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ABOUT THIS BOOK

SECTION ONE:
Overview of Registered Investment Companies

SECTION TWO:
Recent Mutual Fund Trends

SECTION THREE:
Mutual Fund Fees and Expenses

SECTION FOUR:
Who Owns Mutual Funds?

SECTION FIVE:
Mutual Funds in the Retirement and Education Savings Markets

SECTION SIX:
Where Investors Purchase Fund Shares

DATA TABLES

APPENDIX A:
Funds and Taxation

APPENDIX B:
How Funds Operate

GLOSSARY

The U.S. mutual fund, introduced more than 80 years ago, has made securities market investing accessible and convenient for greater numbers of Americans. This section provides an overview of how funds operate and discusses the features that have made fund investing popular among investors. It includes:

• a brief history of the mutual fund concept;
• a look at the different types of investment companies;
• how funds are organized and created;
• the various entities that make fund investing possible; and
• the main benefits of fund investing.

The Origins of Fund Investing

A mutual fund is a type of investment company that gathers assets from investors and collectively invests those assets in stocks, bonds, or money market instruments. The investment company concept dates to Europe in the late 1700s, according to K. Geert Rouwenhorst in The Origins of Mutual Funds, when “a Dutch merchant and broker … invited subscriptions from investors to form a trust … to provide an opportunity to diversify for small investors with limited means.”

The emergence of “investment pooling” in England in the 1800s brought the concept closer to U.S. shores. The enactment of two British laws, the Joint Stock Companies Acts of 1862 and 1867, permitted investors to share in the profits of an investment enterprise, and limited investor liability to the amount of investment capital devoted to the enterprise. Shortly thereafter, in 1868, the Foreign and Colonial Government Trust formed in London. This trust resembled the U.S. fund model in basic structure, providing “the investor of moderate means the same advantages as the large capitalists … by spreading the investment over a number of different stocks.”

Perhaps more importantly, the British fund model established a direct link with U.S. securities markets, helping finance the development of the post-Civil War U.S. economy. The Scottish American Investment Trust, formed on February 1, 1873 by fund pioneer Robert Fleming, invested in the economic potential of the United States, chiefly through American railroad bonds. Many other trusts followed that not only targeted investment in America, but led to the introduction of the fund investing concept on U.S. shores in the late 1800s and early 1900s.

The First “Mutual” Fund

The first mutual, or “open-end,” fund—in which new shares are issued as new money is invested—would not emerge until 1924 in Boston. The Massachusetts Investors Trust, considered by most accounts as the first mutual fund, was introduced in March of that year. Formed as a common law trust, this fund introduced important innovations to the investment company concept by establishing a simplified capital structure, continuous offering of shares, the ability to redeem shares rather than hold them until dissolution of the fund, and a set of clear investment restrictions and policies.

While a handful of mutual funds were formed during the 1920s, funds managed only $140 million by year-end 1929. The Stock Market Crash of 1929 and the Great Depression that followed greatly hampered industry growth until a succession of landmark securities laws, beginning with the Securities Act of 1933 and concluding with the Investment Company Act of 1940, re-invigorated investor confidence in funds. Renewed investor confidence and many innovations led to relatively steady growth in industry assets in the intervening years, and saw fund assets and shareholder accounts grow, respectively, from $448 million and 296,000 in 1940 to $8.1 trillion and 267 million by year-end 2004.

The Different Types of U.S. Investment Companies

Mutual funds are referred to as open-end funds for two main reasons: 1) they are required to redeem (or buy back) outstanding shares at any time upon a shareholder’s request, at a price based on the current value of the fund’s net assets; and 2) virtually all mutual funds continuously offer new fund shares to the public.

Besides mutual funds, there are two main types of investment companies regulated under the Investment Company Act of 1940: closed-end funds and unit investment trusts.

A closed-end fund is an investment company that issues a fixed number of shares that trade on a stock exchange or in the over-the-counter market. Assets of a closed-end fund are professionally managed in accordance with the fund’s investment objectives and policies, and may be invested in stocks, bonds, or a combination of both. Like other publicly traded securities, the market price of closed-end fund shares fluctuates and is determined by supply and demand in the marketplace. For more information on closed-end funds, see Data Table 11 or the Institute’s Frequently Asked Questions About Closed-End Funds.

