Mutual Funds: What They Are And How They Work

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For being the most popular investments in the country, many people have a "black box" picture of mutual funds. Money goes in one end and more money (usually) comes out the other.

Mutual companies in general are a very old concept. The Egyptians had them in ancient times, mostly for insurance purposes. For one time investments, they go back at least to europe in the middle ages. But it wasn't until 1924 in the United States that somebody had the bright idea of making it a continuing thing, an actual business planned around the continual making of communal investments. (The very first mutual fund is still going, by the way, as a member of one of the bigger advisory fund families.) Regulation of mutual funds and similar entities dates to the Investment Company Act of 1940.

The basic concept is this: A group of people get together and pool their investment money, and invest it as a group. They all own a portion of the entire pool of investments.

This buys a lot. It buys economies of scale, as the costs to trade 10,000 shares are significantly less than 100 times the cost of trading 100 shares, and way less than 10,0000 times the cost of trading a single share. It buys instant diversification, as the group has plenty of money to split among enough investments so that the failure of any one will not unduly hurt them. It buys (theoretically) top tier money management, because there's enough money in the group such that the cost to pay such a person isn't prohibitive, as it is to average investors on their own. Furthermore, there is no need to purchase an even number, or even an integer number of shares, so you can invest any amount that is at least whatever minimum the group agrees upon. You can typically buy mutual fund shares in increments as small as one one thousandth of a share, so if you want to invest $507.63 exactly, that's not a problem as long as it's above the minimum investment, or minimum additional investment, whichever is applicable.

Because there are costs to the group associated with adding a new investor or making a new investment, they do have rules about minimum initial investment and minimum additional investment. For some "no-load" funds, the minimum investment can be several thousand dollars. For advisors funds, where there is a sales charge, the minimums are typically smaller, something along the lines of $250 or $500, as the sales charges discourage short term trading. Indeed, some of the advisors funds will accept initial investments as small as $25, as long as you agree to monthly investments.

The math of mutual fund share price is mostly important to the accountants, not the investors. Initially, it's quite arbitrary. There is a given pool of investment dollars, and the group, or investment company, decides that share price is going to be $10.00 or $25.00 or whatever. Note that, with mutual funds, there is no practical difference between $1000 buying one hundred $10 shares or forty $25 shares. It's just a matter of record-keeping. There is a minor record keeping argument for setting initial share price low, but it's mostly important for record keeping.

During each trading day, the number of shares is kept constant. Whether or not there is any trading activity, any new investment, or any redemption, the number of shares stays constant until the end of the trading day. At the end of the day, the fund computes the value of the underlying investment, divides by the number of shares for that trading day, and that becomes the share price. At this point, the end of the trading day, any redemptions or new investments take effect If someone wants to redeem a given number of shares, the company sends them share price times number of shares. If someone wants to redeem a given amount of money, the fund divides that by the share price and redeems that number of shares. If someone invested money in the fund that day, the purchase takes effect at the end of day price. You can buy a given number of shares (providing you sent them at least enough money) or, more commonly, you can invest a certain number of dollars, which will be divided by the share price to calculate the number of shares you bought. For these reasons, among others, short-term trading mutual funds of any sort is a pointless way to waste money, and Exchange Traded Funds are a method for extorting money from the gullible (If you must day trade, S&P and similar option based alternatives are superior). Mutual funds are for investors who intend to hold for a while.

As time goes on, there are several sorts of events that influence share price. First off, that the underlying pool of investments fluctuates in value, going up and going down with supply and demand. This happens whether that investment is bonds, stocks, or both. Bond prices and stock prices change every day, with supply and demand and market conditions. Always, within a given day, the number of shares in the fund is constant. At the end of the day, the effects of the market and any trading the fund did are taken into account, and the end of day share price is computed, and all of the day's transactions in shares take place at the end of the market day. In order to be processed by the fund on that day, any orders to buy or redeem shares must be received by the fund prior to market close, or they get the next day's share price. There have been people criminally convicted and sent to jail on this point, for gaming the share price.

