A mutual fund is a form of collective investment that pools money from many investors and invests their money in stocks, bonds, short-term money market instruments, and/or other securities.[1] In a mutual fund, the fund manager trades the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.
Legally known as an "open-end company" under the Investment Company Act of 1940 (the primary regulatory statute governing investment companies), a mutual fund is one of three basic types of investment companies available in the United States.[2] Outside of the U.S. (with the exception of Canada, which follows the U.S. model), mutual fund is a generic term for various types of collective investment vehicle. In the U.K. and western Europe (including offshore jurisdictions), other forms of collective investment vehicle are prevalent, including unit trusts, open-ended investment companies (OEICs), SICAVs and unitized insurance funds.
In Australia the term "mutual fund" is not used; the name "managed fund" is used instead. However, "managed fund" is somewhat generic as the definition of a managed fund in Australia is any vehicle in which investors' money is managed by a third party (NB: usually an investment professional or organization). Most managed funds are open-ended (i.e., there is no established maximum number of shares that can be issued); however, this need not be the case. Additionally the Australian government introduced a compulsory superannuation/pension scheme which, although strictly speaking a managed fund, is rarely identified by this term and is instead called a "superannuation fund" because of its special tax concessions and restrictions on when money invested in it can be accessed.
[edit] History
Massachusetts Investors Trust was founded on March 21, 1924, and, after one year, had 200 shareholders and $392,000 in assets. The entire industry, which included a few closed-end funds, represented less than $10 million in 1924.
The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require that a fund be registered with the Securities and Exchange Commission (SEC) and provide prospective investors with a prospectus that contains required disclosures about the fund, the securities themselves, and fund manager. The SEC helped draft the Investment Company Act of 1940, which sets forth the guidelines with which all SEC-registered funds today must comply.
In 1951, the number of funds surpassed 100, and the number of shareholders exceeded 1 million. Only in 1954 did the stock market finally rise above its 1929 peak, and, by the end of the 1950s, there were 155 mutual funds with $15.8 billion in assets. In 1967, funds hit their best year, in one quarter earning at least 50% with an average return of 67%, but this success was achieved by cheating -- using borrowed money and risky options, and pumping up returns with privately traded "letter stock".
With renewed confidence in the stock market, mutual funds began to blossom. By the end of the 1960s, there were approximately 270 funds with $48 billion in assets. The first retail index fund, the First Index Investment Trust, was formed in 1976 and headed by John Bogle, who conceptualized many of the key tenets of the industry in his 1951 senior thesis at Princeton University[3]. It is now called the Vanguard 500 Index fund and is one of the largest mutual funds ever with in excess of $100 billion in assets.
One of the largest contributors of mutual fund growth was individual retirement account (IRA) provisions added to the Internal Revenue Code in 1975, allowing individuals (including those already in corporate pension plans) to contribute $2,000 a year. Mutual funds are now popular in employer-sponsored defined contribution retirement plans (401(k)s), IRAs and Roth IRAs.
As of April 2006, there are 8,606 mutual funds that belong to the Investment Company Institute (ICI), the national association of investment companies in the United States, with combined assets of $9.207 trillion.[4]
[edit] Usage
Mutual funds can invest in many different kinds of securities. The most common are cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as technology or utilities. These are known as sector funds. Bond funds can vary according to risk (e.g., high-yield or junk bonds, investment-grade corporate bonds), type of issuers (e.g., government agencies, corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and foreign securities (global funds), or primarily foreign securities (international funds).
Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts the future performance of investments appropriate for the fund and chooses those which he or she believes will most closely match the fund's stated investment objective. A mutual fund is administered through a parent management company, which may hire or fire fund managers.
Mutual funds are subject to a special set of regulatory, accounting, and tax rules. Unlike most other types of business entities, they are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are also tax-free to the shareholder. Taxable distributions can be either ordinary income or capital gains, depending on how the fund earned those distributions.
[edit] Net asset value
Main article: net asset value
The net asset value, or NAV, is the current market value of a fund's holdings, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but some funds update their NAV multiple times during the trading day. Open-end funds sell and redeem their shares at the NAV, and so process orders only after the NAV is determined. Closed-end funds (the shares of which are traded by investors) may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus.
