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A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. These investors may be retail or institutional in nature. Mutual funds have advantages and disadvantages compared to direct investing in individual securities.
The primary advantages of mutual funds are that they provide economies of scale, a higher level of diversification, they provide liquidity, and they are managed by professional investors.
On the negative side, investors in a mutual fund must pay various fees and expenses. Primary structures of mutual funds include open-end funds , unit investment trusts , and closed-end funds. Exchange-traded funds ETFs are open-end funds or unit investment trusts that trade on an exchange. Mutual funds are also classified by their principal investments as money market funds , bond or fixed income funds, stock or equity funds, hybrid funds or other.
Funds may also be categorized as index funds , which are passively managed funds that match the performance of an index, or actively managed funds. Hedge funds are not mutual funds; hedge funds cannot be sold to the general public and are subject to different government regulations.
The first modern investment funds the precursor of today's mutual funds were established in the Dutch Republic. In response to the financial crisis of —, Amsterdam-based businessman Abraham or Adriaan van Ketwich formed a trust named Eendragt Maakt Magt "unity creates strength". His aim was to provide small investors with an opportunity to diversify. Mutual funds were introduced to the United States in the s. The first open-end mutual fund with redeemable shares was established on March 21, as the Massachusetts Investors Trust.
In the United States, closed-end funds remained more popular than open-end funds throughout the s. After the Wall Street Crash of , the U. Congress passed a series of acts regulating the securities markets in general and mutual funds in particular. These new regulations encouraged the development of open-end mutual funds as opposed to closed-end funds. Growth in the U. The introduction of money market funds in the high interest rate environment of the late s boosted industry growth dramatically.
The first retail index fund , First Index Investment Trust, was formed in by The Vanguard Group , headed by John Bogle ; it is now called the "Vanguard Index Fund" and is one of the world's largest mutual funds. Fund industry growth continued into the s and s. In , the mutual fund industry was involved in a scandal involving unequal treatment of fund shareholders.
Some fund management companies allowed favored investors to engage in late trading , which is illegal, or market timing , which is a practice prohibited by fund policy. The scandal was initially discovered by former New York Attorney General Eliot Spitzer and led to a significant increase in regulation.
Total mutual fund assets fell in as a result of the financial crisis of — In the United States, mutual funds play an important role in U. Their role in retirement savings was even more significant, since mutual funds accounted for roughly half of the assets in individual retirement accounts, k s and other similar retirement plans. These funds may be sold throughout the European Union and in other countries that have adopted mutual recognition regimes.
Mutual funds have advantages and disadvantages compared to investing directly in individual securities:. Open-end and closed-end funds are overseen by a board of directors , if organized as a corporation, or by a board of trustees , if organized as a trust.
The Board must ensure that the fund is managed in the interests of the fund's investors. The board hires the fund manager and other service providers to the fund. The fund sponsors trades buys and sells the fund's investments in accordance with the fund's investment objective.
Funds that are managed by the same company under the same brand are known as a fund family or fund complex. The sponsor or fund management company, often referred to as the fund manager, trades buys and sells the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment adviser. In the European Union, funds are governed by laws and regulations established by their home country.
However, the European Union has established a mutual recognition regime that allows funds regulated in one country to be sold in all other countries in the European Union, but only if they comply with certain requirements. Regulation of mutual funds in Canada is primarily governed by National Instrument "Mutual Funds. The Canadian Securities Administrator works to harmonize regulation across Canada. There are three primary structures of mutual funds: Open-end mutual funds must be willing to buy back "redeem" their shares from their investors at the net asset value NAV computed that day based upon the prices of the securities owned by the fund.
In the United States, open-end funds must be willing to buy back shares at the end of every business day. In other jurisdictions, open-funds may only be required to buy back shares at longer intervals.
Most open-end funds also sell shares to the public every business day; these shares are priced at NAV. Most mutual funds are open-end funds. Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who want to sell their shares must sell their shares to another investor in the market; they cannot sell their shares back to the fund.
The price that investors receive for their shares may be significantly different from NAV; it may be at a "premium" to NAV i. Unit investment trusts UITs are issued to the public only once, when they are created. UITs generally have a limited life span, established at creation. Investors can redeem shares directly with the fund at any time similar to an open-end fund or wait to redeem them upon the trust's termination.
Less commonly, they can sell their shares in the open market. Unlike other types of mutual funds, unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT.
ETFs combine characteristics of both closed-end funds and open-end funds. ETFs are traded throughout the day on a stock exchange. An arbitrage mechanism is used to keep the trading price close to net asset value of the ETF holdings. Mutual funds are normally classified by their principal investments, as described in the prospectus and investment objective. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds, and hybrid funds.
Within these categories, funds may be subclassified by investment objective, investment approach or specific focus. The types of securities that a particular fund may invest in are set forth in the fund's prospectus , a legal document which describes the fund's investment objective, investment approach and permitted investments. The investment objective describes the type of income that the fund seeks. For example, a capital appreciation fund generally looks to earn most of its returns from increases in the prices of the securities it holds, rather than from dividend or interest income.
The investment approach describes the criteria that the fund manager uses to select investments for the fund. Bond, stock, and hybrid funds may be classified as either index or passively-managed funds or actively managed funds. Money market funds invest in money market instruments, which are fixed income securities with a very short time to maturity and high credit quality. Investors often use money market funds as a substitute for bank savings accounts , though money market funds are not insured by the government, unlike bank savings accounts.
Other money market funds must compute a net asset value based on the value of the securities held in the funds. Bond funds invest in fixed income or debt securities.
Bond funds can be sub-classified according to:. Stock, or equity, funds invest in common stocks. Stock funds may focus on a particular area of the stock market, such as. Hybrid funds invest in both bonds and stocks or in convertible securities.
Balanced funds, asset allocation funds, target date or target risk funds, and lifecycle or lifestyle funds are all types of hybrid funds. Hybrid funds may be structured as funds of funds , meaning that they invest by buying shares in other mutual funds that invest in securities. Many funds of funds invest in affiliated funds meaning mutual funds managed by the same fund sponsor , although some invest in unaffiliated funds i.
Investors in a mutual fund pay the fund's expenses. Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value. The management fee is paid by the fund to the management company or sponsor that organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand to the fund. The fund manager may also provide other administrative services. The management fee often has breakpoints, which means that it declines as assets in either the specific fund or in the fund family as a whole increase.
The fund's board reviews the management fee annually. Fund shareholders must vote on any proposed increase, but the fund manager or sponsor can agree to waive some or all of the management fee in order to lower the fund's expense ratio. Distribution charges pay for marketing, distribution of the fund's shares as well as services to investors.
There are three types of distribution charges. A mutual fund pays expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. These costs are normally positively correlated with turnover.
Shareholders may be required to pay fees for certain transactions, such as buying or selling shares of the fund. For example, a fund may charge a flat fee for maintaining an individual retirement account for an investor.
Some funds charge redemption fees when an investor sells fund shares shortly after buying them usually defined as within 30, 60 or 90 days of purchase ; redemption fees are computed as a percentage of the sale amount. Shareholder transaction fees are not part of the expense ratio. The expense ratio equals recurring fees and expenses charged to the fund during the year divided by average net assets.
The management fee and fund services charges are ordinarily included in the expense ratio; front-end and back-end loads, securities transaction fees and shareholder transaction fees are normally excluded.
To facilitate comparisons of expenses, regulators generally require that funds use the same formula to compute the expense ratio and publish the results.