Mutual funds belong to a group of financial intermediaries known as investment companies, which are in the business of collecting funds from investors and pooling them for the purpose of building a portfolio of securities according to stated objectives. They are also known as open-end investment companies. Other members of the group are closed-end investment companies (also known as closed-end funds) and unit investment trusts. In the United States, investment companies are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940.

Mutual funds are generally organized as corporations or trusts, and, as such, they have a board of directors or trustees elected by the shareholders. Almost all aspects of their operations are externally managed. They engage a management company to manage the investment for a fee, generally based on a percentage of the fund's average net assets during the year. The management company may be an affiliated organization or an independent contractor. They sell their shares to investors either directly or through other firms such as broker-dealers, financial planners, employees of insurance companies, and banks. Even the day-to-day administration of a fund is carried out by an outsider, which may be the management company or an unaffiliated third party.

The management company is responsible for selecting an investment portfolio that is consistent with the objectives of the fund as stated in its prospectus and managing the portfolio in the best interest of the shareholders. The directors of the fund are responsibile for overall governance of the fund; they are expected to establish procedures and review the performance of the management company and others who perform services for the fund.

Mutual funds are known as open-end investment companies because they are required to issue shares and redeem (buy back) outstanding shares upon demand. Closed-end funds, on the other other hand, issue a certain number of shares but do not stand ready to buy back their own shares from investors. Their shares are traded on an exchange or in the over-the-counter market. They cannot increase or decrease their outstanding shares easily. A feature common of both mutual funds and closed-end funds is that they are managed investment companies, because they can change the composition of their portfolios by adding and deleting securities and altering the amount invested in each security. Unit investment trusts are not managed investment companies like the mutual funds because their portfolio consists of a fixed set of securities for life. They stand ready, however, to buy back their shares.

Types of Mutual Funds

There are four basic types of mutual funds: money market, stock (also called equity), bond, and hybrid. This classification is based on the type and the maturity of the securities selected for investment. Money market funds invest in securities that mature in one year or less, such as Treasury bills, commercial paper, and certificates of deposits. They are often referred to as short-term funds. Stock, bond, and hybrid funds invest in long-term securities; as such, they are known as long-term funds. Hybrid funds invest in a combination of stocks, bonds, and other securities. According to the Investment Company Institute (ICI), the national association of the U.S. investment company industry, there were 7,791 (6,746 long-term and 1,045 short-term) mutual funds in the United States and 35,979 outside the country at the end of 1999. The total investment by U.S mutual funds amounted to $6.8 trillion (stock $4.04 trillion, bond $808 billion, hybrid $383 billion, money market $1.61 trillion) and by non-U.S. funds to $3.5 trillion at the end of 1999. The total assets of U.S. mutual funds are less than the total assets of U.S. depository institutions, which stood at $7.5 trillion at the end of 1999.

Mutual funds also differ in terms of their investment objectives, as outlined in their prospectuses. The ICI classifies mutual funds into thirty-three investment objective categories. The main investment objectives within the stock funds include capital appreciation, total return, and world equity. Within each of these objectives, there are subcategories. There are two groups of bond funds: taxable bond funds and tax-free bond funds. Main categories in taxable bond funds are corporate bond funds, high-yield funds, world bond funds, government bond funds, and strategic income funds. The main tax-free bond fund categories are state municipal bond funds and national municipal bond funds. Among money market funds, there are also taxable money market funds and tax-exempt money market funds. As in the case of stock funds, many subcategories exist within each main category of bond and money market funds. In addition to these, there are specialty or sector funds, which invest in a particular segment of the securities market. Examples include biotechnology funds, small-company growth funds, technology funds, index funds, and social criteria funds.

Mutual Fund Share Pricing

By law, mutual funds are required to determine the price of their shares each business day. They release their prices the same day for publication in the next day's newspapers. Daily prices of mutual fund shares can also be obtained directly from the fund's offices or Web sites of commercial venders of financial information.