[edit] Turnover
Turnover is a measure of the fund's securities transactions, usually calculated over a year's time, and usually expressed as a percentage of net asset value.
This value is usually calculated as the value of all transactions (buying, selling) divided by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and another one bought as one "turnover". Thus turnover measures the replacement of holdings.
In Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is calculated based on the lesser of purchases or sales divided by the average size of the portfolio (including cash).
Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The very process of buying and selling securities also has its own costs, such as brokerage commissions, which are borne by the fund's shareholders.
[edit] Expenses and TER's
Mutual funds bear expenses similar to other companies. The fee structure of a mutual fund can be divided into two or three main components: management fee, nonmanagement expense, and 12b-1/non-12b-1 fees. All expenses are expressed as a percentage of the average daily net assets of the fund.
Management Fees
The management fee for the fund is usually synonymous with the contractual investment advisory fee charged for the management of a fund's investments. However, as many fund companies include administrative fees in the advisory fee component, when attempting to compare the total management expenses of different funds, it is helpful to define management fee as equal to the contractual advisory fee + the contractual administrator fee. This "levels the playing field" when comparing management fee components across multiple funds.
Contractual advisory fees may be structured as "flat-rate" fees, i.e., a single fee charged to the fund, regardless of the asset size of the fund. However, many funds have contractual fees which include breakpoints, so that as the value of a fund's assets increases, the advisory fee paid decreases. Another way in which the advisory fees remain competitive is by structuring the fee so that is based on the value of all of the assets of a group or a complex of funds rather than those of a single fund.
Nonmanagement Expenses
Apart from the management fee, there are certain nonmanagement expenses which most funds must pay. Some of the more significant (in terms of amount) nonmanagement expenses are: transfer agent expenses (this is usually the person you get on the other end of the phone line when you want to purchase/sell shares of a fund), custodian expense (the fund's assets are kept in custody by a bank which charges a custody fee), legal/audit expense, fund accounting expense, registration expense (the SEC charges a registration fee when funds file registration statements with it), board of directors/trustees expense (the disinterested members of the board who oversee the fund are usually paid a fee for their time spent at board meetings), and printing and postage expense (incurred when printing and delivering shareholder reports).
12b-1/Non-12b-1 Service Fees
12b-1 service fees/shareholder servicing fees are contractual fees which a fund may charge to cover the marketing expenses of the fund. Non-12b-1 service fees are marketing/shareholder servicing fees which do not fall under SEC rule 12b-1. While funds do not have to charge the full contractual 12b-1 fee, they often do. When investing in a front-end load or no-load fund, the 12b-1 fees for the fund are usually .250% (or 25 basis points). The 12b-1 fees for back-end and level-load share classes are usually between 50 and 75 basis points but may be as much as 100 basis points. While funds are often marketed as "no-load" funds, this does not mean they do not charge a distribution expense through a different mechanism. It is expected that a fund listed on an online brokerage site will be paying for the "shelf-space" in a different manner even if not directly through a 12b-1 fee.
Fees and Expenses Borne by the Investor (not the Fund)
Fees and expenses borne by the investor vary based on the arrangement made with the investor's broker. Sales loads (or contingent deferred sales loads (CDSL)) are not included in the fund's total expense ratio (TER) because they do not pass through the statement of operations for the fund. Additionally, funds may charge early redemption fees to discourage investors from swapping money into and out of the fund quickly, which may force the fund to make bad trades to obtain the necessary liquidity. For example, Fidelity Diversified International Fund (FDIVX) charges a 1 percent fee on money removed from the fund in less than 30 days.
Brokerage Commissions
An additional expense which does not pass through the statement of operations and cannot be controlled by the investor is brokerage commissions. Brokerage commissions are incorporated into the price of the fund and are reported usually 3 months after the fund's annual report in the statement of additional information. Brokerage commissions are directly related to portfolio turnover (portfolio turnover refers to the number of times the fund's assets are bought and sold over the course of a year). Usually the higher the rate of the portfolio turnover, the higher the brokerage commissions. The advisors of mutual fund companies are required to achieve "best execution" through brokerage arrangements so that the commissions charged to the fund will not be excessive.
