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Mutual fund
The definition of a mutual fund is a form of collective
investment that pools money from many investors and invests their money in
stocks, bonds, dividends, short-term money market instruments, and/or other
securities. In a mutual fund, the fund manager trades the fund's underlying
securities, realizing capital gains or losses, and collects the dividend or
interest income. The investment proceeds are then passed along to the
individual investors. The value of a share of the mutual fund, known as the net
asset value per share (NAV), is calculated daily based on the total value of
the fund divided by the number of shares currently issued and outstanding.
Legally known as an "open-end company" under the
Investment Company Act of 1940 (the primary regulatory statute governing
investment companies), a mutual fund is one of three basic types of investment
companies available in the United
States. Outside of the United States (with the exception of Canada, which follows the U.S. model),
mutual fund is a generic term for various types of collective investment
vehicle. In the United
Kingdom and western Europe (including
offshore jurisdictions), other forms of collective investment vehicle are
prevalent, including unit trusts, open-ended investment companies (OEICs),
SICAVs and unitized insurance funds.
In Australia
the term "mutual fund" is generally not used; the name "managed
fund" is used instead. However, "managed fund" is somewhat
generic as the definition of a managed fund in Australia is any vehicle in which
investors' money is managed by a third party (NB: usually an investment
professional or organization). Most managed funds are open-ended (i.e., there
is no established maximum number of shares that can be issued); however, this
need not be the case. Additionally the Australian government introduced a
compulsory superannuation/pension scheme which, although strictly speaking a
managed fund, is rarely identified by this term and is instead called a
"superannuation fund" because of its special tax concessions and
restrictions on when money invested in it can be accessed.
Contents
1 History
2 Usage
3 Net asset value
4 Turnover
5 Expenses and TER's
5.1 Management Fees
5.2 Non-management Expenses
5.3 12b-1/Non-12b-1 Service Fees
5.4 Fees and Expenses Borne by
the Investor (not the Fund)
5.5 Brokerage Commissions
6 Types of mutual funds
6.1 Open-end fund
6.2 Exchange-traded funds
6.3 Equity funds
6.3.1 Capitalization
6.3.2 Growth vs. value
6.3.3 Index funds versus active
management
6.4 Bond funds
6.5 Money market funds
6.6 Funds of funds
6.7 Hedge funds
7 Mutual funds vs. other investments
8 Selecting a mutual fund
8.1 Share classes
8.2 Load and expenses
9 Criticism of managed mutual funds
9.1 Scandals
1. History
Massachusetts Investors Trust was founded on March 21, 1924,
and, after one year, had 200 shareholders and $392,000 in assets. The entire
industry, which included a few closed-end funds, courtney represented less than
$10 million in 1924.
The stock market crash of 1929 slowed the growth of mutual
funds. In response to the stock market crash, Congress passed the Securities
Act of 1933 and the Securities Exchange Act of 1934. These laws require that a
fund be registered with the Securities and Exchange Commission (SEC) and
provide prospective investors with a prospectus that contains required
disclosures about the fund, the securities themselves, and fund manager. The
SEC helped draft the Investment Company Act of 1940, which sets forth the
guidelines with which all SEC-registered funds today must comply.
With renewed confidence in the stock market, mutual funds
began to blossom. By the end of the 1960s, there were approximately 270 funds
with $48 billion in assets. The first retail index fund, the First Index
Investment Trust, was formed in 1976 and headed by John Bogle, who
conceptualized many of the key tenets of the industry in his 1951 senior thesis
at Princeton University. It is now called the
Vanguard 500 Index fund and is one of the largest mutual funds ever with in
excess of $100 billion in assets.
One of the largest contributors of mutual fund growth was
individual retirement account (IRA) provisions added to the Internal Revenue
Code in 1975, allowing individuals (including those already in corporate
pension plans) to contribute $2,000 a year. Mutual funds are now popular in
employer-sponsored defined contribution retirement plans (401(k)s), IRAs and
Roth IRAs.
As of April 2006, there are 8,606 mutual funds that belong
to the Investment Company Institute (ICI), the national association of
investment companies in the United
States, with combined assets of $9.207
trillion.
