 made many people aware of a feature about mutual funds that they had never fully focused on or understand. Although people talked about “trading” mutual funds, in reality these securities could not be bought and sold during the trading day like stocks. As the market plunged on October 19, many people wanted to sell their mutual funds before the market hit its lowest point. Instead they became aware that all orders to buy or redeem mutual fund shares are executed only at the end of the business day when the closing prices of the securities in the fund’s portfolio are calculated. This prompted people to begin asking, “Why can’t mutual funds be tradable?”

Some mutual fund companies experimented with executing orders for mutual fund shares based on stock and bond prices at specific times during the trading day. These intraday executions were not widely embraced by the industry and gradually stopped. The investment products group at the American Stock Exchange (AMEX), however, began to see if a “tradable mutual fund” could be created based on the increasing public interest in index mutual funds. What they discovered was that the legal structure of a mutual fund (discussed in Chapter 1) was not the best. So using another structure defined under the Investment Company of 1940, the AMEX launched the first tradable index fund shares based on the Standard & Poor’s 500 index in 1993. Widely referred to as “spiders” (an acronym based on the first letters in Standard and Poor’s Depositary Receipts, the proper name for this product), this security became the first exchange-traded fund (ETF) to be introduced in the United States, and it eventually became a direct challenge to traditional index funds, which are redeemable, not tradable. ETFs have become one of the most successful products introduced into the investment markets in recent years. There are broad-market ETFs, sector-specific ETFs, and country-specific ETFs. And many of the largest, traditional mutual fund companies such as Vanguard are creating ETF-versions of its most popular and successful index funds.

Today, the primary inflows to (and outflows from) traditional mutual funds are monies invested through company retirement plans—e.g., 401(k), profit-sharing, Simplified Employee Pension (SEP), defined benefit plans—and some private sector plans. Small investors and personal IRAs still represent a significant percentage of the monies invested.

Like any industry that’s growing quickly—much more quickly than regulators envisioned—the mutual fund industry has encountered some problems. One was portfolio drift. In trying to achieve higher returns, some investment managers would slowly begin buying securities for the fund’s portfolio that were not totally in keeping with the fund’s investment objective. To correct this problem, a rule was implemented in 2001, generally called the “Truth in Advertising” rule, which requires that a fund’s name and the securities bought into its portfolio must be in keeping with the fund’s stated investment objectives. This was designed to reduce confusion among investors.

During 2001, the number of mutual funds in the United States reached 8,305. This record number included 4,716 equity funds, 486 hybrid funds, 2,091 bond funds, and 1,015 money market mutual funds. Staggering amounts of money were flowing into funds. As the Dow Jones Industrial Average went above 14,000 in October 2007, few investors would have imagined that this represented a market top and that 2008 would be one of the worst bear markets in history. Mutual fund investors, along with investors in other securities, have seen trillions of dollars of value wiped away. Undoubtedly one of the most disturbing events of 2008 was when the Reserved Primary Money Market fund “broke the buck.” This means the market value of the assets in the money market account fell below $1 per share. Investors who had put money into this fund would get back less, but they did not know how much less. Because money market accounts were considered a totally safe place in which to hold cash while earning a low amount of interest, this incident caused a run on money market accounts. The U.S. government stepped in and temporarily insured all money market accounts in order to restore investor confidence.

As the losses deepened throughout 2008, mutual fund holders all across the United States debated whether to sell or continue to hold their funds. For those who continued to hold, the big question became—and remains—“Have the markets reach the bottom?” Many pundits and mutual fund portfolio managers saw this severe drop in the stock market in 2008 as one of the best buying opportunities to come along in decades. They reason that buying at these low levels could yield substantial gains when the markets recover. Certainly the market gains in 2009–2010 would support that point of view. Today, however, the markets remain quite volatile, with no clear direction in sight. Clearly such times require diligence and patience. Among all these investors, both individual and professional, an old adage still rings true: “Money always seeks the best return.” Getting Started in Mutual Funds, Second Edition, will, I hope, make your search for, analysis of, and decisions about which funds to invest your money in better informed and more successful—through all market conditions.