A unit investment trust (UIT) is an investment company that buys and holds a generally fixed portfolio of stocks, bonds, or other securities. “Units” in the trust are sold to investors, or “unit holders,” who, during the life of the trust, receive their proportionate share of dividends or interest paid by the trust. Unlike other investment companies, a UIT has a stated date for termination that varies according to the investments held in its portfolio. At termination, investors receive their proportionate share of the UIT’s net assets. For more information on UITs, see Data Table 13 or the Institute’s Frequently Asked Questions About Unit Investment Trusts.

Another fund available to investors is an exchange-traded fund (ETF). An ETF is an investment company, typically an open-end fund or UIT, whose shares are traded intraday on stock exchanges at market-determined prices. As such, an ETF has the features of an investment company (diversified portfolio, professional management) but its shares trade like an equity security in the retail market. Indeed, investors buy or sell ETF shares through a broker just as they would the shares of any publicly traded company. For more information on ETFs, see Data Table 12 or the Institute’s Frequently Asked Questions About Exchange-Traded Funds.

Four Principal Securities Laws Govern Mutual Funds
 

The Organization of a Mutual Fund

Individuals and institutions invest in a mutual fund by purchasing shares issued by the fund. It is through these sales of shares that a mutual fund raises the cash used to invest in its portfolio of stocks, bonds, and other securities. Each investor shares in the returns from the fund’s portfolio while benefiting from professional investment management, diversification, and liquidity. Mutual funds may offer other benefits and services, such as asset allocation programs or money market sweep accounts.

A mutual fund is organized either as a corporation or a business trust that sells its shares to investors. Mutual funds have officers and directors or trustees. In this way, mutual funds are like any other type of company, such as IBM or General Motors.

Unlike other companies, however, a mutual fund is typically externally managed: it is not an operating company and it has no employees in the traditional sense. Instead, a fund relies upon third parties or service providers, either affiliated organizations or independent contractors, to invest fund assets and carry out other business activities. The diagram below shows the types of service providers usually relied upon by a fund.

Structure of a Mutual Fund

How a Fund Is Created

Setting up a mutual fund is a complicated process performed by the fund’s sponsor, typically the fund investment adviser, administrator, or principal underwriter (also known as the distributor).

The fund sponsor has a variety of responsibilities. For example, it must assemble the group of third parties needed to launch the fund, including the persons or entities that are charged with managing and operating the fund. The sponsor provides officers and affiliated directors to oversee the fund, and recruits unaffiliated persons to serve as independent directors. It must also register the fund under state law as either a business trust or corporation. In addition, in order to sell its shares to the public, the fund must first register those shares with the SEC by filing a federal registration statement pursuant to the Securities Act of 1933, and make filings with each state (except Florida) in which the fund’s shares will be offered.

Broker-dealers and their registered representatives who sell fund shares to the public are subject to regulation under the Securities Exchange Act of 1934, while the investment adviser to the fund must register under the Investment Advisers Act of 1940.

Preparing the federal registration statement, contracts, filings with individual states, and corporate documents typically costs the fund sponsor several hundred thousand dollars. In addition, the Investment Company Act of 1940, a federal statute expressly governing mutual fund operations, requires that a mutual fund register with the SEC as a “registered investment company.” It also requires that each new fund have assets of at least $100,000 of “seed capital” before distributing its shares to the public; this capital is usually contributed by the adviser or other sponsor in the form of an initial investment.

The ongoing operation of a mutual fund is also complicated and costly. In addition to management fees, funds regularly incur transfer agent, custodian, accounting, and other business expenses to continually meet federal and state requirements and to service shareholder accounts.

Status as a registered investment company allows the fund to be treated as a “pass-through” investment vehicle for tax purposes. In other words, the fund’s income flows through to shareholders without being taxed at the fund level.

Although a mutual fund is created from the seed money of a fund sponsor, it is managed for the benefit of all those investors who decide to buy shares once the fund is created and offered to the public.

Shareholders

Investors are given comprehensive information about the fund to help them make informed decisions. A mutual fund’s prospectus describes the fund’s goals, fees and expenses, investment strategies and risks, and how to buy and sell shares. The SEC requires a fund to provide a full prospectus either before an investment or together with the confirmation statement of an initial investment. In addition, periodic shareholder reports, provided to investors at least every six months, discuss the fund’s recent performance and include other important information, such as the fund’s financial statements. By examining these reports, an investor can learn if a fund has been effective in meeting the goals and investment strategies described in the fund’s prospectus.

