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 (share sales back to the fund) 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. After that, the security trades in the secondary market. The number of outstanding shares or units 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 considered 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 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 you can see what the fund is designed 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. For example, 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 operate 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 cover 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 include:
Companies like Charles Schwab, Fidelity, and Vanguard sponsor their own funds, but they also offer customers mutual funds from other companies. For example, a customer of Fidelity can invest in Fidelity funds and Schwab or Vanguard funds (or funds from hundreds of other sponsors).
There’s typically a financial incentive to offer competitors’ funds. In particular, the selling company often 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 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 be involved in appointing roles connected to 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, 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 in shareholder assets, and managing sums of that size is complex. As a result, fund managers typically have years of 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 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,” which is 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.
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 shareholders.
One major benefit is professional management, especially for investors who don’t have the market knowledge (or time) to manage their own portfolios.
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 is essential for many investors because it spreads money across many securities instead of concentrating it in just one or a few. Investors who concentrate money in a small number of investments take on substantial capital risk. Without diversification, if one security drops sharply in value, the investor’s entire account can be heavily impacted. 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 create and run mutual funds for free. A fund can charge a variety of fees while you’re invested, but you typically won’t see them as separate line items.
A fund’s operational expenses are bundled into one representative cost: the expense ratio. If a fund has an expense ratio of 1%, its total annual operating 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 shareholders. 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 usually the management fee, paid to the investment adviser for its services. The custodian fee is paid to the institution that maintains custody of the fund’s assets. Funds may also charge legal and administrative fees for 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 can’t be purchased using 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 can’t purchase primary market offerings on margin (and this includes mutual funds).
Additionally, mutual funds can’t be sold short.
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