Open-end management companies, commonly called mutual funds, give investors access to professionally managed portfolios (also called pools or funds). The term open-end describes how many shares the fund has outstanding.
For example, assume ABC Mutual Fund has 1,000,000 shares outstanding at the beginning of the day.
Bottom line: purchases increase outstanding shares, and redemptions decrease outstanding shares.
This structure is unusual in the securities world. Most issuers offer a fixed number of shares or units to the investing public in the primary market (where securities are sold for the first time). After that, the security trades in the secondary market (where investors trade securities after the primary market offering). The number of outstanding shares or units typically stays fixed unless the issuer sells more shares in an additional public offering (APO) or buys back its securities in the open market. With mutual funds, the number of outstanding shares can change daily.
All new purchases of mutual fund shares are considered primary market transactions (similar to initial public offerings). Whether a trade is primary or secondary depends on who is selling:
Mutual fund transactions always involve the issuer (the fund), so mutual fund transactions occur in the primary market.
Investors in mutual funds are called shareholders. This is similar to common stockholders: shareholders are owners and receive specific rights. In particular, shareholders have the right to receive dividends* and voting rights on important issues (covered later in this unit).
*Similar to equity (common and preferred stock) securities, the Board of Directors approves dividend payments.
Each mutual fund follows a specific investment strategy and goal, so you can see what the fund intends to do before you invest. For example, the Fidelity Corporate Bond Fund (ticker: FCBFX) invests in longer-term corporate debt securities. Once an investor’s money is placed in a mutual fund (by buying shares), it’s invested according to the fund’s objectives. So, an investor purchasing Fidelity Corporate Bond Fund shares would have their money invested in the corporate bonds held in the fund’s portfolio.
Various parties must fulfill roles and responsibilities for a mutual fund to function as intended. We’ll discuss the following in this section:
Fund sponsor (underwriter)
The fund sponsor (sometimes called the fund underwriter) is responsible for establishing the fund, registering it, and creating a marketing strategy.
Establishing the fund includes gathering initial capital (money) and setting the investment company’s structure. Regulations require at least $100,000 of net capital to assemble an open-end investment company. Once the money is in place, the sponsor files the appropriate documents to create the fund (similar to forming a new business).
Once the fund is officially created, it must be registered with the Securities and Exchange Commission (SEC) before being offered to the public. We’ll discuss more about this process in the primary market unit. For now, treat registration as filing paperwork with the SEC and making required disclosures to potential investors. Those disclosures are provided in the prospectus, which we’ll cover in detail later in this unit.
The sponsor then develops a marketing strategy for the fund. This may involve adding the fund to an existing distribution network (for example, making the fund available on Charles Schwab’s platform) or creating a new network of funds (for example, building a new business to compete with companies like Schwab).
Companies like Charles Schwab, Fidelity, and Vanguard (which sponsor their own funds) also offer customers mutual funds from other sponsors. For example, a Fidelity customer can invest in Fidelity funds and Schwab or Vanguard funds (or funds from hundreds of other sponsors). There’s a financial incentive for these companies to offer competitors’ funds: the selling company typically earns a sales charge. For example, Fidelity charges its customers $75 to purchase shares of Vanguard mutual funds (as of April 2023).
Board of Directors (BOD)
A mutual fund’s BOD plays a role similar to the BOD of corporations with outstanding stock. The BOD represents shareholder interests, approves dividend payments, and is responsible for the fund’s overall success. Depending on how the sponsor sets up the fund, the sponsor may initially appoint the BOD, or the BOD may appoint the sponsor (either way, it’s not a critical test point). Once the BOD is in place, shareholders are responsible for approving the directors’ continued service or voting in new members over time.
Investment adviser & fund manager
The fund sponsor must hire an investment adviser, the company responsible for managing the fund’s investments. Often, the sponsor hires itself to act as the investment adviser. The investment adviser then appoints one or more employees to serve as the fund manager(s) - the person (or people) responsible for implementing the fund’s strategy.
A real-world example helps clarify the roles. The Vanguard Diversified Equity Fund (ticker: FDEQX) lists Vanguard (The Vanguard Group, Inc.) as its investment adviser, and three Vanguard employees serve as co-fund managers (Aurélie Denis, Walter Nejman, and Michael R. Roach).
Fund managers invest shareholder assets according to the fund’s investment objective. They choose which securities to buy and sell, but they must stay within the fund’s stated parameters. For example, a municipal bond fund manager would invest shareholder assets in municipal bonds.
Many mutual funds manage hundreds of millions or billions of dollars, which makes the job demanding. Fund managers typically have years of finance experience and strong educational backgrounds. In larger funds, fund managers also rely on teams of analysts (hired by the investment adviser) to support investment decisions.
The mutual fund industry is competitive, and it’s common for a fund manager to be replaced if performance is poor. Conversely, a long-tenured fund manager often indicates sustained success managing shareholder money. For example, Will Danoff has managed the Fidelity Contrafund for well over 30 years. His average return is over 12%, which exceeds the average annual return of the S&P 500 by greater than 2%. This is known as “beating the market,” and it’s difficult to do consistently over long periods. In fact, roughly 20% of fund managers like Will Danoff outperform the market over a five year period.
Custodian bank
The custodian bank (sometimes called the mutual fund custodian) is responsible for holding, safekeeping, and recordkeeping the fund’s assets. This role is typically filled by large banks like JPMorgan Chase, BNY Mellon, and US Bank.
Mutual funds provide several benefits to their shareholders. Professional management is a major benefit, especially for investors who don’t have market knowledge or time to manage their own investments.
Mutual funds also provide instant diversification because most funds hold dozens or hundreds of different investments. For example, the Fidelity Contrafund holds over 300 securities in its portfolio. When you purchase a single share of a mutual fund, you gain a small ownership interest in many securities.
Diversification matters because it spreads your money across many investments instead of concentrating it in one or a few. Investors who concentrate their money in a small number of investments face significant capital risk. Without diversification, if one security drops sharply in value, the investor’s entire account can drop with it. With diversification, losses in one investment may be offset by gains in others. As we learned in a previous chapter, diversification directly reduces exposure to non-systematic risk.
Fund sponsors and managers don’t create and run mutual funds for free. A fund can assess many fees while you’re invested, but investors often don’t see these charges directly.
A fund’s operating expenses are bundled into one representative cost: the expense ratio. If a fund has an expense ratio of 1%, its total fees are equal to 1% of the fund’s assets. For example, a fund with $100 million of assets and a 1% expense ratio collects $1 million per year in operating expenses. To cover these costs, the fund withholds part of the returns it earns. For example, a fund may liquidate a position for $5 million and hold back $1 million to pay for its operations.
There are several components of the expense ratio. The largest and most prominent is the management fee, paid to the investment adviser for its services. The custodian fee is paid to the institution that holds the fund’s assets. There are also legal and administrative fees that cover legal services and general costs like recordkeeping.
Mutual fund investors generally prefer lower expense ratios because expenses reduce shareholder returns. The lower the ratio, the more efficient the fund is with its money and the more attractive it tends to be to investors.
Mutual funds generally do not mix with margin, which involves borrowing money to invest. A margin account allows investors to purchase securities with money borrowed from their broker. Due to securities regulations, investors cannot purchase primary market offerings on margin (this includes mutual funds).
Additionally, mutual funds cannot be sold short*.
*A short sale involves the sale of borrowed securities, typically as a means of betting against that security.
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