Like shareholders of other companies, mutual fund shareholders have specific voting rights. These include the right to elect directors at meetings called for that purpose (subject to a limited exception for filling vacancies). Shareholders must also approve material changes in the terms of a fund’s contract with its investment adviser, the entity that manages the fund’s assets. For example, a fund’s management fee can be increased only when a majority of shareholders vote to approve the increase. Furthermore, funds seeking to change investment objectives or fundamental policies must obtain the approval of the holders of a majority of the fund’s outstanding voting securities.

Fund Entities

Boards of Directors

A fund’s board of directors is elected by the fund’s shareholders to govern the fund, and its role is primarily one of oversight. The board of directors typically is not involved in the day-to-day management affairs of the fund company. Instead, day-to-day management of the fund is handled by the fund’s investment adviser or administrator pursuant to a contract with the fund, as well as by the fund’s chief compliance officer, whose appointment must be approved by the board.

Directors must exercise the care that a reasonably prudent person would take with his or her own business. They are expected to exercise sound business judgment, approve policies and procedures to ensure the fund’s compliance with the federal securities laws, and undertake oversight and review of the performance of the fund’s operations as well as the operations of the fund’s service providers (with respect to the services they provide to the fund).

As part of this fiduciary duty, a director is expected to obtain adequate information about issues that come before the board in order to exercise his or her “business judgment,” a legal concept that involves a good-faith effort by the director.

Independent Directors. Mutual funds are required by law to have independent directors on their boards: individuals who cannot have any significant relationship with the fund’s adviser or underwriter, in order to better enable the board to provide an independent check on the fund’s operations. Generally speaking, as of January 2006, 75 percent of each fund’s board must be composed of independent directors and the board’s chairman must be independent.

Investment Advisers

As noted above, a fund’s investment adviser is often the fund’s initial sponsor and its initial shareholder through the “seed money” it invests to create the fund. The investment adviser invests the fund’s assets in accordance with the fund’s investment objectives and policies as stated in the registration statement it files with the SEC.

An investment adviser’s management of fund assets is overseen by the fund’s board of directors. The board must also oversee the investment adviser’s compliance with its advisory contract and fund prospectus disclosure on an ongoing basis.

As a professional money manager, the investment adviser provides a level of money management expertise usually beyond the scope of the average individual investor. Indeed, an investment adviser’s service to a mutual fund provides an economical, convenient way for the average investor to benefit from professional money management much like large institutions and wealthy investors receive.

Administrators

A fund’s administrator provides administrative services to a fund. The administrator can be either an affiliate of the fund, typically the investment adviser, or an unaffiliated third party. The services it provides to the fund include overseeing other companies that provide services to the fund, as well as ensuring that the fund’s operations comply with applicable federal requirements. Fund administrators typically pay for office space, equipment, personnel, and facilities; provide general accounting services; and help establish and maintain compliance procedures and internal controls. Often, they also assume responsibility for preparing and filing SEC, tax, shareholder, and other reports.

Principal Underwriters

Most mutual funds continuously offer new shares to the public at a price based on the current value of fund net assets plus any sales charges (see Liquidity and Fund Pricing). To reach investors, a fund’s sponsor has many choices for marketing shares of the fund. Historically, a fund sponsor would choose one of two main options to market its shares:

• directly to investors through the principal underwriter, or
• indirectly, through the principal underwriter, but with the underwriter relying on an unaffiliated distributor or group of distributors that may include any combination of brokers, financial planners, life insurance companies, and banks employing sales agents.

Investors buy and redeem fund shares either directly or indirectly through the principal underwriter, also known as the fund’s distributor. Principal underwriters are registered under the Securities Exchange Act of 1934 as broker-dealers, and, as such, are subject to strict rules governing how they offer and sell securities to investors.

The principal underwriter contracts with the fund to purchase and then resell fund shares to the public. A majority of both the fund’s independent directors and the entire fund board must approve the initial contract with the underwriter.

The role of the principal underwriter is crucial to a fund’s success and viability, in large part, because the principal underwriter is charged with attracting investors to the fund. Although many investors are long-term investors, an industry that competes on service and performance—combined with a shareholder’s ability to redeem on demand—makes attracting new shareholders crucial.

