 Mutual Fund Basics
By Dipendra Khatiwada
As the government in this year’s budget announcement has shown interest to develop mutual fund business, this has become a matter of growing interest among the investors. Here we present what and how about mutual fund.
What is mutual fund?
A mutual fund is a form of collective investments that pools money from many investors and invests their money in stocks, bonds, short-term money market instruments, and/or other securities. In a mutual fund, the fund manager who is also known as the portfolio 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” in USA 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 (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 always. 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.
A mutual fund is a company that pools the money of many investors — its shareholders — to invest in a variety of different securities. Investments may be in stocks, bonds, money market securities or some combination of these. Those securities are professionally managed on behalf of the shareholders, and each investor holds a pro rata share of the portfolio — entitled to any profits when the securities are sold, but subject to any losses in value as well.
For you as the individual investor, mutual funds provide the benefit of having someone else manage your investments, take care of recordkeeping for your account, and diversify your investment over many different securities that may not be available or affordable to you otherwise. Today, minimum investment requirements on many funds are low enough that even the smallest investor can get started in mutual funds.
A mutual fund, by its very nature, is diversified — its assets are invested in many different securities. Beyond that, there are many different types of mutual funds with different objectives and levels of growth potential, furthering your chances to diversify.
History:
In USA, Massachusetts Investors Trust (now MFS Investment Management) 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, 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.
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.
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.
Mutual funds Vs. Stocks:
An Informed Investor Is The Best Investor!
Investing is not a mystery. It does, however, depend on your basic working knowledge of investing and your tolerance for risk. If you choose to invest on your own or decide to have a broker or financial planner manage your investments for you, a good foundation of basic terms is a must and is the first step in starting to create wealth. If you are a beginning investor and can not decide if you should invest in a stock or a mutual fund, read on to find some helpful information that will help you decide. Remember, the best kind of investor is an informed investor, so let’s get started on understanding the basics of stocks and a mutual fund.
Stocks
A stock is partial ownership or equity in a company. When you buy stock in a company, you become a shareholder. There are two types of stocks: common and preferred. If you are a shareholder of common stocks, you are entitled to vote in the election of company officials, and entitled to receive dividends on your shares (if the company pays dividends). If you are a shareholder of preferred stocks, usually you do not have voting rights but you receive a fixed dividend and are paid before common stockholders. Dividends are distributions of a company’s profit or earnings back to the company’s shareholders. Many company’s offer dividend reinvestment plans, which means that instead of sending you a check for the dividends earned, the dividend is used to purchase additional shares of the company’s stock. This is a great way to increase your investment in the company over a period of time!
You can purchase stocks through a broker, through dividend reinvestment plans or directly through the company, which is known as direct stock purchase. Dividend reinvestment plans, also called DRIPs, are managed by a transfer agent (usually a bank) for the company. DRIPs and direct stock purchases allow the individual investor to purchase shares directly from the company.
To learn about a particular stock, you can (1) request a copy of the company’s annual report (2) search the internet (3) call the company and ask any questions that you may have; and (4) track the stock in the news. As always, remember to research the company before becoming a shareholder.
Mutual Funds
A mutual fund is a professionally managed pool of investment money from investors with similar investment objectives. A mutual fund represents many individual stocks from a variety of industries and is managed by a fund manager. Mutual funds offer diversification and professional management of your money. As an investor in a mutual fund, you are buying shares of the fund known as the net asset value. Before investing in a mutual fund, find out if it is a load or no-load fund. A load is a commission to compensate the broker or sales agent who assisted in the purchase of a mutual fund. Load funds charge a sales commission while no-load funds do not charge a sales commission. If you pay a sales commission when you purchase the mutual fund, this is known as a front-end load fund. A commission paid when you sell the mutual fund is known as a back-end load fund.
Before investing in a mutual fund, make sure that you request a copy of the company’s prospectus. A prospectus provides information about the mutual fund, including the fund’s objective, major holdings (individual companies), fees, and names of company officials.