2. Usage
Mutual funds can invest in many different kinds of
securities. The most common are cash, stock, and bonds, but there are hundreds
of sub-categories. Stock funds, for instance, can invest primarily in the
shares of a particular industry, such as technology or utilities. These are
known as sector funds. Bond funds can vary according to risk (e.g., high-yield
or junk bonds, investment-grade corporate bonds), type of issuers (e.g.,
government agencies, corporations, or municipalities), or maturity of the bonds
(short- or long-term). Both stock and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and
foreign securities (global funds), or primarily foreign securities
(international funds).
Most mutual funds' investment portfolios are continually
adjusted under the supervision of a professional manager, who forecasts the
future performance of investments appropriate for the fund and chooses those
which he or she believes will most closely match the fund's stated investment
objective. A mutual fund is administered through a parent management company,
which may hire or fire fund managers.
Mutual funds are liable to a special set of regulatory,
accounting, and tax rules. Unlike most other types of business entities, they
are not taxed on their income as long as they distribute substantially all of
it to their shareholders. Also, the type of income they earn is often unchanged
as it passes through to the shareholders. Mutual fund distributions of tax-free
municipal bond income are also tax-free to the shareholder. Taxable
distributions can be either ordinary income or capital gains, depending on how
the fund earned those distributions.
3. Net asset value
The net asset value, or NAV, is the current market value of
a fund's holdings, usually expressed as a per-share amount. For most funds, the
NAV is determined daily, after the close of trading on some specified financial
exchange, but some funds update their NAV multiple times during the trading
day. Open-end funds sell and redeem their shares at the NAV, and so process
orders only after the NAV is determined. Closed-end funds (the shares of which
are traded by investors) may trade at a higher or lower price than their NAV;
this is known as a premium or discount, respectively. If a fund is divided into
multiple classes of shares, each class will typically have its own NAV,
reflecting differences in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly
traded on any formal exchange. These may be shares in very small or bankrupt
companies; they may be derivatives; or they may be private investments in
unregistered financial instruments (such as stock in a non-public company). In
the absence of a public market for these securities, it is the responsibility
of the fund manager to form an estimate of their value when computing the NAV.
How much of a fund's assets may be invested in such securities is stated in the
fund's prospectus.
4. Turnover
Turnover is a measure of the fund's securities transactions,
usually calculated over a year's time, and usually expressed as a percentage of
net asset value.
This value is usually calculated as the value of all
transactions (buying, selling) divided by 2 divided by the fund's total
holdings; i.e., the fund counts one security sold and another one bought as one
"turnover". Thus turnover measures the replacement of holdings.
In Canada, under NI 81-106 (required disclosure for
investment funds) turnover ratio is calculated based on the lesser of purchases
or sales divided by the average size of the portfolio (including cash).
Turnover generally has tax consequences for a fund, which
are passed through to investors. In particular, when selling an investment from
its portfolio, a fund may realize a capital gain, which will ultimately be
distributed to investors as taxable income. The verkjsdhgkjsdhgkjshdgy process
of buying and selling securities also has its own costs, such as brokerage
commissions, which are borne by the fund's shareholders.
5. Expenses and TER's
Mutual funds bear expenses similar to other companies. The
fee structure of a mutual fund can be divided into two or three main
components: management fee, nonmanagement expense, and 12b-1/non-12b-1 fees.
All expenses are expressed as a percentage of the average daily net assets of
the fund.
5.1 Management Fees
The management fee for the fund is usually synonymous with
the contractual investment advisory fee charged for the management of a fund's
investments. However, as many fund companies include administrative fees in the
advisory fee component, when attempting to compare the total management
expenses of different funds, it is helpful to define management fee as equal to
the contractual advisory fee + the contractual administrator fee. This
"levels the playing field" when comparing management fee components
across multiple funds.
Contractual advisory fees may be structured as "flat-rate"
fees, i.e., a single fee charged to the fund, regardless of the asset size of
the fund. However, many funds have contractual fees which include breakpoints,
so that as the value of a fund's assets increases, the advisory fee paid decreases.
