WHAT
IS A MUTUAL FUND?
by Peter W. Johnson, Jr.
OVERVIEW Description.
A mutual fund is a company that
combines, or pools, investors' money and, generally, purchases
stocks or bonds. Ideally, a fund's size
and resultant efficiency, combined with experienced management, provide advantages
for investors that include diversification, expert stock
and bond selection, low costs, and convenience.
In terms of legal structure, a mutual fund is a corporation
that receives preferential tax treatment under the U.S. Internal
Revenue Code. The assets of a mutual fund consist
almost entirely of the securities it holds in its portfolio. The most common type
of mutual fund, called an open-end fund, allows investors
to buy and sell stock in it on an ongoing basis.
How it Works. The mutual fund issues shares of stock (just like any
other corporation) to investors in exchange for cash. It is
interesting to note that funds do not issue a pre-determined
amount of stock, as do most corporations; new shares are issued
as each new investment is made. Investors thus become part-owners
of the fund itself, and thereby the assets of the fund. The
fund, in turn, uses investors' cash to purchase securities,
such as stocks and bonds. As mentioned above, the primary
assets of a fund are the securities it invests in (other assets,
such as equipment, are a relatively small part of the total
assets of a fund).
PRICING AND VALUATION Description.
The value of the shares of an open-end mutual fund is readily
determined. Each day, the accounting staff of a fund simply
adds up the value of all the securities in the portfolio,
adds in other assets, deducts liabilities,
and comes up with a net overall value. It is then a simple
matter to divide the net
assets by the number of shares outstanding. This is
called the net
asset value, and is the price at which investors buy
and sell shares from the fund. The net asset value is listed
in the financial section of many major newspapers.
How it Works. Let's look at a simplified example. Suppose
we start a brand-new fund, the We Fly Higher Stock Fund.
On its first day of operation, the We Fly Higher Stock Fund
(which I'll refer to as WFHSF, for short) receives $100 from
John Smith. At $10.00 per share, Mr. Smith receives ten shares.
(At the start, the fund's starting share price-in this case,
$10.00 per share -- is arbitrary and set by the Fund.) The
result of the transaction? The assets of the Fund are $100
in cash, and there are ten shares outstanding. Divide $100
in assets by 10 shares to get $10.00 per share.
On day two, WFHSF buys two shares of Amalgamated Fish &
Chips, a seafood and technology company, for $50 each. We
still have a per share value in WFHSF of $10.00, because the
total assets of the fund are still worth $100 (2 shares of
Amalgamated at $50.00 each), and there are still ten shares
of the fund outstanding. However, from this point on, the
share value in the Fund will vary, and will no longer be arbitrary.
Federal regulations require a daily re-valuation process,
called marking-to-market,
of all open-end mutual funds. Marking to market refers to
adjusting the per-share price of the fund to reflect changes
in the Fund's portfolio, or asset, value. In this way, investors
know the true value of their investments on a daily basis,
and as new investors buy into, and sell out of, the Fund,
everyone gets a fair shake. With that in mind, let's see how
the fluctuations in daily share prices occur, as we continue
to follow the fortunes of the We Fly Higher Stock Fund.
On day three, mercury contamination (resulting from improper
disposal of chip-manufacturing by-products) is found in Amalgamated's
fish, and the bad news spreads rapidly. Fearing the worst,
investors flock to sell Amalgamated shares, and the price
of its stock plunges 50%, from $50 to $25 per share. Of course,
back at the Fund, the assets have declined, too, because the
Fund's assets are entirely in Amalgamated stock. The two shares
the Fund holds have declined to $25 per share, as noted, and
now are worth a sum total of $50. The accounting department
at the Fund calculates the new value per share of the Fund
by adding up all the assets, now $50.00, and dividing by ten
(the number of shares outstanding), and note that each share
of the Fund is now worth only $5.00. This is called the net
asset value (per share is implied).
LOAD AND NO-LOAD FUNDS
Description. Many people have heard the words load
and no-load
in connection with mutual funds, but do not understand what
these terms refer to. Simply put, a load, or loaded, fund
is one that has a sales
charge. A no-load fund has no sales charge.
How it Works. As noted above, not all funds have sales
charges. Those that do simply add them on to the net asset
value of the fund, thus coming up with a new, higher offering
price per share. It is important to note that the
underlying value of the fund's shares do not change; and further,
that an investor selling shares will still receive only the
net asset value.
Again, an example will be helpful. Let's go back to day one
of the We Fly Higher Stock Fund. The beginning net asset value,
or price per share, was $10.00. However, if the Fund had a
5% sales charge, shares would be priced at $10.53 to the public.