Diversification
If you decide to invest in a stock or mutual fund, make sure that you diversify. Diversification simply means ‘not putting all of your eggs in one basket.’ Diversification means to invest in stocks in different industries so that you can minimize your loses as the market fluctuates from one day to the next.
Stocks vs. Mutual Funds
If you are quite knowledgeable about investing, have enough money to purchase stocks of companies in different industries to allow for diversification, and have the time to research stocks, then maybe investing in individual stocks is a good starting point for you. If you have limited knowledge about investing, have a small amount of money that you can invest regularly, and are not comfortable with the ups and downs of individual stocks, and then maybe mutual funds will be a better fit for you.
Why Mutual Funds
Let’s suppose you’re just getting started as an investor and have Rs. 5,000 to invest and you have three important goals you want to achieve. First, you don’t want to lose your money in a risky venture so you want security, like that found in a certificate of deposit or other fixed income investment. But you also want to make the most money you can, so you want the prospect for growth potential, too. Finally, since you don’t have the time or knowledge to actively manage your money, you want professional money management — occasionally diversifying your investments into promising new opportunities. That sounds like a very good plan, but where can you invest your money and have a chance to meet all three criteria?
Certificates of deposit and other fixed income investments offer security, but often with low rates of interest and a fixed potential for growth. Individual stocks may carry greater potential for growth, but Rs. 5,000 isn’t a lot to invest and if you put it all in one stock, you risk everything if it performs poorly. And, brokers and investment advisors can offer you advice and money management, but at a price — you pay for their services, which reduce further the amount you have available to invest. So where can you invest your money? The answer is mutual funds. Because Mutual funds make it easy and less costly for investors to satisfy their need for capital growth, income and/or income preservation, and Mutual funds bring diversification and professional money management to the individual investor.
Types of Mutual funds:
Open Mutual Funds
Open mutual funds are established by a fund sponsor, usually a mutual fund company. The sponsor has promised in the documents of the fund that it will issue and refund or units of the fund at the fund unit value. This type of fund is valued by the fund company or an outside valuation agent. This means that the investments of the fund are valued at “fair market” value, which is the closing market value for listed public securities. Essentially, the fund company prices all of the fund’s holdings at the market close and adds up their value; it then subtracts amounts owing and adds amounts to be received by the fund; and finally it divides this net amount by the number of units outstanding to “strike” the unit value for that day. Any participants withdrawing funds from the fund that day receive this unit value for their funds withdrawn. Any new purchases are made at the same unit value.
Open mutual funds keep some portion of their assets in short-term and money market securities to provide available funds for redemptions. A large portion of most open mutual funds is invested in highly “liquid securities”, which means that the fund can raise money by selling securities at prices very close to those used for valuations. Funds also have the ability to borrow money for short periods of time to fund redemptions. The documents of open mutual funds usually provide for the suspension of unit redemptions in “extraordinary conditions” such as major interruptions to the financial markets or total demands for redemptions forming a substantial portion of the fund assets in a short period of time. These clauses were invoked in USA in October, 1987, when the stock market crashed 30% in a few days and the volume of stock transactions caused trading activity to be hours out date.
Illiquid investments, those not actively traded on the public markets, are restricted by US government regulators because they are difficult to dispose of in a short period of time. A fund holding an illiquid investment might not be able to sell it in a short period of time or would have to take a significant discount to the valuation level the fund was using. In Canada, most open real estate mutual funds suspended redemptions during the real estate debacle of the early 1990s. Fund participants did not obtain redeemed funds until these funds were restructured into closed-end funds in the mid 1990s and they could sell their units on the stock market.
The valuation of investments that are less liquid and trade infrequently is an important issue for mutual funds.