Another way in which the advisory fees remain competitive is by structuring the
fee so that it is based on the value of all of the assets of a group or a
complex of funds rather than those of a single fund.
5.2 Non-management Expenses
Apart from the management fee, there are certain
non-management expenses which most funds must pay. Some of the more significant
(in terms of amount) non-management expenses are: transfer agent expenses (this
is usually the person you get on the other end of the phone line when you want
to purchase/sell shares of a fund), custodian expense (the fund's assets are
kept in custody by a bank which charges a custody fee), legal/audit expense,
fund accounting expense, registration expense (the SEC charges a registration
fee when funds file registration statements with it), board of
directors/trustees expense (the disinterested members of the board who oversee
the fund are usually paid a fee for their time spent at board meetings), and
printing and postage expense (incurred when printing and delivering shareholder
reports).
5.3 12b-1/Non-12b-1 Service Fees
12b-1 service fees/shareholder servicing fees are
contractual fees which a fund may charge to cover the marketing expenses of the
fund. Non-12b-1 service fees are marketing/shareholder servicing fees which do
not fall under SEC rule 12b-1. While funds do not have to charge the full
contractual 12b-1 fee, they often do. When investing in a front-end load or
no-load fund, the 12b-1 fees for the fund are usually .250% (or 25 basis points).
The 12b-1 fees for back-end and level-load share classes are usually between 50
and 75 basis points but may be as much as 100 basis points. While funds are
often marketed as "no-load" funds, this does not mean they do not
charge a distribution expense through a different mechanism. It is expected
that a fund listed on an online brokerage site will be paying for the
"shelf-space" in a different manner even if not directly through a
12b-1 fee.
5.4 Fees and Expenses Borne by the Investor (not the
Fund)
Fees and expenses borne by the investor vary based on the
arrangement made with the investor's broker. Sales loads (or contingent
deferred sales loads (CDSL)) are not included in the fund's total expense ratio
(TER) because they do not pass through the statement of operations for the
fund. Additionally, funds may charge early redemption fees to discourage
investors from swapping money into and out of the fund quickly, which may force
the fund to make bad trades to obtain the necessary liquidity. For example, Fidelity
Diversified International Fund (FDIVX) charges a 1 percent fee on money removed
from the fund in less than 30 days.
5.5 Brokerage Commissions
An additional expense which does not pass through the
statement of operations and cannot be controlled by the investor is brokerage
commissions. Brokerage commissions are incorporated into the price of the fund
and are reported usually 3 months after the fund's annual report in the
statement of additional information. Brokerage commissions are directly related
to portfolio turnover (portfolio turnover refers to the number of times the
fund's assets are bought and sold over the course of a year). Usually the
higher the rate of the portfolio turnover, the higher the brokerage
commissions. The advisors of mutual fund companies are required to achieve
"best execution" through brokerage arrangements so that the
commissions charged to the fund will not be excessive.
6. Types of mutual funds
6.1 Open-end fund
The term mutual fund is the common name for an open-end
investment company. Being open-ended means that, at the end of every day, the
fund issues new shares to investors and buys back shares from investors wishing
to leave the fund.
Mutual funds may be legally structured as corporations or
business trusts but in either instance are classed as open-end investment
companies by the SEC.
Other funds have a limited number of shares; these are
either closed-end funds or unit investment trusts, neither of which is a mutual
fund.
6.2 Exchange-traded funds
A relatively new innovation, the exchange traded fund (ETF),
is often formulated as an open-end investment company. ETFs combine
characteristics of both mutual funds and closed-end funds. An ETF usually
tracks a stock index (see Index funds). Shares are issued or redeemed by
institutional investors in large blocks (typically of 50,000). Investors
typically purchase shares in small quantities through brokers at a small
premium or discount to the net asset value; this is how the institutional
investor makes its profit. Because the institutional investors handle the
majority of trades, ETFs are more efficient than traditional mutual funds
(which are continuously issuing new securities and redeeming old ones, keeping
detailed records of such issuance and redemption transactions, and, to effect
such transactions, continually buying and selling securities and maintaining
liquidity position) and therefore tend to have lower expenses. ETFs are traded
throughout the day on a stock exchange, just like closed-end funds.