In recent years, fund sponsors have looked for new ways to reach prospective investors, leading many to abandon earlier, single-channel distribution strategies in favor of multi-channel distribution. For example, a fund sponsor might offer funds through a fund supermarket as well as through a variety of broker-dealers and other financial intermediaries. See Section 6 for more information on how investors buy and sell fund shares today.

Custodians

Mutual funds are required by law to protect their portfolio securities by placing them with a custodian. Nearly all mutual funds use banks that comply with various regulatory requirements designed to protect the fund’s assets and make them eligible to be a fund’s custodian. The SEC requires any bank acting as a mutual fund custodian to segregate mutual fund portfolio securities from other bank assets.

Transfer Agents

Mutual funds and their shareholders also rely on the services of third parties, called transfer agents, to maintain records of shareholder accounts, calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances, and maintain customer service departments to respond to shareholder inquiries.

Features of Mutual Funds

Professional Money Management

The investment adviser employed by a fund has its own employees who work on behalf of the fund’s shareholders. For example, the employees of an investment adviser who oversee “an actively managed” fund portfolio—typically, a team of experienced investment professionals headed by one or more portfolio managers—determine which securities to buy and sell in the fund’s portfolio. These decisions are based on a variety of factors, including the fund’s investment objectives, its risk tolerance, and extensive research of the financial performance of specific securities (e.g., market conditions or the performance of a particular company’s securities).

As economic conditions change, the fund management team may adjust the mix of its investments to a more aggressive or defensive footing to meet its overall investment objectives. In contrast, the investment adviser to a “passively managed” fund—for example, a fund tracking the performance of a market index such as the S&P 500—would buy and hold all, or a large representative sample, of the securities in the market index. An investment adviser adjusts the portfolio of a passively managed fund only to accommodate revisions to the securities that compose the relevant index.

A fund’s investment adviser and the adviser’s employees are subject to numerous standards and legal restrictions, especially regarding transactions between the adviser and the fund it advises. The written contract between a mutual fund and its investment adviser specifies the services the adviser performs. Most advisory contracts provide that the adviser receive an annual fee based on a percentage of the fund’s average net assets (see Mutual Fund Fees and Expenses).

Diversification

One function of the investment adviser is to ensure that the fund’s investments are appropriately diversified as required by federal laws and/or the fund’s prospectus. An investment portfolio diversified over a variety of securities reduces the risk that the poor performance of any one security will dramatically reduce the value of the fund’s overall assets. The allocation of a fund’s assets is constantly monitored and adjusted by the fund’s investment adviser to protect the interests of shareholders in the fund as dictated by its investment objectives.

Variety

At the end of 2004, there were more than 8,000 U.S. mutual funds available to investors. The wide variety enables investors to select a fund that meets their investment goals and objectives. It also helps ensure that fund companies compete vigorously for investor business.

There are four basic types of mutual funds: equity (also called stock), bond, hybrid, and money market. Equity funds concentrate their investments in stocks; bond funds primarily invest in bonds. Hybrid funds typically invest in a combination of stocks, bonds, and other securities. Equity, bond, and hybrid funds are called long-term funds. By contrast, money market funds invest in securities that generally mature in about one year or less and are, therefore, referred to as short-term funds. Of the total $8.107 trillion invested in mutual funds at the end of 2004, $4.384 trillion were invested in equity funds, $1.290 trillion in bond funds, $519 billion in hybrid funds, and $1.913 trillion in money market funds.

Number of Mutual Funds by Type of Fund, 1984 and 2004
 

Note: Data for funds that invest in other mutual funds were excluded from the series.
For statistical information on funds that invest in other funds, see Data Tables 14 and 15.
Download an Excel file of this data.

Liquidity and Fund Pricing

Because investors are, by law, able to redeem mutual fund shares on a daily basis, fund shares are very liquid investments. Most mutual funds also continually offer new shares to investors, and many fund companies allow shareholders to transfer money—or make “exchanges”—from one fund to another within the same fund family. Mutual funds process sales, redemptions, and exchanges as a normal part of daily business activity.

The price per share at which shares are redeemed is known as the net asset value (NAV). NAV is the current market value of all the fund’s assets, minus liabilities, divided by the total number of outstanding shares (see illustration below). This calculation ensures that the value of each share in the fund is identical and that an investor may determine his or her pro rata share of the mutual fund by multiplying the number of shares held by the fund’s NAV. Federal law requires that a fund’s NAV be calculated daily (excluding weekends and holidays).