Closed Mutual Funds
Closed mutual funds are really financial securities that are traded on the stock market. A sponsor, a mutual fund company or investment dealer, will create a “trust fund” that raises funds through an underwriting to be invested in a specific fashion. The fund retains an investment manager to manage the fund assets in the manner specified. A good example of this type of fund are the “country funds” that were underwritten during the international investment euphoria of the early 1990s. An investment dealer would decide that a “Germany” or “Portugal” or “Emerging Country” fund would sell given the popular consensus that these were “no lose” investments. It would then retain a well respected investment advisor to manage the fund assets for a fee and underwrite a public issue that it would sell through retail stock brokers to individual investors. It is interesting to note that many of these funds were caught in the sell-off of the stock market of 1994 and have languished ever since. This has led to the phrase “submerging country” replacing “emerging market” for many of these funds. This is wry proof of the fickleness of investor fashion!
Once underwritten, closed mutual funds trade on stock exchanges like stocks or bonds. Their value is what investors will pay for them. Usually closed mutual funds trade at discounts to their underlying asset value. For example, if the price of the fund assets less liabilities divided by the outstanding units is Rs. 10, the fund might trade on the stock market at Rs. 9. This fund would be said to be trading at a “10% discount to its net asset value”. The reason for this discount is debated by academics, but is due in large part to the lack of liquidity of the fund units and the presence of the management fee.
Categories of mutual funds:
Aggressive Growth Funds
Aggressive growth funds aim to maximize capital gains (buy low and sell high). These funds may leverage their assets by borrowing funds, and may trade in stock options.
These funds often have low, current yields. Because they don’t invest for dividend income, and often have little cash in interest-bearing accounts, short-term yield is not optimized.
If the market is going up, these are the funds that will benefit the most. Conversely, aggressive growth funds are the ones hardest hit in bear markets. The volatility of these funds makes them inappropriate for risk-averse investors.
Growth Funds
Growth funds are similar to aggressive growth funds, but do not usually trade stock options or borrow money with which to trade. Most growth funds surpass the S&P 500 during bull markets, but do a little worse than average during bear markets.
Just as in aggressive growth funds, growth funds are not aimed at the short-term market timer. The aggressive investor may find that they are an ideal complement for aggressive growth funds, as the differing investment strategies used by the two types of funds can produce maximum gains. The volatility of these funds makes them inappropriate as the sole investment vehicle for risk-averse investors.
Growth-Income Funds
Growth-income funds are specialists in blue chip stocks. These funds invest in utilities, Dow industrials, and other seasoned stocks. They work to maximize dividend income while also generating capital gains. These funds are suitable as a substitute for conservative investment in the stock market.
Income Funds
Income funds focus on dividend income, while also enjoying the capital gains that usually accompany investment in common and preferred stocks. These funds are particularly favored by conservative investors.
International Funds
International funds hold primarily foreign securities. There are two elements of risk in this investment: the normal economic risk of holding stocks; as well as the currency risk associated with repatriating money after taking the investment profits. These funds are an vital aspect of many portfolios, but any individual fund may prove too volatile for the average investor as the sole investment.
Asset Allocation Funds
Asset allocation funds don’t invest in just stocks. Instead, they focus on stocks, bonds, gold, real estate, and money market funds. This portfolio approach decreases the reliance on any one segment of the marketplace, easing any declines. A plus factor is limited by this strategy as well.
Precious Metal Funds
Precious metal funds invest in gold, silver, and platinum. Gold and silver often move in the opposite direction from the stock market, and thus these funds can provide a hedge against investments in common stocks.
Bond Funds
Bond funds invest in corporate and government bonds. A common misunderstanding among investors is that the return on a bond fund is similar to the returns of the bonds purchased. One might expect that a fund that owns primarily 8 percent-yielding bonds would return 8 percent to investors. In fact, the yield from the fund is based primarily on the trading of bonds, which are extraordinarily sensitive to interest rates. Thus, one could find a bond fund that was earning double-digit returns as the prime rate climbed from 4 percent to 6 percent.
In addition to mutual funds, there are money market funds, which are essentially mutual funds that invest solely in government-insured short-term instruments. These funds nearly always reflect the current interest rates, and rarely engage in interest-rate speculation.
(Khatiwada is Executive Director of Commodities and Metal Exchange Nepal - COMEN)
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