The second thing that happens to influence share price is income. Every so often, one of the fund's underlying investments will pay a dividend (stocks) or make an interest payment (bonds). Each one of the fund's shares (not shareholders!) is entitled to an equal share of this money. Say that the fund gets a million dollars over the course of a certain period, and there are ten million shares outstanding. Each of the shares will get a payout of approximately ten cents. I say approximately, because there are other concerns involved. Now, because this money has been received over a period of time, and until the payout was included in the overall value of the fund, the price per share will be reduced by whatever the payout is (and all funds hold at least a small amount of cash). So if the price per share was $15.00 before a $.10 per share payout, it will be $14.90 afterwards. Some shareholders will have elected to receive income in cash, and some will have elected to have it automatically reinvested (each share's payout purchasing 1/149th of a share in this example), but in either case, this has tax consequences for the investors unless they made their investment from within a tax deferred account such as an IRA (among many others), and the money remains within that account.

The third thing that has an impact upon share price is capital gains (and losses!). If the fund invested $1 million by buying 50,000 shares of ABC company at $20 per share, and ABC company goes to $30 per share, the value of those shares has increased to $1.5 million. So long as the fund management holds onto those 50,000 shares of ABC, it's just a paper increase, and if there are ten million shares of the fund outstanding, that means that each share of the fund effectively owns fifteen cents of ABC, and five cents of that is an unrealized gain.

But let's say that the share price of ABC goes to $50 per share, and the fund management decides that it's time to sell those 50,000 shares. Now they sold for $2.5 million, and of that, they cost $1 million to buy (This is usually stated by saying that those 50,000 shares had a basis of one million dollars) But the remaining 1.5 million dollars is profit for the fund. If there are still ten million shares outstanding, that's a 15 cent per share capital gain. Assuming there are no other capital gains or losses for the period, the fund declares a fifteen cent capital gain. Just like income received, if the share price was $15.15 before, it will be $15.00 after. Some investors will have chosen a payout, and some will have chosen to reinvest. The ones who have chosen a payout will get a check of fifteen cents multiplied by however many shares of the fund they own, while the ones who have chosen to reinvest will each get one one hundredth of a share per share they already own. Whichever they have chosen, unless the investment comes from and remains within a tax deferred account such as an IRA, there will be tax consequences for the individual investors.

Most mutual funds are not "stand-alone" investment companies. They are members of a family of funds, theoretically investing only in a particular investment niche. This allows the entire fund family to amalgamate their marketing efforts and administration. Particularly with advisory funds, most investors should find a single fund family that meets their needs to stay within, in order to minimize sales charges. The family may or may not have input as to a given fund's management team. Nonetheless, each fund has its own board of directors, and there is not usually anything legally binding a particular fund ("investment company") to a particular fund family if the investors and fund management really want to leave.

Now there are some potential weaknesses of mutual funds. The fact that there are tax consequences for investors is not an issue while still holding most other sorts of investments, at least not to the same degree. So most mutual funds find themselves with incentives to do something, or not do something they would otherwise have done, due to tax consequences to their investors. Furthermore, most mutual funds are way too dilute. The optimum number of investments, according to mathematical models, is between twenty and thirty, and given that the overwhelming majority of investors who invest in mutual funds have invested in several different ones, a smaller number of investments per fund is more appropriate than a larger number. It being that time of year right now, I just got a statement from one of my funds listing over 400 holdings. There are reasons I continue to invest in that fund and that family, but I'm certainly not happy about that aspect.

Nonetheless, even with these weaknesses, a mutual fund's ability to deliver immediate diversification, economies of scale, and professional management with only a modest investment, well within the capabilities of beginning investors, are excellent reasons why most investors should strongly consider them as an investment vehicle, especially starting out. That they are also very liquid, and not subject to large purchases and redemptions significantly influencing share prices, can give even a large investor with "high risk" predilections reason to park money there for a time.

Caveat Emptor


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This page contains a single entry by Dan Melson published on August 3, 2006 10:00 AM.

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