Exchange traded funds are also valuable for foreign
investors who are often able to buy and sell securities traded on a stock
market, but who, for regulatory reasons, are unable to participate in
traditional US
mutual funds.
6.3 Equity funds
Equity funds, which consist mainly of stock investments, are
the most common type of mutual fund. Equity funds hold 50 percent of all
amounts invested in mutual funds in the United States. Often equity funds focus investments on
particular strategies and certain types of issuers.
6.3.1 Capitalization
Fund managers and other investment professionals have
varying definitions of mid-cap, and large-cap ranges. The following ranges are
used by Russell Indexes:
@ Russell Microcap Index - micro-cap ($54.8 - 539.5 million)
@ Russell 2000 Index - small-cap ($182.6 million - 1.8
billion)
@ Russell Midcap Index - mid-cap ($1.8 - 13.7 billion)
@ Russell 1000 Index - large-cap ($1.8 - 386.9 billion)
6.3.2 Growth vs. value
Another distinction made is between growth funds, which
invest in stocks of companies that have the potential for large capital gains,
and value funds, which concentrate on stocks that are undervalued. Growth
stocks typically have the potential for a greater return; however, such
investments also bear larger risks. Growth funds tend not to pay regular
dividends. Sector funds focus on specific industry sectors, such as
biotechnology or energy. Income funds tend to be more conservative investments,
with a focus on stocks that pay dividends. A balanced fund may use a
combination of strategies, typically including some level of investment in
bonds, to stay more conservative when it comes to risk, yet aim for some
growth.
6.3.3 Index funds versus active management
An index fund maintains investments in companies that are
part of major stock (or bond) indices, such as the S&P 500, while an
actively managed fund attempts to outperform a relevant index through superior
stock-picking techniques. The assets of an index fund are managed to closely
approximate the performance of a particular published index. Since the
composition of an index changes infrequently, an index fund manager makes fewer
trades, on average, than does an active fund manager. For this reason, index
funds generally have lower trading expenses than actively managed funds, and
typically incur fewer short-term capital gains which must be passed on to
shareholders. Additionally, index funds do not incur expenses to pay for
selection of individual stocks (proprietary selection techniques, research,
etc.) and deciding when to buy, hold or sell individual holdings. Instead, a
fairly simple computer model can identify whatever changes are needed to bring
the fund back into agreement with its target index.
The performance of an actively managed fund largely depends
on the investment decisions of its manager. Statistically, for every investor
who outperforms the market, there is one who underperforms. Among those who
outperform their index before expenses, though, many end up underperforming
after expenses. Before expenses, a well-run index fund should have average
performance. By minimizing the impact of expenses, index funds should be able
to perform better than average.
Certain empirical evidence seems to illustrate that mutual
funds do not beat the market and actively managed mutual funds under-perform
other broad-based portfolios with similar characteristics. One study found that
nearly 1,500 U.S.
mutual funds under-performed the market in approximately half of the years
between 1962 and 1992. Moreover, funds that performed well in the past are not
able to beat the market again in the future (shown by Jensen, 1968; Grimblatt
and Titman, 1989. However, as quantitative finance is in its early stages of
development, more accurate studies are required to reach a decisive conclusion.
6.4 Bond funds
Bond funds account for 18% of mutual fund assets. Types of
bond funds include term funds, which have a fixed set of time (short-, medium-,
or long-term) before they mature. Municipal bond funds generally have lower
returns, but have tax advantages and lower risk. High-yield bond funds invest
in corporate bonds, including high-yield or junk bonds. With the potential for
high yield, these bonds also come with greater risk.
6.5 Money market funds
Money market funds hold 26% of mutual fund assets in the United States.
Money market funds entail the least risk, as well as lower rates of return.
Unlike certificates of deposit (CDs), money market shares are liquid and
redeemable at any time. The interest rate quoted by money market funds is known
as the 7 Day SEC Yield.
