Open-end management companies, commonly called mutual funds, give investors access to professionally managed portfolios (also called pools or funds). The term open-end refers to the number of outstanding shares the fund maintains.
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 public in the primary market. After that, the security trades among investors in the secondary market. The number of outstanding shares typically stays fixed unless the issuer:
With mutual funds, the number of outstanding shares can change daily.
All new purchases of mutual fund shares are primary market transactions (similar to initial public offerings). Whether a trade is “primary” or “secondary” depends on who the parties are:
Mutual fund transactions always involve the issuer (the fund), so mutual fund purchases and redemptions 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 to vote on important issues (covered later in this unit).
*As with 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. When you buy shares of a mutual fund, your money is invested according to that fund’s stated objectives. In this example, buying Fidelity Corporate Bond Fund shares means your money is invested in the corporate bonds held in the fund’s portfolio.
Various parties must carry out specific roles for a mutual fund to operate as intended. We’ll discuss the following in this section:
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 up the investment company’s structure. Regulations require at least $100,000 of net capital to form an open-end investment company. Once the money is in place, the sponsor files the documents needed to create the fund (similar to forming a new business).
After the fund is created, it must be registered with the Securities and Exchange Commission (SEC) before it can be offered to the public. We’ll cover this process in more detail in a future chapter. For now, treat registration as filing paperwork with the SEC and making required disclosures to investors. Those disclosures appear in the prospectus, which we’ll cover later in this unit.
The sponsor also develops a marketing strategy for the fund. This might include:
Companies like Charles Schwab, Fidelity, and Vanguard sponsor their own funds, but they 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 typically a financial incentive for a firm to sell funds sponsored by other companies. In particular, the selling firm often earns a sales charge. For example, Fidelity charges its customers $75 to purchase shares of Vanguard mutual funds (as of June 2023).
A mutual fund’s BOD plays a similar role 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). After the BOD is in place, shareholders are responsible for approving the directors or voting in new members over time.
The fund sponsor must hire an investment adviser, the firm 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 fund manager is 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 specific securities, 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, and investing sums of that size is complex. As a result, fund managers typically have significant finance experience and strong educational backgrounds. Larger funds often rely on teams of analysts (employed by the investment adviser) to support investment decisions.
The mutual fund industry is competitive, and fund managers may be replaced if performance is poor. On the other hand, a long-tenured fund manager often signals sustained success managing shareholder assets. 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, only 20% of fund managers like Will Danoff outperform the market over a five-year period.
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 offer several benefits to shareholders.
A major benefit is professional management, which is especially useful for investors who don’t have the time or expertise to manage their own portfolios.
Mutual funds also provide instant diversification because most funds hold dozens or hundreds of investments. For example, the Fidelity Contrafund holds over 300 securities in its portfolio. When you buy a single share of a mutual fund, you gain a small ownership interest across many securities.
Diversification matters because it helps manage capital risk. If your money is concentrated in one or a few investments, a sharp decline in a single security can significantly damage your overall account value. With diversification, losses in one holding may be offset by gains in others.
As we learned in a previous chapter, diversification reduces exposure to non-systematic risk.
Fund sponsors and managers don’t operate mutual funds for free. Funds can charge a variety of fees, but investors often don’t see them directly.
A fund’s operating costs are bundled into a single figure called the expense ratio. If a fund has an expense ratio of 1%, its total annual operating expenses are equal to 1% of the fund’s assets.
For example, a fund with $100 million in assets and a 1% expense ratio collects $1 million per year in operating expenses. To cover these costs, the fund keeps a portion of the returns it earns. For instance, the fund might liquidate a position for $5 million and retain $1 million to pay operating expenses.
The expense ratio has several components. The largest and most prominent is usually the management fee, paid to the investment adviser. The custodian fee is paid to the institution that holds the fund’s assets. Funds may also charge legal and administrative fees for legal services and general operating costs like recordkeeping.
Mutual fund investors generally prefer lower expense ratios because expenses reduce shareholder returns. All else equal, a lower expense ratio means the fund is operating more efficiently and may be more attractive to investors.
Mutual funds generally don’t mix with margin, which involves borrowing money to invest. A margin account allows investors to purchase securities using money borrowed from their broker (covered in a future chapter). Due to securities regulations, investors can’t purchase primary market offerings on margin (and this includes mutual funds).
Additionally, mutual funds can’t be sold short*.
**Selling short involves the sale of a borrowed security in an effort to bet against that security. We’ll learn more about this type of investment strategy in a future chapter.
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