Mutual Funds

A mutual fund is a portfolio of securities consisting of one type of security or a combination of several different types. A fund is a convenient way for an investor to have a diversified portfolio of investments in just about any investable asset. The oldest mutual fund is believed to have been founded by Adriaan van Ketwich in 1774. Ketwich invited investors to contribute to a trust fund to spread the risk of investing in foreign bonds. The idea moved from the Netherlands to Scotland and then to the United States, where the Boston Personal Property Trust established the first mutual fund in 1893 (Investment Funds Institute of Canada, 2017).

Mutual funds play a significant role in individual investment decisions. A mutual fund provides an investor with cheaper and simpler diversification and security selection, requiring only one transaction to own a diversified portfolio (the mutual fund). By buying shares in the fund rather than individual securities, you achieve extensive diversification for a much lower transaction cost than by investing in individual securities and making individual transactions. You also benefit from professional security selection, which theoretically minimizes the opportunity costs of fewer choices. So, by using a mutual fund, you get more and better security selection and diversification.

A mutual fund also provides stock and bond issuers with a mass market. Rather than selling shares to investors individually (and incurring the costs of doing so), issuers can more easily find a market for their shares in mutual funds.

Structures and Types of Mutual Funds

Like stocks and bonds, mutual funds may be actively or passively managed. As you read"Owning Bonds and Investing in Mutual Funds," actively managed funds provide investors with professional management and the expected research, analysis, and watchfulness that goes with it. Passively managed index funds, on the other hand, are designed to mirror the performance of a specific index constructed to be representative of an asset class.

Mutual funds are structured in three ways:

1. Closed-end funds
2. Open-end funds
3. Exchange-traded funds

Closed-end funds are funds for which a limited number of shares are issued. Once all shares have been issued, the fund is "closed," so a new investor can only buy shares from an existing investor. Since the shares are traded on an exchange, the limited supply of shares and the demand for them in that market directly determines the value of the shares for a closed-end fund.

Most mutual funds are open-end funds in which investors buy shares directly from the fund and redeem or sell shares back to the fund. The price of a share is its net asset value (NAV), or the market value of each share, as determined by the fund's assets and liabilities and the number of shares that exist. Here is the basic formula for calculating NAV:

$\text{NAV = }\dfrac{\text{(market value of fund securities − fund liabilities)}}{\text{number of shares outstanding}}$

Demand for shares is reflected in the number of shares outstanding, because the fund can create new shares for new investors. NAV calculations are usually done once per day at the close of trading, when mutual fund transactions are recorded.

The NAV is the price that the fund will pay you when you redeem your shares, so it is a gauge of the shares' value. It will increase if the market value of the securities in the fund increases faster than the number of new shares.

Exchange-traded funds (ETFs) are structured like closed-end funds but are traded like stocks. Shares are traded and priced continuously throughout the day's trading session rather than once per day at the end of trading. ETFs trade more like individual securities; that is, if you are trying to time a market, they are a nimbler asset to trade than open- or closed-end funds.

Originally designed as index funds, exchange-traded funds now target almost every asset, sector, and economic region imaginable.

Table 14.4.1 compares the features of closed-end funds, open-end funds, and ETFs.

Table 14.4.1

Shares of closed-end funds and exchange-traded funds are bought and sold on exchanges, much like shares of stock. You would go through a broker to make those transactions. Shares of open-end funds may be bought and sold directly from the fund sponsor, a mutual fund company, or an investment manager. You can make those transactions at any of the company's offices, by telephone, or online. About 40 percent of all mutual fund transactions are done directly (without a broker) through a retirement plan contribution or a mutual fund company (The Investment Company Institute, 2009).

Some other types of mutual funds are shown in Table 14.4.2. Some research companies, such as Morningstar, track as many as 48 different categories of mutual funds.

Table 14.4.2

Mutual Fund Fees and Returns

All funds must disclose their fees to potential investors: sales fees, management fees, and expenses. A load fund charges a sales commission on each share purchase. That sales charge (a front-end load) is a percentage of the purchase price. A no-load fund, in contrast, does not charge a sales commission because shares may be purchased directly from the fund or through a discount broker. The front-end load can be as much as 8.5 percent, so if you plan to invest often or in large amounts, that can be a substantial charge. For example, a $5,000 investment may cost you $425, reducing the amount you have to invest and earn a return.

A fund may charge a back-end load, actually a deferred sales charge, paid when you sell your shares instead of when you buy them. The charge may be phased out if you own the shares for a specified time; however, it is usually five to seven years.

A fund may charge a management fee on an annual basis. The management fee is stated as a fixed percentage of the fund's asset value per share. Management fees can range from 0.1 percent to 2.0 percent annually. Typically, a more actively managed fund can be expected to charge a higher management fee, while a passively managed fund, such as an index fund, should charge a minimal management fee.

