History & Overview

In one form or another, mutual fund companies have existed in the United States since 1924 with the advent of the Massachusetts Investors Trust managed by Massachusetts Financial Services and later the formation of State Street Investment Corporation (mutual funds as investment vehicles predate these companies). In many ways, the general idea has remained the same ever since offer small investors, or savers, access to diversified portfolios as a low-risk means of growing financial wealth. Like other financial services vendors, these investment intermediaries match savers with borrowers and provide both parties with risk sharing, liquidity, and reduced information costs. By an Investment Company Institute estimate, mutual funds worldwide accounted for close to $27 trillion USD in investment dollars as of the end of 2012. The industry is significant, needless to say, and these investment vehicles are a lazy strategy favorite. Here we offer a primer on mutual fund companies and funds, complete with a summary of some key judgement metrics.

Most generally, these institutions utilize pooled investment funds from numerous customers to service and grow diversified portfolios of securities, from stocks to bonds to commercial paper to treasuries. These portfolios can be industry or sector specific, index-based, or location-oriented, and can be geared towards long or short-term holding periods. For instance, one fund may hold long-term tax-exempt New Jersey municipal bonds, another may focus on shares of mining and precious-metals firms, and yet another may be composed of shares of companies listed on the S&P 500.

In return for investing your savings, you receive shares in mutual funds of your choice. Purchasing shares can be mechanically quite similar to buying shares in a publicly traded company you can research the funds using ticker symbols, you can scan their performance and holdings (among other bits of information), and, in many cases, you can purchase them through the same brokers you use to purchase stocks. Or, you can purchase them directly from the mutual fund companies themselves. However, it should be noted that mutual fund shares are not traded on the same exchanges as publicly-traded stocks, although their ETF counterparts are. Additionally, there is usually a minimum investment required (often $3,000 for Vanguard funds).

Mutual fund companies can reduce your risk as an investor through portfolio diversification. They provide liquidity through your ability to quickly and easily sell your fund shares or, as is the case with many money market mutual funds, even write checks against your holdings. You save on information costs by leaving the information gathering and investment research to the company managing the fund in question. Through diversified portfolio holdings, mutual fund companies also reduce your transaction costs, not just risk and information costs, as it is much more economical to buy into a mutual fund than it would be to attempt to acquire all of a funds holdings piece by piece on your own. Whats more, mutual funds offer you exposure to investments that may have been previously unavailable to you.

The reality that mutual fund companies match savers and borrowers is especially clear when it comes to money market mutual funds. Such funds hold short-term investments, like treasuries and commercial paper, providing you, the saver, with the aforementioned benefits and providing borrowers, such as corporations and local and federal governments, with funds for their operations. Other clear-cut examples include municipal bond funds where savers invest in the debt of municipalities.

Mutual Fund Structures

When discussing mutual funds, we must distinguish between closed- and open-end, and load and no-load funds. Whereas closed-end mutual fund shares are not redeemable, or cannot be sold back to the fund but are traded in over-the-counter (OTC) markets, open-end fund shares are redeemable and allow you to sell them back to the fund, or redeem them. Thus, the value of closed-end fund shares depends not only on the value of the underlying assets, be they stocks or bonds or other securities, but also on how easily traded, or how liquid, those fund shares are and how well-managed the fund is itself. In these ways, closed-end fund shares more closely resemble common stock than open-end fund shares do, which derive their value from the assets they are based on, but also resemble bonds in that they can be sold at a premium or at a discount, because again their value depends on more than just the underlying assets. Mutual fund shares are priced according to their net asset value (NAV), or the value of the underlying assets, plus any charges, such as fees.

Then there is the load, no-load distinction, which can be summarized as the difference between a fund that charges you commissions on transactions and one that instead charges you fees. Examples of the latter include management fees and, in some cases, advertising fees passed on to you by the fund.

Risks

Just as the financial system poses risks to you, mutual funds face financial risks as well. Ironically, one risk stems from a previously mentioned benefit to you – liquidity. The ease with which you can redeem your mutual fund shares may actually pose a risk to the mutual fund itself, especially if you and other investors collectively lose confidence in the markets or if you as a group fall upon hard times requiring you to withdraw funds to cover expenses. We saw this occur in 2008 – low investor confidence drove many to redeem their mutual fund shares rather than risk further investment losses. Too many customers attempting to redeem shares at one time can have a similar effect to a run on a bank, potentially leaving the mutual fund at least temporarily unable to satisfy customer redemptions.

Financial turmoil, as we experienced then, can pose risks to mutual funds in other ways. Take the bankruptcy of Lehman Brothers, for example. When Lehman went belly-up, more than one money market fund that was holding Lehman debt securities had to take a loss on the securities and “broke-the-buck,” meaning the net asset value (NAV) of each share fell below $1, which is the minimum at which an investor is supposed to be able to redeem shares. As the financial crisis continued, many customers preferred cash to investments, meaning that mutual funds actually saw negative growth for a term. The second quarter of 2008, for instance, saw a negative $156.2 billion in net share issues of money market mutual funds.

In times of financial distress, moreover, mutual fund managers may be faced with fewer choices when it comes to worthwhile investments, threatening the diversity of portfolios and exposing mutual funds to even more risk. Then, there is the ever-present risk posed by poor management. In good or bad times, poor management can hurt a mutual fund’s returns and reputation.

Regulation

Mutual funds have been under the regulatory umbrella of the SEC since the passage of the Investment Company Act of 1940, which lays out how a mutual fund may advertise itself, where it may do business, how it is to be structured, and what details it must disclose about itself to investors, among other things. The SECs Division of Investment Management oversees the regulation of investment institutions like mutual fund companies. Historically, the market crash of 1929 served as the catalyst for regulation of the investment industry, including mutual funds. The financial crisis of 2008 saw the SEC vote in favor of expanding its regulatory requirements of mutual funds.

Some Key Judgement Metrics

Expense Ratio: This metric captures how costly it is for you to own shares of a particular mutual fund. It is the percentage of assets held by the fund in question that is lost to operating expenses. Remember that costs of ownership will eat into any returns earned. Seek a fund with a low expense ratio.

Turnover Ratio: The frequency with which a fund turns over its investments, or how often it trades. It’s measured as the percentage of a fund’s purchases or sales (the smaller of the two) against the average market value of the fund’s long-term investments. The higher the turnover, most likely the greater the expense ratio since trading costs money and those costs get passed on to you, hurting your returns. Plus, passive strategies tend to beat active ones over time. Seek a fund with lower turnover.

NAV (Net Asset Value): The market value of the funds underlying assets minus its liabilities, often presented on a per-share basis.

Fund Lifespan: A fund that has been around a long time is more tried and true than one born yesterday. You dont want to get caught up in an investment fad. Plus, a longer lifespan means the availability of more performance data. While historical returns never indicate future results, ever, fund performance data can prove helpful in understanding how certain investments have weathered storms, for instance, and in conjunction with other data points, can help to prove the benefits of diversification among other things.

Management Tenure: High management turnover is generally not a good sign under any circumstances in any industry. Avoid funds that seem to have a new captain every year. Otherwise, you may find yourself the investor in a fund with an unclear and inconsistent investment strategy or a fund that is in trouble for other reasons.