Chapter 1

Definition and Structure of a Mutual Fund

The concept underlying a mutual fund has probably existed since securities were created. In its simplest form, it works as follows. A group of individuals, with a similar investment objective or goal, place their investment monies into a common pool. These funds are then used to buy and sell securities. By pooling their money, the participants reap two primary benefits. The first benefit is diversification. The collective buying power of the group’s pooled resources enable it to purchase shares or bonds in a broader range of industries or business sectors than any individual in the pool could do on his or her own. The second benefit is lower transaction costs per participant. Because the commissions and other trading fees are spread over more shares and more investors, the cost per person is usually much lower than it would be if each individual had bought the same shares directly through a brokerage firm.

mutual fund

commonly used name for an open-end management company that establishes a portfolio of securities and then continually issues new shares and redeems already outstanding shares representing ownership in the portfolio.

Originally, one person, usually a contributor to the pool, was designated by power of attorney or other legal means to select which securities to buy and sell. Each person in the pool shared in the gains and losses on the investments. Their percentage of gains and losses was equal to their percentage of the participation in the pool.

investment objective

the strategy by which an investor wishes to increase the value of his or her assets.

bull market

a period during which the overall prices of securities are rising.

These loosely run and unregulated pools were especially popular in the United States during the bull market of the 1920s. In March 1924, Massachusetts Financial Services created the first true mutual fund in the United States. It was called the Massachusetts Investors Trust. Following the market crash of 1929, Congress passed legislation designed to give clearer structure to and better regulate the various type of investment pools (also called investment companies). The Investment Company Act of 1940 was the first U.S. law to define the different types of pools.

investment company

generic name for one of the many companies, like a mutual fund, whose primary business is investing and reinvesting in securities.

One of the types of investment companies defined in the Act is a management company. It is a corporation or trust whose primary business purpose is to invest and re-invest in securities in accordance with a stated investment objective. The securities that a management company’s professional advisor buys and sells are held in an investment portfolio. When an individual buys shares of a management company, he or she is, in reality, buying an undivided interest in the portfolio of securities created by the company.

When a management company is formed, it will have either a closed-end structure or an open-end structure. (See Figure 1.1.) The basic difference between the two forms is how frequently new shares are issued to the investing public. A closed-end management company creates an investment portfolio and then issues shares backed by that portfolio to the public only one time. Therefore, the number of shares outstanding, called the company’s capitalization, remains relatively fixed. (This is discussed in more detail at the end of this chapter.)

FIGURE 1.1Types of management companies.

An open-end management company also creates an investment portfolio and then issues shares to the public backed by that portfolio. In contrast, however, this company, continually issues new shares and buys back already outstanding shares each business day in direct response to investors’ orders to put more of their money into or pull money out of the underlying portfolio. The number of shares outstanding—its capitalization—changes continually. An open-end management company is the legal name for what is widely called a mutual fund.

Open-End Management Company (aka, Mutual Fund)

Each mutual fund is legally registered as a separate management company or trust with the Securities and Exchange Commission (SEC). The financial services company that creates a fund is called the sponsor. It invests its own money to start the fund’s portfolio. (The minimum dollar amount that the sponsor is required to invest is specified in the provisions of the Investment Company Act of 1940.) It also initially selects the fund’s portfolio manager. The sponsor then seeks to bring additional money into the portfolio by marketing it to the public. The more shares it sells, the more money it has to invest in stocks and/or bonds.

Investment Company Act of 1940

the federal legislation that defines the types of organizations that qualify as investment companies and requires them to register with the SEC.

open-end management company

legal name for a mutual fund under the Investment Company Act of 1940.

A mutual fund is called an “open-end” management company because it stands ready to issue new shares and redeem outstanding shares every business day. As individuals buy (i.e., invest more money in) a fund, it issues more shares to the purchasers. The fund’s portfolio manager then uses that money to purchase additional stocks and/or bonds into the portfolio. When investors sell (i.e., redeem or pull money out of) a fund, the total shares outstanding declines. If the number of redemptions is very high, then the fund’s portfolio manager may have to sell some of the stock and/or bonds out of the portfolio in order to pay the investors who have sold (i.e., redeemed) their mutual fund shares. Thus, the number of a mutual fund’s shares outstanding changes daily depending on the number of purchases or redemptions. Even when a mutual fund closes to new investors, those people who already have money invested in the fund can continue to buy and redeem that fund’s shares.

sponsor

the corporation or trust that creates a mutual fund or a family of mutual funds.

stock

a negotiable security representing ownership of a company and entitling its owner to the right to receive dividends.

