On May 28th, 2024, settlement for regular-way trades will be shortened from T+2 to T+1. If you already studied the T+2 timeline, don't worry! The logic is the same; the correct answer will just be one business day sooner. We will update our materials to reflect the updated T+1 timeline on May 27th.
Open-end management companies, known popularly as mutual funds, provide investors access to professionally managed portfolios (a.k.a. pools or funds). ‘Open-end’ refers to the number of outstanding shares this type of management company maintains. Every new purchase of a mutual fund involves the creation of shares, while every redemption (sale) of a mutual fund involves destroying shares. For example, assume ABC Mutual Fund has 1,000,000 shares outstanding at the beginning of the day. If an investor purchases one new share of ABC Mutual Fund, the outstanding shares increase to 1,000,001. On the other hand, if an investor owning ABC Mutual Fund shares decides to redeem one of them, the outstanding shares decrease to 999,999. Bottom line - new purchases increase outstanding shares while redemptions (share sales) decrease outstanding shares.
This structure is unique in the world of securities. Issuers usually offer a fixed number of shares or units to the investing public in the primary market. After this, the security trades in the secondary market. The number of outstanding shares or units stays fixed indefinitely 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 changes daily.
All new purchases of mutual fund shares are considered primary market transactions (like initial public offerings). The parties in any given transaction determine whether a security is traded in the primary or secondary market. When an issuer sells a security directly to investors, it’s a primary market transaction. When any party other than the issuer sells a security, it’s a secondary market transaction (e.g., an investor selling shares of stock to another investor in the market). Mutual funds always involve the issuer, so mutual fund transactions occur in the primary market.
Investors in mutual funds are known as shareholders. It is a similar investment structure to common stockholders, as investors are considered owners and are granted specific rights. In particular, shareholders maintain the right to receive dividends* and voting rights over important issues (detailed later in this unit).
*Similar to equity (common and preferred stock) securities, the Board of Directors approves dividend payments.
Each mutual fund contains a unique investment strategy and goal, so investors know what they’re getting into when they 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 (when buying shares), it is invested according to its objectives. For example, an investor purchasing Fidelity Corporate Bond Fund shares would have their money directly invested into corporate bonds within the fund’s portfolio.
Mutual fund parties
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)
Board of Directors
Investment adviser & fund manager
Custodian bank
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 requires 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 appropriate documents to create the fund (similar to creating 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, assume registration involves filing paperwork with the SEC and making numerous disclosures to potential investors. Those disclosures are provided to investors in the prospectus, a document we’ll cover in detail later in this unit.
The sponsor will then develop a marketing strategy for the fund. The strategy may involve adding the fund to an already-established network (e.g., making the fund available on Charles Schwab’s platform) or creating a new network of funds (e.g., 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 of other companies. For example, a customer of Fidelity can invest in Fidelity funds and Schwab or Vanguard funds (or the funds of hundreds of other sponsors). Of course, there’s a financial incentive for these companies to offer funds of their competitors. In particular, the selling company typically earns a sales charge. For example, Fidelity charges its customers $75 to purchase shares of Vanguard mutual funds (as of June 2023).
Board of Directors (BOD)
A mutual fund’s BOD plays a very similar role to the BOD of corporations with outstanding stock. They represent shareholder interests, approve dividend payments, and are responsible for the fund’s overall success. Depending on how the fund sponsor sets the fund structure, the sponsor may initially appoint the BOD, or vice versa (either way, it’s not a critical test point). Once the BOD is set, it’s the responsibility of the shareholders to approve their standing or vote in new members as time goes on.
Investment adviser & fund manager
The fund sponsor must hire an investment adviser, a company responsible for the investments in the fund. Often, the sponsor hires itself to act as the investment adviser. From there, the investment adviser appoints an employee or employees to serve as the fund manager(s), the person in charge of implementing the fund’s strategy. While this may seem confusing, let’s discuss a real world example. The Vanguard Diversified Equity Fund (ticker: FDEQX) maintains 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. Although they choose which securities to invest in, they must invest within the fund’s parameters. For example, a municipal bond fund manager would invest shareholder assets in municipal bonds.
Many mutual funds contain hundreds of millions or billions in shareholder assets, and managing these large sums is challenging. Therefore, fund managers typically have years of finance experience and stellar educational backgrounds. For larger funds, fund managers utilize teams of analysts hired by the investment adviser to help them make investment decisions.
The mutual fund industry is very competitive, and it’s common for a fund manager to be fired if their strategies do not perform well. Conversely, a fund manager with a long tenure typically means they’ve found great 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,” which is incredibly difficult to do over long periods. In fact, only 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.
Shareholder benefits
Mutual funds provide several benefits to their shareholders. Professional management is a significant benefit, especially to investors lacking market knowledge or the time to spend investing their own money. Mutual funds also provide instant diversification to their investors as most funds contain dozens or hundreds of different investments within their portfolio. For example, the Fidelity Contrafund holds over 300 securities in its portfolio. When a single share of a mutual fund is purchased, the investor gains a small amount of ownership in numerous securities.
Diversification is essential for many investors to succeed, which involves investing in many different securities instead of just one or a few. Investors with money concentrated in one or a few investments are subject to considerable capital risk. Without diversification, if one security falls drastically in value, the investor’s entire account goes with it. With diversification, losses from one investment can be offset by the success of other securities in the portfolio. As we learned in a previous chapter, diversification directly reduces an investor’s exposure to non-systematic risk.
Expense ratio
Fund sponsors and managers don’t create and run mutual funds for free. Plenty of fees can be assessed while invested in the fund. However, investors typically don’t notice them.
A fund’s operational expenses are wrapped up into one representative cost - the expense ratio. If a fund maintains an expense ratio of 1%, its total fees are equivalent to 1% of the fund’s assets. A fund with $100 million of assets and a 1% expense ratio collects $1 million in annual operational expenses. To pay for its operations, the fund will withhold part of the returns it makes for its customers. 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 their services. The custodian fee is paid to the institution maintaining custody of the fund’s assets. There are also legal and administrative fees that pay for legal services and other general costs like record keeping.
Mutual fund investors prefer lower expense ratios, as a fund’s expenses cut into shareholder returns. The lower the ratio, the more efficient a fund is with its money and the more attractive it is to investors.
Limitations
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 (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).