Hence, the price paid per share would consist of two parts:
the sales charge of $0.53 per share (5% of $10.53), and the
remainder would be the net asset value ($10.53 - $0.53 = $10.00).
Thus, in this example, an investor who purchased a share for
$10.53 on the first day, and sold it the next day, would lose
$0.53 -- the amount of the sales charge (assuming that no
other changes in value occurred). Accordingly, there are two
daily price listings for so-called "load" funds: the offering
price (the investor's purchase price), and the net asset value
(the investor's selling price). Who gets the sales charge
in a load fund? Why, the salesman (or, broker),
and his company, of course! The fund receives none of the
sales charge.
A no-load fund is simpler. The net asset value is used for
both the purchase price and the selling price. Therefore,
the two prices are always identical.
BUYING AND SELLING
FUND SHARES Description. Here we are talking
about the mechanics of what an investor generally does when
buying or selling shares in a mutual fund. In the case of
a load fund, the broker usually takes care of the details
for you. In the case of a no-load fund, investors usually
deal directly with the fund in question. It is really a very
simple process, and fund representatives are almost always
available, through a toll-free telephone number, to help.
How it Works. Since investors in load funds (presumably)
have the assistance of their brokers, we will discuss the
process of buying and selling no-load funds. Many investors
are a bit daunted by this process, which is unfamiliar to
them. If they knew how easy it is, they wouldn't hesitate
to "do it themselves"!
Once an investor knows the name of a fund that he or she has
an interest in, the first task is to find the toll-free telephone
number. A simple call to the fund, requesting a prospectus
(a booklet that describes the investment--more below) and
application,
sets the process in motion. In a few days, these documents
arrive in the mail. After reviewing the prospectus, the investor
fills out the application, writes a check to the fund, and
mails the application and check back to the fund in the enclosed
envelope. That's all there is to it! Upon receipt, the fund
will then open an account for the investor, purchasing as
many shares as the investment dollar amount allows (fractional
shares are common). Then, the fund issues periodic statements
to the investor, detailing all transactions, including purchases,
sales and dividends.
Selling shares is even easier than purchasing them. A simple
phone call will initiate the process of the sale of shares,
as directed, and money can be sent to the investor by check
or wire, depending on how the account was set up. (Helpful
tip: Unless you might be tempted to spend money that is too
easily available, always sign up for all of the selling options
available -- that way, you can get your money more quickly,
should you require it, or should you find that one or more
options are unavailable when the time to sell comes.)
By the way, you can almost always add to your account, or
take partial proceeds out. Most funds have a minimum beginning
amount, but after that, almost anything goes in terms of additions
and withdrawals (be sure to check the prospectus for details
on individual fund operations procedures in this regard).
One last point. Mutual funds are heavily regulated and have
proven to be trustworthy over time. You need not have trepidations
about dealing through the mail with mutual funds.
FUND OBJECTIVES AND THE PROSPECTUS
Description. We have learned that mutual funds are
investment companies, and that they may invest in securities
of various kinds, such as stocks and bonds. Money
market mutual funds, which constitute a major portion
of the fund universe, invest only in very short-term bonds.
A fund's objective, described in the prospectus, gives broad
indications of the types of investments a fund may make. The
prospectus discloses important specific details about the
fund that the prospective investor should be aware of, including
allowable investments, expenses, risks, and financial statements.
Therefore, investors should always read the prospectus
carefully before investing or sending money!
How it Works. The following paragraphs will give you
a more in-depth view of the contents and purpose of the prospectus.
The most important aspect of a fund is its investment objective.
The fund's objective tells investors the goals the fund seeks
to achieve, and a good deal about how it intends to achieve
them. A balanced fund will generally hold stocks and bonds.
A fund seeking growth
fund will utilize stocks. A fund seeking income
with little or no concern for growth will generally hold bonds.
The objective of a fund is so fundamental that it generally
determines the category into which a fund will be assigned.
For example, we speak of growth funds, foreign funds, income
funds, and money-market funds. The stated objective is usually
quite short, one or two paragraphs in length, and can be found
in the very beginning of the fund's prospectus.
Listed below are some examples of major objective categories:
- Investment Objective:
- Preservation of Capital & Liquidity--Achieved
by investing in very short-term bonds
- Income--Achieved by investing in bonds
- Balanced--Achieved by investing in bonds and stocks
- Growth--Achieved by investing in stocks
Immediately following the investment objective in the prospectus
is a discussion of what investments are allowed, and in what
percentages. Fully diversified stock funds, for example, must
conform to legal limits for maximum holdings in any one stock
or industry.
