Mutual Funds

Mutual funds are a type of financial investment. The term "mutual fund" can refer to both the investment itself and the companies that create and manage mutual funds. Since their introduction into the US economy in the 1920s, mutual funds have become a huge part of the United States’ financial-services sector.

Mutual funds are investment vehicles in which money from a group of many different people is pooled together and invested in securities such as stocks and bonds. A mutual fund may have hundreds of thousands of investors. The combined investment revenue from these mutual funds can total into the billions of dollars.

Proponents of mutual funds contend that they offer decreased exposure to risk through diversification and access to professional money managers. Critics point to the fees investors pay for owning a share in the mutual fund, as well as the potential for increased tax exposure.

Brief History

The earliest known version of a mutual fund appeared in Europe in the early 1770s. A merchant in the Netherlands, Adriaan van Ketwich, pooled money from a group of investors in 1774 in reaction to an unstable economic climate in Europe. Van Ketwich named the fund "Eendragt Maakt Magt," which translates to "unity creates strength." The fund comprised diverse investments across Europe and the American colonies so that financial risk was minimized for its investors. Van Ketwich’s fund operated until 1824. By the 1890s, this early form of mutual fund had appeared in England, France, and the United States.

In the early 1920s, Edward Leffler, a securities salesman in Massachusetts, helped form what would become the first modern mutual fund. Leffler sought to create an investment vehicle that would benefit all types of investors. Some core concepts he used to develop modern-day mutual funds included professional management of investments, diversification, reasonable fees, and liquidity, or the ability for investors to cash out of the investment easily.

Leffler’s investment idea eventually attracted the interest of Learoyd, Foster, & Company, a brokerage firm in Boston. After hiring Leffler, the firm formed the first modern mutual fund, the Massachusetts Investment Trust, in 1924. The mutual fund invested in a broad range of industries, including railroads, insurance, and industrial firms.

In 1940, the United States Congress passed the Investment Company Act, which dictated that mutual funds and other financial services be subject to the regulation of the US Securities and Exchange Commission (SEC). The act requires mutual funds to keep records of their transactions and file reports with the SEC on a regular basis. The Investment Company Act has been updated and amended several times over the years. Eventually, as a result of this legislation, mutual-fund firms were required to provide a prospectus, a legal document detailing their dealings, fees, and performance. By the early twenty-first century, all prospective investors had access to prospectuses when selecting a mutual fund in which to invest.

Throughout the twentieth century, the popularity of mutual funds grew. In the 1940s, approximately $1 billion was invested in mutual funds. By 2014, according to the Investment Company Institute’s 2015 Investment Company Fact Book, that amount had grown to $15.9 trillion. One of the reasons for the continued growth of the industry is a popular investment tool known as a 401(k). By the late twentieth century, companies had begun to offer 401(k)s to their employees instead of pensions, which by that time had become more expensive for private-sector employers to maintain. The majority of 401(k)s are actually investments in mutual funds; however, with a 401(k), an investor’s option to liquidate, or cash out of, the investment is restricted.

Benefits of Mutual Funds

The benefits of investing in a mutual fund are clear: diversification, which reduces risk; access to professional money managers; and the freedom to liquidate part or all of the investment when and if the investor so chooses.

Diversification is the key attribute of mutual funds. A mutual fund generally invests in between twenty and one hundred securities, sometimes more. Each investor in a mutual fund owns a share of that fund’s investment portfolio. Because money from many investors is spread out across a range of investments, mutual funds minimize individual investors’ exposure to risk. Another advantage of the mutual-fund model is that by combining funds from many investors, mutual funds offer access to stocks and bonds that a small-scale investor may not otherwise be able to afford.

Another benefit of mutual-fund investment is access to professional money managers. Mutual funds employ money managers to invest their capital. Such funds have millions or even billions of investor dollars to utilize. Consequently, these money managers tend to have a level of training and experience that an individual investor may not have or be able to afford. Access to professional money managers also means that investors in mutual funds do not have to make decisions about their investments, beyond selecting the mutual fund and deciding when to liquidate their shares. In addition, investors in mutual funds retain access to their money. Fund investors are able to liquidate their assets whenever they choose.

