6.1 Mutual Funds

Mutual funds pool money from many investors to invest in a diversified portfolio of securities. They are one of the most popular investment vehicles for individual investors, offering professional management, diversification, and liquidity.

Structure of Investment Companies

The Investment Company Act of 1940 regulates three types of investment companies:

Open-End Funds (Mutual Funds): Continuously issue and redeem shares at NAV

Closed-End Funds: Fixed number of shares; trade on exchanges

Unit Investment Trusts (UITs): Fixed, unmanaged portfolio with termination date

This section focuses on open-end mutual funds, which are the most common type.

Net Asset Value (NAV)

NAV is the price at which mutual fund shares are bought and sold. It represents the per-share value of the fund's assets.

NAV Calculation

NAV = (Total Assets - Liabilities) / Shares Outstanding

Key NAV Rules

Calculation Timing: At least once daily after market close (4:00 PM ET)

Forward Pricing: Orders received today execute at today's closing NAV

Same-Day Pricing: Orders before 4 PM get that day's NAV; after 4 PM get next day's

Example Calculation

A mutual fund has:

- Total assets: $330 million

- Liabilities: $15 million

- Outstanding shares: 10 million

NAV = ($330M - $15M) / 10M = $315M / 10M = $31.50 per share

In Practice

An investor places an order at 2:00 PM to purchase mutual fund shares. Since the order was placed before 4:00 PM, it will be executed at that day's closing NAV. The investor won't know the exact purchase price until after the market closes.

Types of Mutual Funds by Objective

Equity Funds

Growth Funds: Investment Focus - Capital appreciation; growth stocks. Risk Level: High

Value Funds: Investment Focus - Undervalued stocks; dividends. Risk Level: Moderate

Blend Funds: Investment Focus - Mix of growth and value. Risk Level: Moderate

Large-Cap Funds: Investment Focus - Companies with market cap greater than $10B. Risk Level: Lower

Small-Cap Funds: Investment Focus - Companies with market cap less than $2B. Risk Level: Higher

Sector Funds: Investment Focus - Specific industries (tech, healthcare). Risk Level: Higher

Fixed-Income Funds

Government Bond Funds: Investment Focus - Treasury, agency securities. Risk Level: Lower

Corporate Bond Funds: Investment Focus - Investment-grade corporate debt. Risk Level: Moderate

High-Yield Funds: Investment Focus - Below investment-grade bonds. Risk Level: Higher

Municipal Bond Funds: Investment Focus - State and local government debt. Risk Level: Tax-advantaged

Short-Term Bond Funds: Investment Focus - Maturities less than 3 years. Risk Level: Lower

Specialized Funds

Balanced Funds: Investment Focus - Mix of stocks and bonds. Key Feature: Built-in asset allocation

Index Funds: Investment Focus - Mirror a specific index. Key Feature: Passive management; low costs

Money Market Funds: Investment Focus - Short-term debt securities. Key Feature: Seek stable $1.00 NAV

International Funds: Investment Focus - Foreign securities only. Key Feature: Currency risk

Global Funds: Investment Focus - Both U.S. and foreign. Key Feature: Geographic diversification

Target-Date Funds: Investment Focus - Asset mix adjusts over time. Key Feature: "Set and forget" retirement

Money Market Funds

Money market funds invest in short-term, high-quality debt instruments and seek to maintain a stable $1.00 NAV.

Types of Money Market Funds

Government Money Market: Investments - Treasury bills, agency securities. NAV: Fixed $1.00

Prime Money Market: Investments - Commercial paper, CDs, repos. NAV: Floating NAV (institutional)

Tax-Exempt Money Market: Investments - Short-term municipal securities. NAV: May float

2014 SEC Reforms

- Government funds: Can maintain $1.00 fixed NAV

- Institutional prime/muni funds: Must use floating NAV

- Retail prime/muni funds: Can maintain $1.00 NAV with gates/fees

On the Exam: Money market funds seek to maintain a stable NAV but are not guaranteed. Unlike FDIC-insured bank accounts, money market funds can "break the buck" (fall below $1.00), though this is rare.

Index Funds

Index funds use passive management to replicate the performance of a benchmark index.

Characteristics

- Low expense ratios: No active management costs

- Tax efficient: Low turnover means fewer capital gains distributions

- Full market exposure: Own all (or representative sample of) index constituents

- Tracking error: Small difference between fund and index returns

Common Indexes Tracked

S&P 500: 500 large-cap U.S. stocks

Dow Jones Industrial Average: 30 blue-chip stocks

Russell 2000: 2,000 small-cap stocks

Bloomberg Aggregate Bond: U.S. investment-grade bonds

MSCI EAFE: International developed markets

Management Styles

Active vs. Passive Management

Goal: Active Management - Beat the benchmark; Passive Management - Match the benchmark

Expense Ratio: Active Management - Higher (0.5%-1.5%+); Passive Management - Lower (0.03%-0.20%)

Turnover: Active Management - Higher; Passive Management - Lower

Tax Efficiency: Active Management - Lower; Passive Management - Higher

Examples: Active Management - Stock-picking funds; Passive Management - Index funds

In Practice: Studies consistently show that most actively managed funds underperform their benchmark index over long periods, especially after accounting for higher fees. This has driven massive growth in index fund assets.

Mutual Fund Distributions

Mutual funds must distribute substantially all income and realized capital gains to shareholders to maintain their tax-advantaged status.

Types of Distributions

Ordinary Dividends: Source - Interest, dividends received. Tax Treatment: Ordinary income (or qualified rates)

Capital Gains: Source - Profits from selling securities. Tax Treatment: Short-term or long-term rates

Return of Capital: Source - Distribution of investor's own capital. Tax Treatment: Tax-deferred; reduces basis

Ex-Dividend Date

On the ex-dividend date, the fund's NAV drops by the distribution amount. Buying just before the ex-date means receiving a distribution you'll owe taxes on - don't confuse this with "free money."

Key Takeaways

- Mutual funds calculate NAV once daily after market close using forward pricing

- Open-end funds continuously issue and redeem shares; closed-end funds have fixed shares

- Growth funds focus on capital appreciation; income funds focus on current income

- Index funds passively track benchmarks with low fees and high tax efficiency

- Money market funds seek stable $1.00 NAV but are not guaranteed

- All distributions reduce NAV by the distribution amount on the ex-date