Mutual Funds

If you don't want to actively buy and sell individual securities, you can invest in stocks, bonds, or other financial assets through a mutual fund. Mutual funds are simply a way of pooling together money of a large group of investors. The buy and sell decisions for the pool are made by fund managers who are paid for the service they provide.

Mutual funds provide indirect access to financial markets for individual investors; these funds are a form of financial intermediary. Mutual funds have a lot of power. They are now the largest type of financial intermediary in the United States, followed by commercial banks and life insurance companies.

As of the end of 2001, about 93 million Americans in 55 million households owned mutual funds, up from 5 million households in 1980. Investors contributed $505 billion to mutual funds in 2001, and total mutual fund assets totaled $7 trillion.
Open-End Versus Closed-End Mutual Funds

There are two type of mutual funds, open-end and closed-end. Whenever you invest in a mutual fund, you do so by buying shares in the fund. However, how your shares are bought and sold depends on which type of fund you are considering.

With an open-end fund, the fund itself will sell new shares to anyone wishing to buy and will buy back shares from anyone who wants to sell. When an investor wants to buy open-end fund shares the fund simply issues the shares and then the fund manager invests the money received from the investor. When someone wants to sell open-end fund shares, the fund sells some of its assets and uses the cash to redeem the shares. As a result, with an open-end fund, the number of shares outstanding fluctuates over time.

In a closed-end fund, the number of shares is fixed and never changes. If you want to buy shares, you must buy them from another investor. Similarly, if you wish to sell shares that you own, you must sell them to another investor.
Net Asset Value

A mutual fund's net asset value (NAV) is calculated by taking the total value of the assets held by the fund less any liabilities and then dividing by the number of outstanding shares. For example, suppose a mutual fund has $105 million in assets and $5 million in liabilities based on current market values and a total of 5 million shares outstanding. Based on the value of net assets held by the fund, $100 million, each share has a value of $20 ($100 million / 5 million shares).

Shares in an open-end fund are always worth their net asset value. In contrast, because the shares of closed-end funds are bought and sold in the stock market, the share price is dictated by the market and may or may not be equal to the NAV.
Mutual Fund Organization and Creation

A mutual fund is simply a corporation. Like a corporation, a mutual fund is owned by its shareholders. The shareholders elect a board of directors, and they are responsible for hiring managers to oversee the fund's operations. Every individual fund is a separate company owned by its shareholders.

Most mutual funds are created by investment advisory firms, which are businesses that specialize in managing mutual funds. Such firms have additional operations as discount brokerages or offer other financial services.

An investment advisory firm can create multiple funds. Over time, this process leads to a family of funds all managed by the same advisory firm. Each fund in the family will have its own fund manager, but the advisory firm will generally handle the record keeping, marketing, and much of the research that underlies the fund's investment decisions.
Taxation of Investment Companies

As long as an advisory firm meets certain rules set by the Internal Revenue Service, it is treated as a "regulated investment company" for tax purposes. This is important because a regulated investment company does not pay taxes on its investment income. Mutual funds act as a "pass-through entity" in terms of tax law, funneling capital gains and losses to the shareholders in proportion to their investment.
Types of Stock Mutual Funds

1. Capital appreciation stock funds seek maximum capital appreciation. They generally invest in companies that have, in the opinion of the fund manager, the best prospects for share price appreciation without regard to dividends or company size. Often this means investing in unproven companies or out-of-favor companies.

2. Growth stock funds seek capital appreciation, but tend to invest in large, more established companies. These funds may be somewhat less volatile as a result. Dividends are an important consideration for the mutual fund manager in purchasing a stock.

3. Growth and income funds seek capital appreciation, but at least part of their focus is on dividend-paying companies.

4. Equity income stock funds focus almost exclusively on stocks with relatively high dividend yields, thereby maximizing the current income on the stock portfolio. The dividend yield is the anticipated dividend divided by the present price of a share of stock.

5. Small company stock funds focus on stocks in small companies. "Small" refers to the total market value of the stock. Small stocks have historically performed very well, at least over the long run, hence the demand for funds that specialize in such stocks. With small-company mutual funds, what constitutes small covers a wide range from perhaps $10 million up to $1 billion or so in total market value, and some funds specialize in smaller companies than others. Since most small companies don't pay dividends, these funds necessarily emphasize capital appreciation.

6. Mid-cap stock funds specialize in stocks that are too small to be in the S&P 500 index but too large to be considered small stocks. Hence, the stocks these mutual funds specialize in are considered to be middle sized stocks or medium sized by market capitalization.

7. Global stock funds have substantial international holdings but also maintain significant investments in U.S. stocks.

8. International stock funds are similar to global funds, but focus most on foreign securities.

9. Index stock funds simply hold the stocks that make up a particular index in the same proportions as the index. The most important index funds are the S&P 500 indexed stock mutual funds which are intended to track the performance of the S&P 500. By their nature, index funds are passively managed and trade only as a necessary to match the index. Such funds are appealing in part because they are generally characterized as low turnover and low operating expenses.

10. Social conscience stock funds are a relatively new creation. They invest only in companies whose products, policies, or politics are viewed as socially desirable. The specific social objectives range from environmental issues to personnel policies. Of course, general agreement on what is socially desirable or responsible is hard to find.

11. Tax-managed stock funds are managed with high regard for the tax liabilities of mutual fund shareholders. Tax-managed stock mutual funds try to hold down turnover to minimize realized capital gains, and they try to match realized gains with realized losses. Fund shareholders have largely escaped taxes as a result.