Mutual Funds

Let's say you and your poker buddies are sitting around the table one night and one of them says: "Hey, let's make some real dough.  Let's all throw some money onto the table and let Harry here buy a bunch of stocks for us.   We'll split up the gains or losses plus any dividends we get according to how much each of us has chipped in.  And we'll pay Harry a small fee for his trouble.  And to keep the feds off our backs let's set up a company to do it."  Voila--you have just put yourself and your friends into the mutual fund business.Let's examine more closely the components of a mutual fund, looking first at the most common type of fund called an "open-end" fund.  First of all it consists of money that a number of investors have put into one big pool.  Then that money gets invested according to an investment strategy that the fund has chosen.  Most commonly mutual funds hold a portfolio of common stocks, but there are funds that invest in corporate bonds, municipal bonds, commodities, and other types of securities.  A mutual fund is an investment security itself, and mutual fund investors own shares in the fund.  The investment goals and strategies are always spelled out in a prospectus, and there is a wide assortment for you to choose from.  Sector funds invest in health care, energy, transportation, and other segments of the economy.  Other funds focus on geographical areas: Asia, Africa,

A professional money manager, employed by the fund, gets to decide what securities to buy and sell.  Every day from the very start the fund will have unrealized gains and losses, and as time goes by it will actually realize gains and losses, and it will collect dividends and interest as well.  Every day a fund's "net asset value (NAV)" is calculated based on the current price at the end of the day of all of its positions.  In most funds the manager keeps trying to grow the fund's assets, so he reinvests gains and income.  Realized gains and losses, and income from interest and dividends, however, are taxable, and the tax consequences are passed on to the investor at the end of the fund's fiscal year.  On the other hand, investors can sell shares whenever they want--the price of a share is equal to the fund's NAV divided by the number of shares outstanding.

A "closed-end" fund works a bit differently.  Closed-end funds have been around since 1893, more than 30 years before the first open-end fund was created in the United States. However, closed-end funds are much less common today than open-end funds. There are fewer than 1,000 closed-end funds on the market, whereas there are around 8,000 mutual funds available.1

Closed-end funds are similar to mutual funds in that investors pool their money together to purchase a professionally managed portfolio of stocks and/or bonds. They also have dividends and capital gains that are distributed annually. In other ways, however, they are very different and actually have more in common with stocks.

Closed-end funds have an initial public offering (IPO) with a fixed number of shares to sell to investors. After that point, the investment company usually does not deal with the public directly, and any investors who want to purchase shares must do so on a secondary market, such as the New York Stock Exchange.  The market price of closed-end fund shares trading on a secondary market is determined by supply and demand, not by the shares’ net asset value (NAV). Although closed-end funds start with a NAV, the trading price may be higher or lower than that value. If the price is higher, shares are selling at a “premium.” If the price is lower, they are selling at a “discount.”

If you are considering investing in a closed-end fund, there are some things to be aware of. Closed-end funds have broker trading fees and are considered riskier than mutual funds. They can invest in a greater amount of illiquid securities and can use leveraging methods usually avoided by mutual funds. Because they are harder to sell, they are less liquid than mutual funds. Closed-end funds are generally not redeemable. The investment company does not have to buy back shares to fulfill investor demand.

How much investors pay for all this and when they pay it varies.  First there are "load" charges.  A “load” is a fee charged to an investor who buys or redeems shares in a mutual fund. It is similar to the commission that investors pay when they purchase a stock. There are two general types of sales loads. If a sales load is charged at the time of purchase, it is called a “front-end” sales load; if it is charged when shares are redeemed, it is a deferred or “back-end” sales load.” The most common type of back-end sales load is a “contingent deferred sales load” or CDSL. The amount will depend on how long an investor held the shares, and it could be nothing if they were held long enough.

Loads generally compensate brokers and/or salespeople for selling you a fund. For example, it might help compensate a financial professional who spends time with you at the beginning of your relationship, learning about your objectives and helping with your investment program. Brokers might also continually keep in touch with you and answer any questions you have. This communication can be particularly handy for busy people whose idea of investment tracking amounts to little more than an occasional call to their financial professionals.

Funds without load fees are called “no-load funds.” These funds are distributed directly by the investment company and therefore do not need to charge for the services of a broker.

In addition, all funds, even those with load charges, have management and expense fees. Management fees pay for the administration of the fund and are usually based on a percentage of the fund’s assets. There are also 12b-1 fees, or distribution fees, that compensate brokers and other sellers of mutual funds for advertising and marketing costs. These fees are typically a very small percentage of the fund’s assets, often less than a half percent.

So if there are 8,000 open-end funds and another 1,000 closed-end funds out there, how do you choose which one to invest in? There are basically three quantitative measures to consider.  The first is historical performance.  As the prospectus will clearly state, "past performance is no guarantee of future performance,"  but it is common sense that a fund manager with a proven track record will continue to perform.  One caution is that a swing from a bull market to a bear market can upset many fund managers.  Managers who have been cautious in strong markets may suddenly outshine their more aggressive brethren in a weak market.  Also, as you look through lists of funds and their performance, you may wonder how so many can do so well.  After all, not everyone can be of average.  The explanation is that fund companies typically shut down the poor performers so they no longer show up.

The second measure is the size of assets under management.  Some financial pros are wary of large funds because there may not be enough liquidity in the market for them to move quickly in and out of their large positions.  On the other hand, there is more money to be made managing large funds and small funds may not be able to attract the best managers.

The last measure is the size of the fees, commonly referred to in the industry as the "expense ratio."  Recall that there are potentially load charge (front-end or back-end), management fees and 12b-1 fees.  Different funds may have different fee structures. For example, funds that charge loads may have lower 12b-1 fees and administration fees, so when you are deciding which type of mutual fund to purchase, it is important to review all the costs and fees involved to see which funds will work best for your investment purposes.  The cheapest fund of course is not necessarily the best choice.  If a fund charges 2% but consistently produces 12% returns, it is much better than a fund with a 1% charge then only returns 8% on average.