A mutual fund is a type of professionally-managed collective investment scheme that pools money from many investors. While there is no legal definition of mutual fund, the term is most commonly applied only to those collective investment schemes that are regulated, available to the general public and open-ended in nature. Hedge funds are not considered a type of mutual fund.
The term mutual fund is less widely used outside of the United States. For collective investment schemes outside of the United States, see articles on specific types of funds including open-ended investment companies, SICAVs, unitized insurance funds, unit trusts and Undertakings for Collective Investment in Transferable Securities.
In the United States, mutual funds must be registered with the Securities and Exchange Commission, overseen by a board of directors or board of trustees and managed by a registered investment advisor. They are not taxed on their income if they comply with certain requirements.
Mutual funds have both advantages and disadvantages compared to direct investing in individual securities. They have a long history in the United States. Today they play an important role in household finances.
There are 3 types of U.S. mutual funds:
- unit investment trust
The most common type, the open-end mutual fund, must be willing to buy back its shares from its investors at the end of every business day. Exchange-traded funds are open-end funds or unit investment trusts that trade on an exchange. Open-end funds are most common, but exchange-traded funds have been gaining in popularity.
Mutual funds are classified by their principal investments. The four largest categories of funds are money market funds, bond or fixed income funds, stock or equity funds and hybrid funds. Funds may also be categorized as index or actively-managed.
Investors in a mutual fund pay the fund’s expenses. There is controversy about the level of these expenses. A single mutual fund may give investors a choice of different combinations of expenses by offering several different types of share classes.
Advantages and Disadvantages
Mutual funds have advantages compared to direct investing in individual securities.These include:
- Increased diversification
- Daily liquidity
- Professional investment management
- Ability to participate in investments that may be available only to larger investors
- Service and convenience
- Government oversight
- Ease of comparison
Mutual funds have disadvantages as well, which include:
- Less control over timing of recognition of gains
- Less predictable income
- No opportunity to customize
The Investment Company Act of 1940 established three types of registered management investment companies in the United States: open-end funds, unit investment trusts (UITs); and closed-end funds. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange; they have gained in popularity recently. While the term "mutual fund" may refer to all three types of registered investment companies, it is more commonly used to refer exclusively to the open-end type.
Open-end mutual funds must be willing to buy back their shares from their investors at the end of every business day at the net asset value computed that day. Most open-end funds also sell shares to the public every business day; these shares are also priced at net asset value. A professional investment manager oversees the portfolio, buying and selling securities as appropriate. The total investment in the fund will vary based on share purchases, share redemptions and fluctuation in market valuation. There is no legal limit on the number of shares that can be issued.
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 no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.
Advertise Here Contact us
Advertise Here Contact us
A relatively recent innovation, the exchange-traded fund or ETF is often structured as an open-end investment company, though ETFs may also be structured as unit investment trusts, partnerships, investments trust, grantor trusts or bonds (as an exchange-traded note). ETFs combine characteristics of both closed-end funds and open-end funds. Like closed-end funds, ETFs are traded throughout the day on a stock exchange at a price determined by the market. However, as with open-end funds, investors normally receive a price that is close to net asset value. To keep the market price close to net asset value, ETFs issue and redeem large blocks of their shares with institutional investors.
Mutual Funds classification
Mutual funds are classified by their principal investments. The four largest 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 SEC requires that mutual fund names not be inconsistent with a fund's investments. For example, the "ABC New Jersey Tax-Exempt Bond Fund" would generally have to invest, under normal circumstances, at least 80% of its assets in bonds that are exempt from federal income tax, from the alternative minimum tax and from taxes in the state of New Jersey.
Money market 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 government insured, unlike bank savings accounts.
Bond funds invest in fixed income securities. Bond funds can be subclassified according to the specific types of bonds owned (such as high-yield or junk bonds, investment-grade corporate bonds, government bonds or municipal bonds) or by the maturity of the bonds held (short-, intermediate- or long-term).
Stock or equity funds
Stock or equity funds invest in common stocks. Stock funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds). They may focus on a specific industry or sector.
Market capitalization or market cap indicates the size of the companies in which a fund invests, based on the value of the company's stock. Each company's market capitalization equals the number of shares outstanding times the market price of the stock. Market capitalizations are typically divided into the following categories:
- Micro cap
- Small cap
- Mid cap
- Large cap
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.
Advertise Here Contact us
Advertise Here Contact us
Investors in a mutual fund pay the fund's expenses. These expenses fall into four categories: distribution charges operating expenses shareholder transaction fees and securities transaction fees. Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value. Operating expenses are included in a fund's operating expense ratio, or simply the "expense ratio".
Distribution charges pay for marketing, distribution of the fund's shares as well as services to investors.
A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested.
Some funds have a back-end load, which is paid by the investor when shares are redeemed depending on how long they are held. The back-end loads may decline the longer the investor holds shares.
A no-load fund does not charge a front-end load under any circumstances, does not charge a back-end load under any circumstances and does not charge a fee greater than 0.25% of fund assets.
Operating Expenses, Expense Ratio, Expense Limitations or Caps
Like any business, funds incur ordinary recurring costs of operating the fund. With most "actively managed" funds (the adviser actively makes investment decisions based on a strategy and other disciplines as opposed to simply following or benchmarking an index), the single largest operating expense of a the fund is the Management or Investment Advisory fee.
Annual operating expenses divided by average daily net assets for the same period of time is equal to the Operating Expense Ratio, or simply the expense ratio. The expense ratio highlights how much fund expenses come out of a shareholder's investment return and allows comparison from one fund to the next. Other fees and charges dilute returns but they are not included in the expense ratio.
The management fee is paid to the fund manager or sponsor who organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand name to the fund.
A mutual fund pays expenses and taxes related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. Securities transaction fees increase the cost basis of the investments.
Also check our Recommend Books list