How a Mutual Fund Determines Its Price
 

The price at which a fund’s shares may be purchased is its NAV per share plus any applicable front-end sales charge (the offering price of a fund without a sales charge would be the same as its NAV per share).

The NAV must reflect the current value of the fund’s securities. The value of these securities is determined either by a market quotation for those securities in which a market quotation is readily available, or if a market quotation is not readily available, at fair value as determined in good faith by a fund’s board of directors.

Funds typically value their portfolio securities using the closing prices from the exchange on which the securities are principally traded. If a material event that will likely affect the value of a security occurs after the exchange closes and before the fund’s share price is determined, it may be necessary to determine the fair value of the security in light of that event, rather than relying on the market price.

The 1940 Act requires “forward pricing”: shareholders who purchase or redeem shares must receive the next computed share price following the fund’s receipt of the transaction order.

Most funds price their securities at 4 pm Eastern time, when the New York Stock Exchange closes. Under forward pricing, orders received prior to 4 pm receive the price determined that same day at 4 pm; orders received after 4 pm receive the price determined at 4 pm on the next business day.

Any income and expenses (including any fees) must be accrued through the date the share price is calculated. Changes in holdings and in the number of shares must be reflected no later than the first calculation of the share price on the next business day.

The Mutual Fund Pricing Process

Mutual fund pricing takes place in a short time frame at the end of each business day. Generally, a fund’s pricing process begins at the close of the New York Stock Exchange, normally 4 pm Eastern time. A mutual fund typically obtains the prices for securities it holds from a pricing service, a company that collects prices on a wide variety of securities. Fund accounting agents internally validate the prices received from a pricing service by subjecting them to various control procedures. In some instances, a fund may use more than one pricing service either to ensure accuracy or to receive prices for various types of securities in its portfolio (e.g., stocks or bonds).

The vast majority of mutual funds submit their daily share prices to NASDAQ so they may be published in the next day’s morning newspapers. To be published, the price must be delivered to NASDAQ by 5:55 pm Eastern time and the fund must meet other listing criteria. As NASDAQ receives prices, they are instantaneously transmitted to newswire services and other subscribers. Newswire services transmit the prices to their client newspapers. Besides in newspapers, daily fund prices are available from other sources, such as through a fund’s toll-free telephone service or Internet access, which both typically include fund share prices along with other current information.

Accessibility

Mutual fund shares are available through a variety of sources (see Section 6). Investors may purchase fund shares either directly from the fund or through an investment professional, such as a discount broker, full-service broker, financial planner, bank, or insurance company. Some of these entities employ investment professionals to assist investors in analyzing their financial needs and determining those investment options best suited to their needs, objectives, and risk tolerance. Investment professionals are compensated for these services, generally through a sales load or through a fee, commonly referred to as a 12b-1 fee, deducted from the fund’s assets.

Some mutual funds can be purchased directly from fund companies or other intermediaries without the help of an investment professional. When funds are purchased in this manner, investors must do their own research to determine which funds meet their needs.

Mutual funds may also be offered as investment selections in 401(k) plans and other employee benefit plans. See Section 5 for more information on mutual funds and the retirement market or visit the Retirement Security section of this website.

Shareholder Services

Mutual funds offer a wide variety of services to shareholders. These services include 24-hour telephone access to account information and transaction processing, consolidated account statements, shareholder cost basis (tax) information, exchanges between funds, automatic investments, checkwriting privileges on money market and some bond funds, automatic reinvestment of fund dividends, and automatic withdrawals. Mutual funds also provide extensive investor education and other shareholder communications, including newsletters, brochures, retirement and other planning guides, and informative and educational websites.

Affordability

Mutual funds offer their many benefits and services at an affordable price. A fund’s fees and expenses are required by law to be clearly disclosed to investors in a standardized fee table at the front of the fund’s prospectus. Federal law requires each investor to be provided a copy of the fund’s prospectus no later than the completion of the transaction (i.e., when the customer receives confirmation of the transaction). The fee table in the prospectus breaks out the fees and expenses shareholders can expect to pay when purchasing or owning fund shares and allows investors to easily compare the cost of different funds.

Mutual Fund Fees and Expenses
 

*Funds may offer various volume discounts to reduce an investor’s sales charges. More information about these discounts, known as breakpoint discounts, is available in a fund’s prospectus.