A fund may charge an annual distribution fee, also calculated as not more than 1.0 percent per year of the fund's asset value. Some mutual funds charge other extra fees as well, passing on fund expenses to shareholders. You should consider fee structure and rate when choosing mutual funds, and this can be done through calculations of the expense ratio.

Taken together, the annual management, distribution, and expense fees are measured by the management expense ratio (MER) – the total annual fees expressed as a percentage of your total investment. MER costs "are deducted before the fund's performance returns are calculated" (Kapoor et al., 2015, p. 356). Therefore, if your return is 15 percent and your MER is two percent, you will receive a return of 13 percent. That may not sound like much, but it means that if the fund earns a five percent return, your net return may be less than three percent (and after taxes, it is even less). When choosing a fund, you should be aware of all charges – especially annual or ongoing charges – that can affect your investment return.

Owning shares of a mutual fund means owning shares in a pool of assets. The fund's returns are the returns of those assets: interest, dividends, or gains (losses). Income may come from interest distribution if the fund invests in bonds or interest-producing assets or as dividend distribution if the fund invests in stocks.

Mutual funds buy and sell or "turn over" the fund assets. Even passively managed funds need to rebalance to keep pace with their benchmarks as market values change. The turnover ratio is the percentage of fund assets that have been turned over or replaced in the past year, a measure of the fund's trading activity.

Turnover can create capital gains or losses. Periodically, usually once per year, the fund's net capital gains (or losses) are distributed per share basis as a capital gains distribution. You would expect turnover to produce more gains than losses. The more turnover, or the higher the turnover ratio, the greater the capital gains distributions you may expect.

Unless you have invested in a tax-exempt savings plan such as an RRSP, interest, and dividend distributions are taxable as personal income, as are capital gains, including capital gains distributions. A higher turnover ratio may mean a higher tax expense for capital gains distributions. Most open-end mutual funds allow you the option of having your income and gains distributions automatically reinvested rather than paid out, which means that you may be paying taxes on earnings without ever "seeing" the money.

Mutual Fund Information and Strategies

All mutual fund companies must offer a prospectus and a published statement detailing the fund's assets, liabilities, management personnel, and performance record. You should always take the time to read it and to take a closer look at the fund's investments to make sure that the fund will be compatible and appropriate to your investment goals.

For example, suppose you have an investment in a TSX Index fund and are now looking for a global stock fund to complement and diversify your holdings in domestic (Canadian) equities. You go to the website of a large mutual fund company offering hundreds of funds. You find a stock fund called "Global Stock Fund": it sounds like it's just what you are looking for. Looking closer, however, you can see that this fund is invested in the stocks of companies in Germany, Japan, and the United Kingdom. While they are not Canadian stocks, those economies are similar to the US economy – perhaps too similar to provide the diversity you are looking for.

Or suppose you are looking for a bond fund to create income and security. You find a fund called the "Investment Grade Fixed Income Fund."On closer inspection, however, you find that the fund does not invest only in investment-grade bonds but that the average rating of its bonds is investment-grade. This means that the fund invests in many investment-grade bonds but also in some speculative-grade bonds to achieve higher income. While this fund may suit your need for income, it may not be appropriate for your risk tolerance.

Mutual fund companies make this information readily available online and in prospectuses. You should always make the extra effort to be sure you know what's in your fund. In addition, many performance analysts widely follow mutual funds. Rating agencies such as Morningstar and investment publications such as Barron's and Forbes track, analyze, and report the performance of mutual funds. That information is available online or in print and provides comparisons of mutual funds that you may find helpful in choosing your fund. For more information on Canadian mutual funds, please see the FUNDATA website.

In print and online newspapers, mutual fund performance is reported daily in the form of tables that compare the average returns of funds from week to week. Reported average returns are based on the net asset value per share (NAVPS). Investors can use this information to choose or compare funds and track the performance of funds they own.

In conclusion, since a mutual fund may be made up of any kind or many kinds of securities (e.g., stocks, bonds, real estate, and commodities), it is not really another kind of investment. Rather, it is a way to invest without specifically selecting securities, a way of achieving a desired asset allocation without choosing individual assets.

The advantages of investing in a mutual fund are the diversification available with minimal transaction costs and the professional management or security selection that you buy when you buy into the fund.

Compared to actively managed funds, passively managed or index funds offer similar diversification but with lower management fees and expense ratios because you aren't paying for market timing or security selection skills. The turnover ratio shows how passive or active the fund management is. Performance history has shown that actively managed funds, on average, do not necessarily outperform passively managed funds (Malkiel, 2007).

Since they usually have higher fees, any advantage created by active management is usually canceled out by their higher costs. Still, there are investors who believe that some mutual funds and mutual fund managers can, on average, outperform the markets or the indexes that provide the benchmarks for passively managed funds.

Source: Bettina Schneider, https://ecampusontario.pressbooks.pub/financialempowerment/chapter/chapter-14-owning-bonds-and-investing-in-mutual-funds/
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