(Specifically, a diversified fund, as defined in the Investment
Company Act of 1940, with respect to 75% of its assets,
may hold no more than 5% in any one company, and not more
than 10% of any firm's outstanding shares. The vast majority
of mutual funds meet these conditions.) On the other end of
the spectrum are sector
funds, which may hold stocks from a single industry only.
Risks of the various allowed investments are discussed in
considerable detail in prospectuses, although it is at this
point in reading the prospectus that many investors get "bogged
down" in the legal verbiage and technical detail.
Although the prospectus is the investor's first line of defense,
and should be examined carefully, it does not disclose everything
that an investor may want to know before investing in a given
fund. Further, it gives information in a way that makes comparison
between funds difficult. As a result of the demand for easier-to-use
and more complete information, we have witnessed a proliferation
of mutual fund guides and newsletters in the past ten years.
Morningstar,
a relative newcomer to the fund scene, has become the dominant,
independent provider of mutual fund information. They achieved
their remarkable success in the market for fund information
by providing comprehensive data that was previously difficult
to obtain, and they did it in a manner that was timely and
made comparisons of funds relatively easy. Examples of information
that Morningstar and other, competitive services include are:
manager's name and tenure, major individual investment holdings,
overall portfolio characteristics (such as amount of stock
in various industries, bond credit ratings, etc.), and performance
information that is easily compared, on an apples-with-apples
basis, with other funds and with indices.
For example, the fund's performance will be compared on a
chart with other, similar funds, and with comparable indices
of similar investments (i.e., a foreign fund's performance
will be compared to the performance of foreign stocks, in
general). In my opinion, no mutual fund investor should be
without a high-quality fund reference guide, such as Morningstar
or the No-Load Fund Analyst, to supplement
the basic information found in the prospectus.
ADVANTAGES AND DISADVANTAGES OF
MUTUAL FUNDS Description. The primary advantages
of mutual funds are summed up in an oft-heard litany: diversification,
professional management and convenience. By and large, most
funds do achieve this basic mission. Over and above that,
funds offer lower costs by virtue of their size; they may
receive breaks on trading
costs, and they certainly spread many internal costs over
a large shareholder
base, allowing for economies
of scale. On the negative side, funds make tax planning
difficult (because the timing of taxable distributions
is uncertain), and may be somewhat difficult to track in terms
of what they actually are investing in (which is generally
not disclosed until after the fact for competitive reasons).
In addition, so-called non-substantial changes in the way
the funds are managed (such as manager switches) may not be
disclosed to investors by fund companies in a timely manner.
How it Works. Diversification is a tremendous benefit
of mutual funds. For a low minimum investment, in most cases,
an investor can own hundreds or thousands of individual security
issues through a single fund, and thus spread risk over a
substantially broader base. Taking things one step further,
different types of funds allow participation in many types
of securities, such as foreign stocks, foreign bonds, real
estate securities, technology stocks, small companies, and
so on. Thus, a single investor can assemble a portfolio of
mutual funds that invest in different asset classes. The chance
of any single person being sufficiently well-versed to manage
such diverse investments is highly unlikely, even if done
full-time! In the extreme, funds may even own other mutual
funds, resulting in a virtual all-in-one portfolio. An example
of the all-in-one, "fund of funds" approach would be Vanguard's
Star Fund. The Star Fund invests in about eight other Vanguard
funds with different objectives
-- small stock, blue chip stock, bonds, etc. -- with no additional
expenses added onto the low expenses of the underlying funds.
Such a fund might serve as an entire investment portfolio
for the small investor.
The second potential benefit, professional management, is
always guaranteed, but sadly, only because managers of funds
are paid for their services. Fortunately, truly dismal mutual
fund management is rare (I can think of only a handful of
cases where investment returns have badly trailed the relevant
market measures over substantial periods of time). Finally,
there is no doubt that investors benefit from substantial
convenience by investing in mutual funds. They are relieved
of the day-to-day tasks involved in researching, buying and
selling securities. In the case of individual securities,
day-to-day vigilance is a virtual requirement, especially
in a diversified portfolio, with many holdings. Mutual funds,
on the other hand, need not be looked at on a daily, weekly
or even monthly basis. Occasional reviews, perhaps once a
year, will suffice. (Helpful Hint: the same guidelines and
practices for picking a mutual fund in the first place are
also useful for fund reviews.)
Perhaps the biggest negative aspect of mutual funds is tax-planning
difficulty and uncertainty. Funds make taxable distributions
in a largely hard-to-foresee manner. In addition, they are
required to distribute long-term capital gains in the year
realized; thus the investor loses control over the timing
of the realization and taxation of capital gains, contrary
to the situation where an investor who owns securities outright,
can choose sale dates. |