6.6 Funds of funds
Funds of funds (FoF) are mutual funds which invest in other
underlying mutual funds (i.e., they are funds comprised of other funds). The
funds at the underlying level are typically funds which an investor can invest
in individually. A fund of funds will typically charge a management fee which
is smaller than that of a normal fund because it is considered a fee charged
for asset allocation services. The fees charged at the underlying fund level do
not pass through the statement of operations, but are usually disclosed in the
fund's annual report, prospectus, or statement of additional information. The
fund should be evaluated on the combination of the fund-level expenses and
underlying fund expenses, as these both reduce the return to the investor.
Most FoFs invest in affiliated funds (i.e., mutual funds
managed by the same advisor), although some invest in funds managed by other
(unaffiliated) advisors. The cost associated with investing in an unaffiliated
underlying fund is most often higher than investing in an affiliated underlying
because of the investment management research involved in investing in fund
advised by a different advisor. Recently, FoFs have been classified into those
that are actively managed (in which the investment advisor reallocates
frequently among the underlying funds in order to adjust to changing market
conditions) and those that are passively managed (the investment advisor
allocates assets on the basis of on an allocation model which is rebalanced on
a regular basis).
The design of FoFs is structured in such a way as to provide
a ready mix of mutual funds for investors who are unable to or unwilling to
determine their own asset allocation model. Fund companies such as TIAA-CREF,
Vanguard, and Fidelity have also entered this market to provide investors with
these options and take the "guess work" out of selecting funds. The
allocation mixes usually vary by the time the investor would like to retire:
2020, 2030, 2050, etc. The more distant the target retirement date, the more
aggressive the asset mix.
6.7 Hedge funds
Hedge funds in the United States are pooled investment
funds with loose SEC regulation and should not be confused with mutual funds.
Certain hedge funds are required to register with SEC as investment advisers
under the Investment Advisers Act. The Act does not require an adviser to
follow or avoid any particular investment strategies, nor does it require or
prohibit specific investments. Hedge funds typically charge a management fee of
1% or more, plus a "performance fee" of 20% of the hedge fund's
profits. There may be a "lock-up" period, during which an investor
cannot cash in shares.
7. Mutual funds vs. other investments
Mutual funds offer several advantages over investing in
individual stocks, including Moreover, the transaction costs associated with
buying individual stocks are spread around among all the mutual fund
shareholders. Additionally, a mutual fund benefits from professional fund
managers who can apply their expertise and dedicate time to research investment
options. Mutual funds, however, are not immune to risks. Mutual funds share the
same risks associated with the types of investments the fund makes. If the fund
invests primarily in stocks, the mutual fund is usually subject to the same ups
and downs and risks as the stock market.
8. Selecting a mutual fund
Picking a mutual fund from among the thousands offered is
not easy. Following are some guidelines:
@ Prior to investing in a tax-exempt or tax-managed fund, it
is best to determine if the tax savings will offset the possibly lower returns.
Additionally, these funds are inappropriate for IRAs and other tax-sheltered
types of account.
@ Investors should match the term of the investment to the
time period they expect to keep the investment. Money that may be needed in the
short term (for example, for car repairs) should generally be in a less
volatile fund, such as a money market fund. Money not needed until a retirement
date decades into the future (or for a newborn's college education) can
reasonably be invested in longer-term, higher-risk investments, such as stock
or bond funds. Investing short-term money in volatile investments puts the
investor at risk of having to sell when the market is low, thereby incurring a
loss. Investing over the long term in very stable investments, on the other
hand, significantly reduces potential returns.
@ Fund expenses degrade investment performance, especially
over the long term. Accordingly, all other things being equal, the lower the
expenses, the better. A mutual fund's expense ratio is required to be disclosed
in the prospectus. Expense ratios are critical in index funds, which seek to
match the performance of bond or stock index. Actively managed funds must pay
the manager for the active management of the portfolio, so they usually have a
higher expense ratio than (passively managed) index funds.
@ Several sector funds often make the "best fund"
lists each year. However, the "best" sector varies from year to year.
Most sectors are vulnerable to industry-wide events that can have a significant
negative effect on performance. It is generally best to avoid making these a
large part of one's portfolio.