Mutual fund shares do not trade on stock exchanges or in the over-the-counter market. In fact, the Financial Industry Regulatory Authority (FINRA) expressly prohibits trading these shares in these secondary markets. It is, therefore, inaccurate to describe mutual fund shares as tradable securities. Investors cannot buy and sell shares among themselves. Instead, mutual funds are redeemable securities. An investor can only buy shares from or redeem them with the fund itself or one of the fund’s authorized sales agents. Redeeming mutual fund shares is widely described as selling fund shares.

bond

a long-term debt security or IOU issued by a corporation, municipality, or government that promises to pay interest periodically and to repay the bond’s principal at maturity.

The emergence of mutual fund supermarkets, like those established by Charles Schwab & Co., OneSource, Fidelity Fund Network, E*Trade Mutual Funds Network. and others, has for some unknown reason caused some people to presume that they are actually trading mutual fund shares with other investors who have accounts at these companies. This belief is wrong. The supermarkets are authorized sales agents for many different mutual fund companies, in addition to selling their own. What many investors misconstrue as “trading” in the supermarket is nothing more than a purchase and a redemption, with the firm that runs the supermarket acting as an agent, directing the order to the specific mutual fund company. Again, there is no secondary market trading of mutual funds.

Structure of a Mutual Fund

Understanding the organization of a mutual fund and the responsibilities of each of its components makes clear two important features (See Figure 1.2):

1. The safeguards and separation of responsibilities designed to empower certain entities and individuals to act as watch dogs for the shareholders and thus protect their interests.

2. The various costs associated with its day-to-day operation, which are passed along to investors as fees and expenses.

FIGURE 1.2Structure of a typical mutual fund and the basic responsibilities of the various parties.

The first feature does not imply that investors’ shares are protected from market price fluctuations. Instead, it means that the fund’s assets are protected from potentially inappropriate and fraudulent activities by the sponsor or portfolio manager. The diagram below illustrates the various participants or entities involved in a mutual fund. Their specific responsibilities and duties are detailed afterward.

redemption

the sale of mutual fund shares back to the fund or its selling agents at the fund’s NAV.

Sponsor

A sponsor is a company—typically a financial services organization such as a brokerage firm, bank, insurance company, or mutual fund company—that creates and makes the first investment in a particular mutual fund or series of mutual funds. For each new fund, the sponsor must file a registration statement with the Securities and Exchange Commission (SEC) and with the appropriate authority in any state in which it plans to offer or sell the fund to the public. This registration document, which becomes the prospectus for the mutual fund, must contain full and fair disclosure about the fund’s sponsor, Board of Directors, investment objectives, types of investments permitted, expenses, fees, and risks.

secondary market

also called the aftermarket market, a collective term for the markets—exchange and OTC—in which securities trade after they are issued to the public.

mutual fund supermarket

a select group of mutual funds from many different sponsors that can be bought and sold through one brokerage at nominal transaction fees.

Registration does not mean or imply in any way that the SEC or a state authority has approved or endorsed the mutual fund. In fact, all mutual fund prospectuses must contain the following statement in:

Like all mutual fund shares, these securities have not been approved or disapproved by the Securities and Exchange Commission or any state securities commission, nor has the Securities and Exchange Commission or any state securities commission passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

Management Company

Each mutual fund is a separate open-end management company that the sponsor must register with the SEC when it is created. Janus Balanced Fund is an open-end management company. Vanguard’s Long Term Bond Index Fund is an open-end management company. And Fidelity Select Gold Fund is a management company.

agent

a registered person or business organization that acts as the intermediary in the purchase or sale of a security.

When a sponsor creates several mutual funds, it may choose to place them all under one umbrella or under different brand names. Such a grouping is called a family of funds. A family of funds may consist only of as few as three mutual funds—a stock fund, a bond fund, and a money market fund. Other companies (Fidelity, for example) create large fund families that include mutual funds that have different brand names (e.g., Fidelity Advisors, Fidelity Selects, Fidelity Spartan); invest in specific industries, specific countries, and specific combinations of securities; or have different investment approaches and different risk-to-reward characteristics.

prospectus

a printed summary of the SEC-filed registration statement that discloses the details of a particular mutual fund’s objective, historical performance, portfolio composition, and other information an investor can use to judge the merits of investing in the fund.

Usually the shareholder services and benefits provided by one fund are also provided by all funds in the same family. Mutual fund companies view this grouping of different management companies as a way of being able to capture a larger percentage of each customer’s investment dollars as, over time, individuals seek to diversify their holdings, or as their investment objects or economic circumstances change.