[edit] Types of mutual funds
[edit] Open-end fund
The term mutual fund is the common name for an open-end investment company. Being open-ended means that, at the end of every day, the fund issues new shares to investors and buys back shares from investors wishing to leave the fund.
Mutual funds may be legally structured as corporations or business trusts but in either instance are classed as open-end investment companies by the SEC.
Other funds have a limited number of shares; these are either closed-end funds or unit investment trusts, neither of which is a mutual fund.
[edit] Exchange-traded funds
Main article: Exchange-traded fund
A relatively new innovation, the exchange traded fund (ETF), is often formulated as an open-end investment company. EFTs combine characteristics of both mutual funds and closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares are issued or redeemed by institutional investors in large blocks (typically of 50,000). Investors typically purchase shares in small quantities through brokers at a small premium or discount to the net asset value; this is how the institutional investor makes its profit. Because the institutional investors handle the majority of trades, ETFs are more efficient than traditional mutual funds (which are continuously issuing new securities and redeeming old ones, keeping detailed records of such issuance and redemption transactions, and, to effect such transactions, continually buying and selling securities and maintaining liquidity position) and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock exchange, just like closed-end funds.
[edit] Equity funds
Equity funds, which consist mainly of stock investments, are the most common type of mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the United States. [5] Often equity funds focus investments on particular strategies and certain types of issuers.
[edit] Capitalization
Some mutual funds focus investments on companies in particular size ranges, with size measured by their market capitalization. The size ranges include micro-cap, small-cap, mid-cap, and large-cap. Fund managers and other investment professionals have varying definitions of these market cap ranges. The following ranges are used by Russell Indexes: [6]
* Russell Microcap Index - micro-cap ($54.8 - 539.5 million)
* Russell 2000 Index - small-cap ($182.6 million - 1.8 billion)
* Russell Midcap Index - mid-cap ($1.8 - 13.7 billion)
* Russell 1000 Index - large-cap ($1.8 - 386.9 billion)
[edit] Growth vs. value
Another distinction made is between growth funds, which invest in stocks of companies that have the potential for large capital gains, and value funds, which concentrate on stocks that are undervalued. Growth stocks typically have the potential for a greater return; however, such investments also bear larger risks. Growth funds tend not to pay regular dividends. Sector funds focus on specific industry sectors, such as biotechnology or energy. Income funds tend to be more conservative investments, with a focus on stocks that pay dividends. A balanced fund may use a combination of strategies, typically including some level of investment in bonds, to stay more conservative when it comes to risk, yet aim for some growth.
[edit] Index funds versus active management
Main articles: Index fund and active management
An index fund maintains investments in companies that are part of major stock (or bond) indices, such as the S&P 500, while an actively managed fund attempts to outperform a relevant index through superior stock-picking techniques. The assets of an index fund are managed to closely approximate the performance of a particular published index. Since the composition of an index changes infrequently, an index fund manager makes fewer trades, on average, than does an active fund manager. For this reason, index funds generally have lower trading expenses than actively managed funds, and typically incur fewer short-term capital gains which must be passed on to shareholders. Additionally, index funds do not incur expenses to pay for selection of individual stocks (proprietary selection techniques, research, etc.) and deciding when to buy, hold or sell individual holdings. Instead, a fairly simple computer model can identify whatever changes are needed to bring the fund back into agreement with its target index.
The performance of an actively managed fund largely depends on the investment decisions of its manager. Statistically, for every investor who outperforms the market, there is one who underperforms. Among those who outperform their index before expenses, though, many end up underperforming after expenses. Before expenses, a well-run index fund should have average performance. By minimizing the impact of expenses, index funds should be able to perform better than average.
