Mutual funds

Mutual Funds1.  By the end of 2010, U.S. investment companies were valued at a respectable $0.9 trillion for ETFs and whopping $11.5 trillion for mutual funds2.  Figure 7 illustrates the functional structure of mutual funds.

Mutual funds are open-end investment companies that create (solid arrows) and redeem (dashed arrows) shares in response to the demand of retail investors [mutual funds also have institutional investors as clients].  Every share is valued at a fraction of the MF portfolio’s net asset value (NAV) at the end of the trading day.  The retail investor and mutual fund exchange cash for shares either directly or through the services of an agent, but the fund’s shares are never listed on the stock exchange.  The MF also exchanges cash for underlying assets.  The underlying index is operated by an independent financial services company that measures the aggregate value of the market where the fund buys its underlying assets.   The mutual fund may use the underlying index as a standard of portfolio performance (i.e., “benchmark”) or a template for portfolio composition.  The yellow dots identify sites of investment risk.

Legal matters.  Mutual funds are typically managed by separate entities known as investment advisors who are registered with the SEC.  Funds vary according to investment objective, investment strategy, and costs of operation.  At redemption, the investor receives the NAV of the shares, less transaction fees, within 7 days.  Fees and expenses reduce the return on investment and are described in the Prospectus.

Risks.  The fund portfolio is either passively or actively managed.  The main risks are 1) active management, 2) NAV, and 3) unrealized capital gains.  First, active management involves designing the portfolio to outperform its underlying index.  The fallacy of active management is that managers can only make a best-guess at how the market will behave and their guess can be wrong.  Second, the NAV is not known until after the market is closed and the fund is no longer accepting orders.  During the time lapse between trading order and order execution, the share price may change to a less favorable value.  Third, the fund passes all tax obligations to its shareholders, including the obligation to pay tax on the fund’s unrealized capital gains.  Thus, the shareholder risks paying  taxes on a capital gain that they don’t receive.

Benefits.  There are two big advantages to investing in a mutual fund.  First, the fund’s portfolio is professionally managed and provides diversity to the retail investor’s investments.  Second, the fund’s shares are guaranteed redeemable at net asset value.

Conclusion.  Mutual funds are most effective as long-term investments.

Copyright © 2011 Douglas R Knight, updated in 2012

References

1.   Mutual Funds. U.S. Securities and Exchange Commission. Modified 12/14/2010.  SEC.gov/answers/mutfund.

2.  Maxey, Daisey. “ETFs and Products hit $1 Trillion in U.S.”, page B17, Wall Street Journal, B17, 12/18/2010.

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