Board of Directors

The Board of Directors of a mutual fund is responsible for overseeing the day-to-day management of that fund as well as the trading activities of its portfolio manager or managers. Some of its specific responsibilities are: (1) deciding whether or not to renew the investment advisor’s annual contract, (2) voting on any changes in the fees the manager charges the fund, (3) monitoring the specific investments within the portfolio to avoid undue concentration in any one sector or company, (4) making sure the advisor’s investments comply with (and do not stray from) the fund’s stated investment objectives, and (5) monitoring the fees charged by the fund to ensure that they are fair and reasonable to the shareholders. The primary purpose of all of the Board’s responsibilities is to protect the interests of the fund’s shareholders.

family of funds

a group of mutual funds created by the same sponsor with different investment objectives or with portfolios of different securities.

The members of the Board are initially appointed by the fund’s sponsor. Afterwards, they are elected by the fund’s shareholders. Proxies are distributed annually and are used by shareholders to vote. To prevent the sponsor, who may have large amounts of money invested in the fund, from having undue influence over the Board, the Investment Company Act of 1940 mandates that although 60 percent of the Board can come from the sponsor, at least 40 percent must be independent directors (also unaffiliated or disinterested persons) that receive no compensation for either working for the fund or rendering services to the fund. These independent directors must also be individuals with no affiliation with the sponsor. In reality, the current percentages still give the sponsor a strong sway over the management. In many cases, the chairman of the Board of Directors is typically the same person who is the Chief Executive Officer (CEO) of the sponsor. Other Board members typically include individuals from the fund’s law firm, its accounting firm, and the trading firm that executes its buy and sell orders, and important business associates of the sponsor.

proxy

a form on which an investor votes. Shareholders can also vote via the Internet or phone.

Board members are paid fees for their services. (Importantly, this is not considered to be compensation.) The amounts are disclosed in the prospectus. It has become a widespread practice for individuals to serve on the boards of several funds, especially if those funds are sponsored by the same company. For example, if you compare the prospectuses for some of the large mutual fund groups, you will discover that many names appear again and again on the Boards of different funds.

Due to this overlap of directors, some shareholder activists and industry regulators have sought to make some changes in the board’s composition. They argue that the large percentage of non-independent directors results in their merely rubber stamping the portfolio manager’s activities, offering little oversight or expertise, failing to monitor expenses, and devoting less time than their fee warrants. Also activists (and regulators) question whether the non-independent board members, who already earn compensation working for a mutual fund or mutual fund company should also “double dip” by earning additional fees to serve as board members. Two important changes to a fund’s Board of Directors have been proposed. First, the required number of independent board members (currently set at 40 percent) should be increased. Since these members are appointed specifically to watch out for the interests of the fund’s shareholders, then the more of them on the board the greater the possibility that the shareholder’s point of view would have greater representation during any conflicts with the fund’s manager or sponsor. And second, there should be a review of member’s compensation to see if it is excessive, perhaps resulting in less careful oversight of the fees charged by the portfolio manager.

Many mutual funds already appoint a number of independent board members in excess of the percentage required under the Investment Company Act of 1940.

[Note: The government had proposed changing the composition of the Board of a mutual fund, increasing the number of disinterested members to 55 percent. This change was proposed in response to scandals that occurred in the late 1990s and early 2000s. However, one of the largest mutual fund companies in the United States was able to challenge the proposed rule change and effectively stop it from being enacted. Given the current climate for financial reform that’s focused on banks and brokerage firms, it seems unlikely that this rule change will be adopted for mutual funds. There are more important issues given the state of the U.S. economy. Nonetheless, increasing the number of unaffiliated, disinterested, or independent persons on a fund’s board is thought to be a reasonable way of providing greater oversight on behalf of the investing public.]

Investment Advisor/Investment Manager/Portfolio Manager/Fund Manager

When most people hear the term investment advisor or portfolio manager, they think of an individual who works directly for the sponsor or the fund itself. In reality, an advisor is generally a corporation that is a wholly owned subsidiary of the sponsor. Fidelity Funds, for example, is managed by Fidelity Management and Research (FMRCo), a subsidiary of Fidelity. Other mutual funds contract an outside investment advisory company, called an asset-managementfirm or a sub-investment advisor