Certain empirical evidence seems to illustrate that mutual funds do not beat the market and actively managed mutual funds under-perform other broad-based portfolios with similar characteristics. [7] finds that nearly 1,500 U.S. mutual funds under-performed the market in approximately half of the years between 1962 and 1992. Moreover, funds that performed well in the past are not able to beat the market again in the future (shown by Jensen, 1968; Grimblatt and Titman, 1989.[8] However, as quantitative finance is in its early stages of development, more accurate studies are required to reach a decisive conclusion.[citation needed]
[edit] Bond funds
Bond funds account for 18% of mutual fund assets. [9] Types of bond funds include term funds, which have a fixed set of time (short-, medium-, or long-term) before they mature. Municipal bond funds generally have lower returns, but have tax advantages and lower risk. High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With the potential for high yield, these bonds also come with greater risk.
[edit] Money market funds
Money market funds hold 26% of mutual fund assets in the United States. [10] Money market funds entail the least risk, as well as lower rates of return. Unlike certificates of deposit (CDs), money market shares are liquid and redeemable at any time. The interest rate quoted by money market funds is known as the 7 Day SEC Yield.
[edit] Funds of funds
Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds (i.e., they are funds comprised of other funds). The funds at the underlying level are typically funds which an investor can invest in individually. A fund of funds will typically charge a management fee which is smaller than that of a normal fund because it is considered a fee charged for asset allocation services. The fees charged at the underlying fund level do not pass through the statement of operations, but are usually disclosed in the fund's annual report, prospectus, or statement of additional information. The fund should be evaluated on the combination of the fund-level expenses and underlying fund expenses, as these both reduce the return to the investor.
Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor), although some invest in funds managed by other (unaffiliated) advisors. The cost associated with investing in an unaffiliated underlying fund is most often higher than investing in an affiliated underlying because of the investment management research involved in investing in fund advised by a different advisor. Recently, FoFs have be classified into those that are actively managed (in which the investment advisor reallocates frequently among the underlying funds in order to adjust to changing market conditions) and those that are passively managed (the investment advisor allocates assets on the basis of on an allocation model which is rebalanced on a regular basis).
The design of FoFs is structured in such a way as to provide a ready mix of mutual funds for investors who are unable to or unwilling to determine their own asset allocation model. Fund companies such as TIAA-CREF, Vanguard, and Fidelity have also entered this market to provide investors with these options and take the "guess work" out of selecting funds. The allocation mixes usually vary by the time the investor would like to retire: 2020, 2030, 2050, etc. The more distant the target retirement date, the more aggressive the asset mix.
[edit] Hedge funds
Main article: Hedge fund
Hedge funds in the United States are pooled investment funds with loose SEC regulation and should not be confused with mutual funds. Certain hedge funds are required to register with SEC as investment advisers under the Investment Advisers Act. [11] The Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. Hedge funds typically charge a fee greater than 1%, plus a "performance fee" of 20% of a hedge fund's profits. There may be a "lock-up" period, during which an investor cannot cash in shares.
[edit] Mutual funds vs. other investments
Mutual funds offer several advantages over investing in individual stocks, including diversification and professional management. A mutual fund may hold investments in hundreds or thousands of stocks, thus reducing the risk associated with owing any particular stock. Moreover, the transaction costs associated with buying individual stocks are spread around among all the mutual fund shareholders. Additionally, a mutual fund benefits from professional fund managers who can apply their expertise and dedicate time to research investment options. Mutual funds, however, are not immune to risks. Mutual funds share the same risks associated with the types of investments the fund makes. If the fund invests primarily in stocks, the mutual fund is usually subject to the same ups and downs and risks as the stock market.
[edit] Selecting a mutual fund
Picking a mutual fund from among the thousands offered is not easy. Following are some guidelines:
1. Prior to investing in a tax-exempt or tax-managed fund, it is best to determine if the tax savings will offset the possibly lower returns. Additionally, these funds are inappropriate for IRAs and other tax-sheltered types of account.