@ Closed-end funds often sell at a discount to the value of
their holdings. An investor can sometimes obtain extra return by buying such
funds, but only if they are willing to hold the fund until the discount
rebounds. Some hedge fund managers use this gambit. However, this also implies
that buying at the original issue may be a bad idea, since the price often
drops immediately because of liquidity concerns.
@ Mutual funds often make taxable distributions near the end
of the year (semi-annual and quarterly distributions are also fairly common).
If an investor plans to invest in a taxable fund, he or she should check the
fund company's website to see when the fund plans to distribute dividends and
capital gains. Investing just prior to the distribution results in part of
one's investment being returned as taxable income without increasing the value
of the account.
@ Prospective investors in mutual funds should read the
prospectus. The prospectus is required by law to disclose the risks will be
taken with investors' money, among other vital topics. Potential investors
should also compare the return and risk profile of a fund against its peers
with similar investment objectives and against the index most closely
associated with it, paying particular attention to performance over both the
long term and the short term. A fund that gained 50% over a 1-year period (an
impressive result) but only 10% over a 5-year period should create some
suspicion, as that would imply that the returns in four out of those five years
were actually very low (possibly even negative (i.e., losses)), as 10%
compounded over 5 years is only 61%.
@ Diversification can reduce risk. Depending on an
investor's risk tolerance and his or her investment horizon, it may be
advisable to hold some stocks, some bonds, and some cash. For longer-term
investments, it is advisable to invest in some foreign stocks. If all of an
investor's mutual funds belong to the same family of funds, the investor's
total portfolio might not be as diversified as it might seem. This is so
because funds within the same family may share research and recommendations.
The same is true for investors who own multiple funds with the same profile or
investment strategy; their returns will likely be similar. Holding too large a
number of funds, on the other hand, will tend to produce the same effect as
holding an index fund, but with higher expenses. Buying individual stocks
exposes investors to company-specific and industry-specific risks, and if
investors buy a large number of stocks, the commissions may cost more than a fund
would.
8.1 Share classes
Many mutual funds offer more than one class of shares. For
example, you may have seen a fund that offers "Class A" and
"Class B" shares. Each class will invest in the same sport (or
investment portfolio) of securities and will have the same investment
objectives and policies. But each class will have different shareholder
services and/or distribution arrangements with different fees and expenses.
These differences are supposed to reflect different costs involved in servicing
investors in various classes; for example, one class may be sold through
brokers with a front-end load, and another class may be sold direct to the
public with no load but a "12b-1 fee" included in the class's
expenses (sometimes referred to as "Class C" shares). Still a third
class might have a minimum investment of $10,000,000 and be available only to
financial institutions (a so-called "institutional" share class). In
some cases, by aggregating regular investments made by many individuals, a
retirement plan (such as a 401(k) plan) may qualify to purchase
"institutional" shares (and gain the benefit of their typically lower
expense ratios) even though no members of the plan would qualify individually.
As a result, each class will likely have different performance results.
A multi-millionaire structure offers investors the ability
to select a fee and expense structure that is most appropriate for their
investment goals (including the length of time that they expect to remain
invested in the fund).
8.2 Load and expenses
A front-end load or sales charge is a commission paid to a
broker by a mutual fund when shares are purchased, taken as a percentage of
funds invested. The value of the investment is reduced by the amount of the
load. Some funds have a deferred sales charge or back-end load. In this type of
fund an investor pays no sales charge when purchasing shares, but will pay a
commission out of the proceeds when shares are redeemed depending on how long
they are held. Another derivative structure is a level-load fund, in which no
sales charge is paid when buying the fund, but a back-end load may be charged
if the shares purchased are sold within a year.
Load funds are sold through financial intermediaries such as
brokers, financial planners, and other types of registered representatives who
charge a commission for their services. Shares of front-end load funds are
frequently eligible for breakpoints (i.e., a reduction in the commission paid)
based on a number of variables. These include other accounts in the same fund
family held by the investor or various family members, or committing to buy
more of the fund within a set period of time in return for a lower commission
"today".
