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, while redemptions (share sales back to the fund) decrease outstanding shares.
This structure is unusual in the securities markets. Most issuers offer a fixed number of shares or units to the public in the primary market. After that, the security trades in the secondary market. The number of outstanding shares or units generally 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 every day.
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 purchases and redemptions occur in the primary market.
Investors in mutual funds are known as 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 stated investment strategy and goal, so investors can understand what the fund is designed to do. 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 the fund’s objectives. In this example, purchasing Fidelity Corporate Bond Fund shares means your investment is allocated to 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 raising initial capital and setting up 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 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 discuss more about this process in the primary market unit. For now, treat registration as filing required paperwork with the SEC and making disclosures to potential investors. Those disclosures are provided in the prospectus, which we’ll cover in detail later in this unit.
The sponsor also develops a marketing strategy for the fund. This may 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 many other sponsors). There’s typically a financial incentive to offer competitors’ funds: the selling firm often 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 oversees the fund’s overall direction. 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 current directors or voting in new members over time.
Investment adviser & fund manager
The fund sponsor must hire an investment adviser, the firm responsible for managing the fund’s investments. Often, the sponsor hires itself to serve as the investment adviser. The investment adviser then appoints one or more employees to act as the fund manager(s), who implement the fund’s strategy.
A real-world example helps clarify the structure. The Vanguard Diversified Equity Fund (ticker: FDEQX) lists Vanguard (The Vanguard Group, Inc.) as its investment adviser, with three Vanguard employees serving 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, so the job is complex. Fund managers typically have substantial finance experience and strong educational backgrounds. Larger funds often rely on teams of analysts (hired by the investment adviser) to support investment decisions.
The mutual fund industry is competitive, and fund managers may be replaced if performance is poor. A long tenure often indicates 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,” which is 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. One major benefit is professional management, especially for investors who don’t have the time or expertise to manage their own portfolios.
Mutual funds also provide instant diversification, since 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 different securities.
Diversification matters because it helps reduce capital risk by avoiding heavy concentration in just one or a few investments. Without diversification, a sharp decline in one security can significantly damage the value of the entire account. With diversification, losses in one holding 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 operate mutual funds for free. A fund can assess many different fees while you’re invested, but you typically won’t see them as separate line items.
Instead, a fund’s ongoing operating costs are bundled into a single measure called the expense ratio. If a fund has an expense ratio of 1%, its 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 retains part of the returns it earns. For example, the 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 usually 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. Funds may also pay 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 more of the fund’s performance is passed through to shareholders.
Mutual funds generally don’t mix with margin, which involves borrowing money to invest. A margin account allows investors to purchase securities with money borrowed from their broker (you’ll learn more about this in a future chapter). Due to securities regulations, investors cannot purchase primary market offerings on margin (this includes mutual funds).
Additionally, mutual funds cannot be sold short.
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