Mutual Funds [Basic Investing I Studied #5]

This one’s gonna be about mutual funds.

A mutual fund is — as you’ll see in a sec — a type of investment company, so let me first sort out what an investment company even is, and then we’ll zoom into mutual funds.

So. An investment company is basically a financial intermediary that pools money from a whole buncha investors — individuals, corporations, whoever — and invests it in a wiiide variety of securities and assets.

Picture it like this: the investment company sweeps a bunch of assets into one big pool, and then hands out claims on that pool to each individual investor. That’s the move.

Why are these things nice to have?

Bookkeeping and admin. If you tried to do this stuff on your own, let’s be real — you probably wouldn’t do a great job. Investment companies keep proper records and put out periodic performance reports. Clean.
Diversification and divisibility. Yeah, it’s a bunch of small investors pooling their money — but if you squint at it from waaay back, the pool itself looks like one giant whale of an investor. lol ok.
Professional portfolio management. They hire ridiculously sharp analysts and managers to actually run the thing.
Low transaction costs. Because they’re slamming through huge trades in bulk, they crush fees down — brokerage commissions, transaction costs, all of it.

OK so investment companies have these perks. Now how do we classify them?

At the top level: unit investment trusts vs. managed investment companies. (The names kinda give it away — a unit investment trust’s portfolio is unmanaged, and a managed investment company’s portfolio is, well, managed.) (Doesn’t quite click yet — it will.)

Managed investment companies then split further into closed-end and open-end.

And open-end? That’s the mutual fund!!!

Anyway, we’ll come back to it.

So one at a time. First — unit investment trusts.

How does a unit investment trust actually invest the pool it’s collected? These guys generally buy a portfolio from a securities firm and park it with a trust institution. The securities firm then sells shares — called redeemable trust certifications — to the public in units. So the unit investment trust scoops up huge piles of, say, government bonds, municipal bonds, corporate bonds, and goes “gather round, folks~”, slaps a premium on top, and sells. (Makes sense — these things would normally be way too pricey for an individual to buy outright.)

And now you can kinda see why we call it unmanaged. With an operation like that, there’s not really much to manage day-to-day.

And since they bought in bulk, they’ve already squeezed the fees down — so even with a not-too-crazy premium, they still come out ahead, right?

That said — these trust assets have apparently been bleeding market share to mutual funds. Trust assets sat at $105 billion in 1990 and shrank to $53 billion by 2007. So yeah, a lot of people walked over to mutual funds.

OK now — let’s look at the managed investment companies, which is the bucket mutual funds live in.

These split into closed-end and open-end. The thing they have in common: shareholders elect the fund’s board of directors, and the board picks a management company to actually run the portfolio. (And of course, that management company gets paid — something like 0.2% to 1.5% of asset value.)

So what’s the difference?

Open-end funds (the ones with fees attached) can issue new shares whenever, or redeem them at NAV. And if an investor wants cash instead of shares, they sell the shares back to the fund and get NAV!!!

Closed-end funds — none of that. No redeeming, no issuing more shares. Wanna cash out? You’re on your own, go find another investor and sell to them.

Closed-end fund shares trade on a stock exchange — you can buy them through a brokerage just like regular stock. Which means there can be a gap between NAV and the actual price~~

Wait — what the heck is NAV?

NAV = net asset value.

Quick example. Say a fund manages a securities portfolio worth $120 million, has to pay $4 million to an investment advisory firm, plus another $1 million in rent, wages, and other expenses, and the fund has issued 5 million shares. Then NAV per share is:

Alright, open-end. Open-end funds = mutual funds. Let’s quickly look at where they invest, how they make money, how they pay it out, etc.

Every mutual fund has a specific investment policy spelled out in its prospectus. Like, money market mutual funds, bond mutual funds — that kinda thing.

A money market mutual fund invests in short-term, low-risk money market instruments. A bond fund invests only in T-bonds. Stuff like that.

And the management company running the show handles all of it — allocating across different industry sectors, shifting between funds when needed, the whole deal.

Big-name shops doing this kind of work: Fidelity, Vanguard, Putnam, Dreyfus.

OK so let’s run through the important fund types, sorted by investment policy.