It is possible to buy many mutual funds without paying a
sales charge. These are called no-load funds. In addition to being available
from the fund company itself, no-load funds may be sold by some discount
brokers for a flat transaction fee or even no fee at all. (This does not
necessarily mean that the broker is not compensated for the transaction; in
such cases, the fund may pay brokers' commissions out of "distribution and
marketing" expenses rather than a specific sales charge. The purchaser is
therefore paying the fee indirectly through the fund's expenses deducted from
profits.)
No-load funds include both index funds and actively managed
funds. The largest mutual fund families selling no-load index funds are
Vanguard and Fidelity, though there are a number of smaller mutual fund
families with no-load funds as well. Expense ratios in some no-load index funds
are less than 0.2% per year versus the typical actively managed fund's expense
ratio of about 1.5% per year. Load funds usually have even higher expense
ratios when the load is considered. The expense ratio is the anticipated annual
cost to the investor of holding shares of the fund. For example, on a $100,000
investment, an expense ratio of 0.2% means $200 of annual expense, while a 1.5%
expense ratio would result in $1,500 of annual expense. These expenses are
before any sales commissions paid to purchase the mutual fund.
Many fee-only financial advisors strongly suggest no-load
funds such as index funds. If the advisor is not of the fee-only type but is
instead compensated by commissions, the advisor may have a conflict of interest
in selling high-commission load funds.
9. Criticism of managed mutual funds
Historically, actively managed mutual funds, over long
periods of time, have not returned as much as comparable index mutual funds.
This, of course, is a criticism of one type of mutual fund over another.
Another criticism concerns sales commissions on load funds,
an upfront or deferred fee as high as 8.5 percent of the amount invested in a
fund. No-load funds typically charge a 12b-1 fee in order to pay for shelf space
on the exchange the investor uses for purchase of the fund, but they do not pay
a load directly to a mutual fund broker. Critics point out that high sales
commissions represent a conflict of interest, as high commissions benefit the
sales people but hurt the investors. High commissions can also cause sales
people to recommend funds that maximize their income. Again, this is a
criticism of one type of mutual fund over another.
Theoretically, this should motivate the fund managers, since
a well performing fund will cause the amount invested in the fund to rise and
increasing the fee earned. It also could motivate the fund company to focus on
advertising to attract more and more new investors, as new investors would also
cause the fund assets to increase.
Mutual fund managers may also have a conflict of interest
due to the way they are paid. In particular fund managers may be encouraged to
take more risks with investors money than they ought to: Fund flows (and
therefore compensation) towards successful, market beating funds are much
larger than outflows from funds that lose to the market. Fund managers may
therefore have an incentive to purchase high risk investments in the hopes of
increasing their odds of beating the market and receiving the high inflows,
with relatively less fear of the consequences of losing to the market (1).
Many analysts, however, believe that the larger the pool of
money one works with, the harder it is to manage actively, and the harder it is
to squeeze good performance out of it. Thus a fund company can be focused on
attracting new customers, thereby hurting its existing investors' performance.
A great deal of a fund's costs are flat and fixed costs, such as the salary for
the manager. Thus it can be more profitable for the fund to try to allow it to
grow as large as possible, instead of limiting its assets. Some fund companies,
notably the Vanguard Group and Fidelity Investments, have closed some funds to
new investors to maintain the integrity of the funds for existing investors.
Other critisicms of mutual funds are that some funds allow
market timing (although many fund companies tightly control this) and that some
fund managers accept extravagant gifts in exchange for trading stocks through
certain investment banks, which presumably charge the fund more for
transactions than would non-gifting investment bank. As a result, many fund
companies strictly limit -- or completely bar -- such gifts.
9.1 Scandals
In September 2003, the United States mutual fund industry
was beset by a scandal in which major fund companies permitted and facilitated
"late trading" and "market timing". See: Mutual-fund
scandal (2003) For a discussion, see Tamar Frankel & Lawrence A.
Cunningham, The Mysterious Ways of Mutual Funds: Market Timing, Annual Review
of Financial and Banking Law (2007)
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