What are Mutual Funds?

Joel Anderson  |

Mutual funds are getting pretty beat up these days. Pretty much everyone’s taking their shots. Really, what are mutual funds except massive dinosaurs that charge exorbitant fees to do an average job, at best, of picking stocks for you? With all that’s been written about the Perfect Market Hypothesis, passive management, and how ETFs carry lower expense ratios, what fool would sink their money into a mutual fund?

According to the Investment Company Institute’s (ICI) 2013 Investment Company Fact Book, a LOT of fools. The numbers are somewhat staggering: mutual funds hold $13 trillion in assets (10 times the $1.3 trillion in ETFs and more than the GDP of China); 44 percent of US households own mutual fund shares; and mutual funds hold 28 percent of all US corporate equity, 28 percent of all US municipal securities, and 42 percent of all commercial paper.

In short, mutual funds are an investment juggernaut. For all the chatter from Ivory Tower intellectuals and financial experts, the vast majority of American investors are perfectly content sinking their retirement savings into a mutual fund that builds a diversified portfolio for them.

So with that in mind, here’s a quick look into the mutual fund and why it does and does not deserve the criticisms leveled at it.

Collective Investment Scheme

Financial professionals are usually loathe to use the word “scheme,” but the primary definition of the term (“a plan, design, or program of action to be followed”) fits here. Mutual funds are “collective investment schemes,” a plan to pool money from multiple sources to make investments. In this case, it’s the money from thousands of investors across the country (and world) purchasing shares of a particular fund. Their money is then taken by the fund and used to purchase assets like stocks and bonds, with the value of the shares being proportional to that of the fund.

The history of mutual funds is a long one, with at least one researcher tracing their origins back to a Dutch merchant in 1774. The first mutual fund outside the Netherlands was formed in London in 1868, and by the 1890s mutual funds had found their way to America. Their popularity picked up speed during the high-flying markets of the roaring 1920s, and, like pretty much every other aspect of the stock market, they came under increased regulatory scrutiny during and after the Great Depression, with the Investment Company Act of 1940 creating most of the legal framework for regulating mutual funds.

Diversification Made Easy

The first piece of advice any beginning investor will get is to “diversify.” This is based on the premise that putting all of your eggs in one basket, or even a dozen baskets, is a pretty big risk. Mutual funds reduce this risk by buying thousands of different types of securities so that even if some fail, the overall health of the fund remains relatively strong.

Diversifying one’s portfolio can be a daunting task. Who has time to sit around researching hundreds of different stocks and bonds to ensure their investments are appropriately balanced across asset classes? In the rush to find the appropriate mix of large-cap, mid-cap, small-cap, growth and value stocks across multiple different sectors and industries, the choice comes down to cutting corners (and subsequently risking bad investments), sinking more time and energy into building a portfolio than it’s worth, or just running the risk of a portfolio that’s not adequately diversified.

However, buying shares of a mutual fund takes care of this for you. The company that manages the fund employs an army of analysts and managers carefully researching and picking stocks and bonds. Investors can get the diversified portfolio they need without any of the legwork.

Types of Mutual Funds

The vast majority of mutual funds used by investors fall into the category of open-end funds. This type of fund tallies up the value of their portfolios at the end of each trading day to determine a Net Asset Value (NAV) and then price shares accordingly. Pretty much anyone who wants to can simply purchase shares in the fund, and the fund will sell them or buy them back at the end of the trading day according to the portfolio’s NAV.

There are more than 7,500 open-end funds in America that account for about $12 trillion of the assets in mutual funds.

There are also mutual funds called closed-end funds. Closed-end funds issue shares only once with an IPO, and the fund will not buy those shares back from anyone who holds them. Any investor wishing to divest has to sell their shares on a secondary market. This also means that closed-end funds can often trade at a value very different from their NAV. A top-performing fund may see shares trade at a premium to NAV, as eager investors are willing to pay more for a chance to get a piece of the fund while a poorly-performing fund may see shares trade at a discount as investors don’t want to buy into a fund that’s difficult to get out of and doesn’t provide enough returns.

There are just over 250 closed-end funds in the United States, with a little more than $250 billion in assets at their disposal.

Finally, one can also invest in what’s called unit-investment trusts (UIT). Like a closed-end fund, they only issue shares once during an IPO. Like an open-end fund, anyone holding the shares can redeem them from the company that issues them. What makes UITs different is that the fund generally has an end date, when the assets are liquidated and shareholders are paid out. What’s more, UITs don’t have an asset manager as there’s no managing to be done. The UIT holds the same basket of securities until the end date.

While there areover 6,000 UITs in the United States, they only control a little under $75 billion in assets.

The Problems With Mutual Funds

As stated above, mutual funds are not en vogue with most investment professionals despite their widespread popularity. There are a few reasons for this.

Part of the issue concerns the idea of passive vs. active management of a fund (a concept examined in greater depth here). In short, the majority of mutual funds fail to beat the market. In fact, over the last 10 years, only 24 percent of professional investors outperformed the major indices. On the whole, it appears as though precious few managers actually accomplish anything by taking the time to pick stocks.

This wouldn’t be a tremendous issue except for the fact that mutual funds charge fees. Every fund has what’s called an expense ratio, which is a portion of assets charged by the fund to pay for their managers and research analysts to help pick stocks. And, compared to passively-managed ETFs that simply try to replicate the holdings of a specific index, mutual funds have high expense ratios.

So, ultimately, investors are paying to have their money managed, but they aren’t really getting anything out of it on most occasions. If you can just buy the SPDR S&P 500 Index ETF (SPY) , which is composed of the same stocks that make up the S&P 500 and mimics the index’s performance, why pay extra for a mutual fund that won’t perform as well?

Why We Invest Anyway

However, despite all this theorizing, people still go with mutual funds. In fact, they’re doing so with gusto. Since 1995, the assets controlled by mutual funds have nearly quintupled from $2.8 trillion to more than $13 trillion today. ETFs are jumping in popularity as well, but certainly not at the expense of mutual funds.

So what draws people into these mutual funds?

In part, the answer’s as simple as willful ignorance. While it’s clearly true that an engaged, informed investor can beat the best mutual funds out there, most don’t want to bother. Even over decades of saving for retirement or college, an extra percentage point in expense ratios will only mean $1,000 less for every $100,000 saved. And that’s well worth it for investors that want to feel comfortable knowing that their nest egg is in the hands of trained professionals.

What’s more, mutual funds do still offer comparatively less risk. The SPY is an incredibly stable investment to make, but it does only have 500 companies in its portfolio. The diversification of mutual funds dilutes potential returns, but it also makes it all the less likely that the fund will suffer some sort of catastrophic devaluation. When an investor is possibly dealing with the savings of a working family, sacrificing performance to reduce risk is often well worth it — even when the risks involved are objectively very small.

Stock price data is provided by IEX Cloud on a 15-minute delayed basis. Chart price data is provided by TradingView on a 15-minute delayed basis.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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