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Investing in a mutual fund requires little more than money and some key strokes on your computer or a phone call to a broker. Notwithstanding the simplicity of interaction, there is a lot going on behind the curtain; much like the Wizard of Oz. Establishing and operating a typical mutual fund consists of a number of different functions. The sponsor of the fund organizes the fund and provides the initial "seed money" to get it started. The sponsor, as the first shareholder, establishes an initial board of directors to manage the fund. Once people invest in the fund, they become the fund's shareholders and thereafter elect the directors. Typically, the sponsor is also the investment adviser, directing the fund's investments and managing the portfolio. This key function could, however, be handled by a different company. Administrators perform the "back office" operations. They provide the various things needed to run a fund such as office space, clerical staff, internal accounting, and the filing of reports with the SEC and the Internal Revenue Service. Mutual fund investors buy and redeem their shares in the fund through an underwriter. The underwriter agrees with the mutual fund to buy and sell shares of the fund to the public. Transfer agents keep track of the accounts and calculate each investor's share of dividends and capital gains distributions. They also provide account statements, notices and income tax information to the shareholders. The fund's portfolio of stocks, bonds or other investment assets are usually held in the name of a custodian. An outside accounting firm audits the books and records of the fund and provides the required opinions concerning its financial status. In short, a fund has a lot of moving parts, and each party playing a role must be paid. Hence, the fees and expenses charged the shareholders.
Mutual funds fall into two general categories: active and passive management. The portfolio of an actively managed fund is overseen by an investment adviser with the goal of beating a recognized market average, such as the S&P 500 index. This is a difficult job, and a majority of funds fail to reach this goal in any given year. This gives rise to a good deal of debate as to the true benefits of mutual funds. On a world wide basis, mutual funds of all kinds invest trillions (yes, that's with a T) of dollars. In recent years, the number of funds in the US, approximately 7,000 or so, exceeds the number of individual stocks listed on the NYSE and the NASDAQ, roughly 4,500. If you add stocks listed on other exchanges, the number of stocks climbs to almost 6,500; a number still smaller than the number of funds investing in them. In effect, mutual funds, collectively, are the market. Their combined trading of stocks creates a large percentage of the annual market volume and movement, in effect, the market average. If that is true and you deduct the fees and expenses of mutual funds from that average, it is simple mathematics. When you deduct the expenses and fees, most mutual funds stand no chance of beating their market average. Notwithstanding this, mutual funds remain the investment of choice for most people.
John C. Bogle, the founder of The Vanguard Group, explained this phenomenon in his 1994 book, Bogle on Mutual Funds New Perspectives for the Intelligent Investor, as follows:
While
the wide selection of mutual fund offerings has provided much of the
impetus for the industry's growth during the past two decades, (he is speaking of the1970s & 1980s) four
time-honored principles of mutual fund investing are the core of the
industry's success. These principles are (1) broad diversification, (2)
professional management, (3) liquidity, and (4) convenience. They
remain as valid today as they were when the first U.S. mutual fund was
introduced.
We will learn more about this type of investment in the next blog.
Comments are always welcome.
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