For many investors, the mutual fund is a mainstay of their investment portfolios, whether it be in an individual account, an IRA or a 401k. Mutual funds come in all shapes and sizes and offer a virtual alphabet soup of share classes. Trying to understand the many nuances of mutual funds can be a bewildering task.
But to protect yourself against financial mismanagement and outright investor fraud, it is important that you have a basic understanding of what a mutual fund is and how it works.
This is the first in a series of blogs that will try to demystify mutual funds, starting with what they are, how they are managed, what they cost, and where to find the necessary information (and how to interpret it).
We also will explore the role and responsibility of the fund’s board of directors as the watchdog looking out for the shareholders’ interest. And finally, we will explore investor and shareholder rights and how to vindicate those rights.
What is a Mutual Fund?
A mutual fund is a pool of money that is used to invest in the stock and bond markets. An entity called an “investment adviser” (e.g. Vanguard, Fidelity) is responsible for the fund’s investment program, whereas an individual called a “portfolio manager” makes the day-to-day investment decisions to buy, sell or hold individual stocks or bonds. The investment adviser and portfolio manager will attract investors to invest money and become shareholders (sometimes known as unitholders) in the fund.
Once the fund has shareholders, the investment adviser will receive a fee from each shareholder for managing the mutual fund’s assets. Mutual funds that attract a lot of investors can be very profitable for investment advisers and portfolio managers alike. Mutual funds that have over 100 shareholders must register with the Securities and Exchange Commission (SEC). The SEC regulates the entire fund industry.
The following are features of mutual funds to keep in mind:
- Investments in mutual funds are securities – similar to a share of stock in a company.
- Mutual fund shareholders are free to cash in, or redeem, their investment based on the current market value.
- Mutual funds are organized as either a corporation or a business trust with a board of directors (sometimes called a board of trustees) that is responsible for oversight of the mutual fund and protecting the interests of shareholders.
How the Fund is Invested
Typically, an investment adviser will launch and publicly market a mutual fund to attract investors. The investment adviser will design a mutual fund with certain investment objectives and strategies in mind. The goal is to meet or exceed the investment performance of the market in which the mutual fund invests. Some mutual funds will pursue that goal by investing in large companies; some in small companies; and some in between. Some might specialize in certain industries, such as energy, technology, or financial services. Others might invest in non-U.S. companies or target individual countries or geographic regions. The possibilities are endless.
Next: In part 2, we will discuss mutual fund fees and expenses.
Charles Field is Managing Partner of the San Diego office of Sanford Heisler Sharp and Chair of the firm’s Financial Services Litigation Practice Group.