Mutual Funds are collective investment schemes. Collective investment schemes may be formed under company law (Corporations), by legal trust (Pension Funds, Universities, or Charities) or by statute(created by our 50 states). The nature of the scheme and its limitations are often linked to its constitutional nature and the associated tax rules for the type of structure within a given jurisdiction (County, State, or Country).
These collective investment schemes are a way of investing money with others to participate in a wider range of investments than feasible for most individual investors, and to share the costs and benefits of doing so.
Typically there is:
2) A fund administrator who manages the trading, reconciliations, valuation and unit pricing.
3) A board of directors or trustees who safeguards the assets and ensures compliance with laws, regulations, and rules.
4) The shareholders or unitholders who own (or have rights to) the assets and associated income.
5) A "marketing" or "distribution" company to promote and sell shares/units of the fund.
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As many of you know by now, I am not a big fan of using mutual funds for investments. Mutual funds are good for diversifying your money into several stocks, bonds, or other investments. You hire a manager to manage the over all portfolio based on the funds by-laws. That is the only thing that mutual funds offer.
On the negative side, by hiring a fund manager, you increase your cost of investing. There may be a percentage charged for purchase, sale of shares, or units called an initial charge (in the UK) or 'front-end load' (in the US). In the US, you may see a ‘back-end load’ as well. This charge may represent profit for the fund manager. It may cover the cost of distribution of the fund by paying commissions to the adviser or broker that arranged the purchase of fund shares. These fees are commonly referred to as 12b-1 fees in the U.S. Not all funds have initial charges; if there are no such charges, the fund is a "no-load" (US) fund.
I worked with a woman who placed a Whole Life Insurance Policy into her IRA. Her IRA had three mutual funds and she could go in and out of these funds in a fund family once a month. But she could not get out of that mutual fund family for 8 years without a large penalty. The funds had a load plus internal monthly fees. At one point I placed her money in the family money market fund giving 1%. She was loosing 2% to 3% of her portfolio per year just doing that because of fees.
If you are going to invest in mutual funds, a “no-load” fund is the way to go. Even then, no one says that the money manager has a “Crystal Ball” into the financial markets future. The IRA investors of 2008 to 2010 can tell you that. You as the investor pay for the fund managment when investing in mutual funds, for better or worst.
In the United States we have basically two types of mutual funds; Open-end and Closed-end funds.
An open-end fund is equitably divided into shares which vary in price in direct proportion to the variation in value of the fund's net asset value. Each time money is invested, new shares or units are created to match the prevailing share price; each time shares are redeemed, the assets sold match the prevailing share price. In this way there is no supply or demand created for shares and they remain a direct reflection of the underlying assets.
A closed-end fund issues a limited number of shares (or units) in an initial public offering ( IPO) or through private placement. If shares are issued through an IPO, they are then traded on an exchange or directly through the fund manager to create a secondary market subject to market forces. If demand for the shares is high, they may trade at a premium to net asset value. If demand is low they may trade at a discount to net asset value. Further share (or unit) offerings may be made by the scheme if demand is high although this may affect the share price.
The Net Asset Value or NAV is the value of a scheme's assets less the value of its liabilities. The method for calculating this varies between scheme types and jurisdiction and can be subject to complex regulation.
Some collective investment schemes have the power to borrow money to make further investments; a process known as gearing or leverage. If markets are growing rapidly this can allow the scheme to take advantage of the growth to a greater extent than if only the subscribed contributions were invested. However this premise only works if the cost of the borrowing is less than the increased growth achieved. If the borrowing costs are more than the growth achieved a net loss is achieved. This loss can be far greater than if just the subscribed contributions were invested.
Leverage can greatly increase the investment risk of the fund by increased volatility and exposure to increased capital risk.
Here is a list of mutual fund families; http://en.wikipedia.org/wiki/List_of_asset_management_firms
Next time, we will look at Unit Investment Trust (UIT).
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