The share price represents the net asset value (NAV) per share, which is the current market value of a fund's assets net of its liabilities. The liabilities include securities purchased, but not yet paid for, accrued fees, dividends payable, and other accrued expenses. The NAV per share is obtained by dividing the NAV by the number of shares of the fund outstanding at the end of the day. A buyer of mutual fund shares pays the NAV per share plus any applicable sales load (also known as a front-end load). Sometimes, the sales load is collected when shares are redeemed; such a sales load is known as a back-end load. Funds that have a sales load are known as load funds; they use a sales organization to sell their shares for a fee. Funds that sell shares directly and do not have a sales load are known as no-load funds. The sales load often differs from fund to fund, and it is subject to National Association of Security Dealers (NASD) regulation. When an investor sells a share, it is the NAV that the seller usually receives. Some mutual funds may charge a redemption fee if the shares are held for less than a specified period.

Benefits and Cost of Investing in Mutual Funds

Mutual funds provide investors with a way to diversify their investment under professional management, which most investors may not be able to obtain on their own. Since the funds operate with a large pool of money, the investors benefit from economies of scale, such as a lower trading cost and a higher yield. Besides delivering attractive yields, many funds provide their investors with such services as check-writing privileges, custody (as a service), and bookkeeping. Investors also benefit from the knowledgeable investment choices of securities and investment objectives that funds offer.

The cost to the shareholder of investing in mutual funds comes in various forms: front-end loads, management fees, cost of maintaining and servicing shareholder accounts (administrative cost), redemption fees, and distribution fees (also known as 12b-1 fees). As mentioned before, a redemption fee is usually levied on shares held for less than a specified period. A distribution fee is a charge on current shareholders to cover the costs of advertising, promotion, selling, and other activities. It is sometimes combined with load charges. All these expenses are aggregated to obtain a single measure of cost to the shareholder. An aggregate measure commonly found in the published data is the expense ratio (expenses as a percent of assets). This measure does not include sales load, if there is one. Rea and Reid (1998) discuss the calculation of an alternative measure of total ownership cost that includes the sales load.

Regulation and Taxation

All U.S. mutual funds are subject to strict regulation by the Securities and Exchange Commission. They are also subject to states's notice filing requirements and anti-fraud statutes. They are required to provide investors a full disclosure of their activities in a written prospectus. They also provide their investors a yearly statement of distribution with the details of the federal tax status of their distribution. Mutual funds in the United States are not subject to corporate income tax, if they meet certain Internal Revenue Code requirements. Instead, mutual fund shareholders are taxed on the distribution of fund's income. For tax purpose, mutual funds distribute their net income to the shareholders in two ways: (1) dividend and interest payments and (2) realized capital gains.

Performance and Comparison

The rate of return is widely used for comparing the performance of mutual funds. The rate of return on a mutual fund investment for a period of one year, for example, is calculated by adding the change in the NAV (NAVt-NAVt-1) to income and capital gains distributed during the year and dividing the sum by the NAV at the beginning of the year. The following describes the calculation of return for no-load funds: where R, i, and c represent rate of return, income, and capital gains, respectively. For load funds, the calculation of return must account for load charges by adding them to the NAVt-1. The performance of a mutual fund is often compared with the performance of a benchmark portfolio that is selected to reflect the investment risk level of the fund's portfolio to see whether the mutual fund had a superior performance.

The rate of return of a mutual fund with a NAV of $15.00 at the beginning of a year and $15.50 at the end of that year, and distributed $0.75 and $0.50 per share as income and capital gain respectively during the year would be: [($15.50 - $15.00) + $0.75 + $0.50]/$15.00 = 11.67%

Analysis and Reporting

Key statistics pertaining to a fund—such as the NAV, offer price, sales charges, expense ratio, and performance measure for various categories of funds—are regularly calculated, analyzed, and published. Two firms well known for their analytical service are the Lipper Analytical Services (Lipperweb.com) and the Morning Star Inc. (Morningstar.com). The Wall Street Journal and Barron's carry the information supplied by Lip per Analytical Services on a regular basis. Investment Company Institute (www.ici.org) also pro vides a wealth of information on mutual funds, including historical data and Web site addresses of its member funds.