Criticisms of Mutual Funds

Despite these advantages, critics point out that returns on investments are not guaranteed. The skill and talent of mutual-fund money managers is no guarantee against bad decisions or lost money. Another point to consider is that mutual funds charge operating fees to their shareholders. These fees are paid from the amount the shareholder has invested with and gained from the mutual fund

A broader criticism of the mutual-fund industry is that it decreases market competition and, over time, raises prices for consumers. Some economists argue that a natural consequence of a fund’s growth is an increase in its market share, which produces an increase in prices for consumers. If a mutual fund holds many shares of many companies in the same industry, it could affect the entire industry in a way that hurts the consumer. In a study published in 2015 titled Anti-Competitive Effects of Common Ownership, José Azar, Martin C. Schmalz, and Isabel Tecu investigated the US airline industry to test this theory. Much of the airline industry is owned by mutual funds and other institutional investors. United Airlines’ largest stockholders are mutual funds and similar entities that also hold some of the largest shares in Delta and Southwest Airlines, among others. The study found that consumer prices increased by as much as 10 percent in the airline industry as a result of this broad and intertwined ownership by mutual funds and similar institutions.

Types of Mutual Funds

There are two main types of mutual funds: open-end and closed-end. Most mutual funds are open-end funds. These funds may issue and sell a virtually unlimited number of shares to as many investors as possible. Most open-end funds are "load" funds. In a load fund, an investor pays a fee to buy into the fund at the outset of his or her investment, and generally there is no liquidation fee. In closed-end mutual funds, the creators of the mutual fund decide at the outset, before shares are sold, the maximum number of shares the fund will comprise. Only about 25 percent of mutual funds are closed-end funds.

Different mutual funds feature different investment types and strategies. Some of the most common types of mutual funds are bond funds, stock funds, international funds, and sector funds. Bond funds invest money in the bond market, while stock funds invest in the stock market. Some mutual funds invest in both stocks and bonds. International funds focus investments on the global market, including the United States. Critics of international mutual funds contend that they are more volatile than domestic funds, which are funds that invest only in US companies. Sector funds invest in one sector of the economy, such as technology, energy, or finance. Some mutual funds invest in a combination of stock, bond, international, and sector funds.

Selecting a Mutual Fund

When selecting a mutual fund, there are many things to consider. As the level of financial risk varies with each fund, investors should be careful to select a fund that matches their desired amount of risk exposure. Prospective investors should also familiarize themselves with the mutual funds’ fee structures and any redemption or exchange fees. Another important aspect to consider is tax consequences. Mutual funds are subject to capital gains tax. An investor in mutual funds may have to consider both personal capital gains tax and the fund’s capital gains tax when filing his or her taxes.

Bibliography

Azar, José, Martin C. Schmalz, and Isabel Tecu. Anti-Competitive Effects of Common Ownership. Working paper no. 1235. Ann Arbor: U of Michigan Stephen M. Ross School of Business, 2015. Social Science Research Network. Web. 30 May 2015.

"Basics of Investing in Mutual Funds." CNN Money. Cable News Network, n.d. Web. 30 May 2015.

Gremillion, Lee. Mutual Fund Industry Handbook: A Comprehensive Guide for Investment Professionals. Hoboken: Wiley, 2005. Print.

"The History of Mutual Funds." The Investment Funds Institute of Canada. Investment Funds Inst. of Canada, n.d. Web. 30 May 2015.

Investment Company Act of 1940. Pub. L. 76-768. 54 Stat. 789–858. 22 Aug. 1940. Amended through Pub. L. 112-90. 3 Jan. 2012. US Securities and Exchange Commission. Web. 30 May 2015.

Investment Company Institute. 2015 Investment Company Fact Book: A Review of Trends and Activities in the US Investment Company Industry. 55th ed. Washington: Investment Co. Inst., 2015. Investment Company Institute. Web. 30 May 2015.

"Invest Wisely: An Introduction to Mutual Funds." US Securities and Exchange Commission. Securities and Exchange Commission, 2 July 2008. Web. 30 May 2015.

Mobius, Mark. Mutual Funds: An Introduction to the Core Concepts. Hoboken: Wiley, 2007. Print.

Posner, Eric, and E. Glen Weyl. "Mutual Funds’ Dark Side." Slate. Slate Group, 16 Apr. 2015. Web. 30 May 2015.

Ramsey, Karen. "How to Choose the Right Mutual Fund." The Smarter Investor. US News & World Report, 30 Apr. 2014. Web. 30 May 2015.