Money market fund. Invests in money market securities — commercial paper, repos, CDs. You can write checks against the account. NAV per share is pinned at basically $1, so things like capital gains tax don't really apply. (They can keep this peg because they're in high-credit, short-term stuff. Although during the global financial crisis it did dip to $0.97 at one point…)

Equity fund. Mostly stocks, but at the manager’s discretion can dabble in other securities too. They also keep at least a sliver of money market securities on hand — gotta have liquidity for redemption requests.

Equity funds split like this:

Income fund: leans toward stocks with high dividend yields, to crank up current income
Growth fund: focuses on capital gains prospects rather than current income

Specialized sector fund. The classic sector fund — equity funds that concentrate on one specific industry. Biotech, utilities, precious metals… that kinda thing. Or funds that focus on the securities of one specific country. (China??? Something like that??? Plenty of them out there, lol.)

Bond fund. Focuses on fixed-income securities — surprise! Concentrated investment in T-bonds, municipal bonds, etc. heh heh. And bond funds get sliced further by maturity — short, medium, long — and apparently there are even ones that go all-in on junk bonds. heh heh. (What kind of life choice is that, lol.)

International fund. Some are called global funds — they invest in companies outside your home country!!!!! There are also regional funds that focus on one specific region, and emerging market funds that concentrate on companies in developing countries.

Balanced fund. Some funds are designed to be your whole portfolio. They lock in a stable ratio of, say, stocks to fixed-income — could be aggressive, could be conservative — and that’s how things like life-cycle funds get built.

Asset allocation fund. Also, as the name says, diversifies across stocks and bonds… so it’s kinda close to the balanced fund above. But the juuust-a-tiny-bit different thing is — an asset allocation fund shifts its allocation based on the manager’s outlook. The balanced fund is built as a low-risk vehicle, but this one’s about market timing. Watch the market, redistribute, maximize gains. That kind of vibe.

Index fund. Remember all those market indices we covered — S&P 500, Dow, NYSE, etc.? Index funds take one of these stock indices and just buy stuff in the same proportions as the index. Yeah, that’s a thing too~~~~

Anyway. A mutual fund company puts together an investment portfolio like this, generates returns this way and that, and I think that’s basically the pitch.

The best part for us? “The pros are doing it for you.”

Now now now now — but if the pros are doing it for us… we gotta pay for that!!! The price tag here is called fees, and —

What kinds of fees are we talking about?

Operating expenses, front-end load (sales fee), back-end load (redemption fee), and 12b-1 charges.

Operating expenses — pretty self-explanatory. Expressed as a ratio to portfolio assets, somewhere around 0.2% to 2%.

Sales fee (front-end load) — what you pay when you buy into the fund. Typically 3% to 6% of the purchase amount. Cheap funds, 3%; pricier ones, 6%. But! There are no-load funds out there!!! And the fee gets taken straight off the actual investment amount. heh.

Back-end load (redemption fee) — what’s that one~~~

It’s the fee you pay when you exit your shares!! Usually starts around 5–6% early in the fund’s life and shrinks by 1% per year. This setup is called a contingent deferred sales charge.

12b-1 fee — this one’s named after an SEC regulation. Which one, you ask?

The fund manager is allowed to charge for advertising costs, annual reports, prospectuses — basically all the production costs for promotional material, plus selling expenses — and the name comes from the regulation that says they can. This cost also gets pulled directly out of fund assets. It’s capped at 1% of average annual net assets. (The cap on 12b-1 sales fees is 0.75%, but you can also charge up to 0.25% for individual services and shareholder account upkeep — and that’s how you get the 1%.)

Now let’s see how mutual funds generate their returns!!!!

The return on a mutual fund: increase in NAV + dividend income + capital gains, that’s the profit. And since it’s a rate of return, you divide that profit by the initial NAV. Boom — mutual fund return. (Feels like a “well, duh” formula, kinda. -_-)

(After all that yapping about fees… the fees are nowhere in here. But I’m guessing $\text{NAV}_0$ is already the value after all the fees you’d subtract have been subtracted.)

Originally written in Korean on my Naver blog (2016-04). Translated to English for gdpark.blog.