2. Investors should match the term of the investment to the time period they expect to keep the investment. Money that may be needed in the short term (for example, for car repairs) should generally be in a less volatile fund, such as a money market fund. Money not needed until a retirement date decades into the future (or for a newborn's college education) can reasonably be invested in longer-term, higher-risk investments, such as stock or bond funds. Investing short-term money in volatile investments puts the investor at risk of having to sell when the market is low, thereby incurring a loss. Investing over the long term in very stable investments, on the other hand, significantly reduces potential returns.
3. Fund expenses degrade investment performance, especially over the long term. Accordingly, all other things being equal, the lower the expenses, the better. A mutual fund's expense ratio is required to be disclosed in the prospectus. Expense ratios are critical in index funds, which seek to match the performance of bond or stock index. Actively managed funds must pay the manager for the active management of the portfolio, so they usually have a higher expense ratio than (passively managed) index funds.
4. Several sector funds often make the "best fund" lists each year. However, the "best" sector varies from year to year. Most sectors are vulnerable to industry-wide events that can have a significant negative effect on performance. It is generally best to avoid making these a large part of one's portfolio.
5. Closed-end funds often sell at a discount to the value of their holdings. An investor can sometimes obtain extra return by buying such funds, but only if they are willing to hold the fund until the discount rebounds. Some hedge fund managers use this gambit. However, this also implies that buying at the original issue may be a bad idea, since the price often drops immediately because of liquidity concerns.
6. Mutual funds often make taxable distributions near the end of the year (semi-annual and quarterly distributions are also fairly common). If an investor plans to invest in a taxable fund, he or she should check the fund company's website to see when the fund plans to distribute dividends and capital gains. Investing just prior to the distribution results in part of one's investment being returned as taxable income without increasing the value of the account.
7. Prospective investors in mutual funds should read the prospectus. The prospectus is required by law to disclose the risks will be taken with investors' money, among other vital topics. Potential investors should also compare the return and risk profile of a fund against its peers with similar investment objectives and against the index most closely associated with it, paying particular attention to performance over both the long term and the short term. A fund that gained 50% over a 1-year period (an impressive result) but only 10% over a 5-year period should create some suspicion, as that would imply that the returns in four out of those five years were actually very low (possibly even negative (i.e., losses)), as 10% compounded over 5 years is only 61%.
8. Diversification can reduce risk. Depending on an investor's risk tolerance and his or her investment horizon, it may be advisable to hold some stocks, some bonds, and some cash. For longer-term investments, it is advisable to invest in some foreign stocks. If all of an investor's mutual funds belong to the same family of funds, the investor's total portfolio might not be as diversified as it might seem. This is so because funds within the same family may share research and recommendations. The same is true for investors who own multiple funds with the same profile or investment strategy; their returns will likely be similar. Holding too large a number of funds, on the other hand, will tend to produce the same effect as holding an index fund, but with higher expenses. Buying individual stocks exposes investors to company-specific and industry-specific risks, and if investors buy a large number of stocks, the commissions may cost more than a fund would.
[edit] Share classes
Many mutual funds offer more than one class of shares. For example, you may have seen a fund that offers "Class A" and "Class B" shares. Each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses. These differences are supposed to reflect different costs involved in servicing investors in various classes; for example, one class may be sold through brokers with a front-end load, and another class may be sold direct to the public with no load but a "12b-1 fee" included in the class's expenses (sometimes referred to as "Class C" shares). Still a third class might have a minimum investment of $10,000,000 and be available only to financial institutions (a so-called "institutional" share class). In some cases, by aggregating regular investments made by many individuals, a retirement plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the benefit of their typically lower expense ratios) even though no members of the plan would qualify individually. [12]As a result, each class will likely have different performance results. [13]
A multi-class structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the length of time that they expect to remain invested in the fund). [13]
[edit] Load and expenses
Main article: Mutual fund fees and expenses
A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased, taken as a percentage of funds invested. The value of the investment is reduced by the amount of the load. Some funds have a deferred sales charge or back-end load. In this type of fund an investor pays no sales charge when purchasing shares, but will pay a commission out of the proceeds when shares are redeemed depending on how long they are held. Another derivative structure is a level-load fund, in which no sales charge is paid when buying the fund, but a back-end load may be charged if the shares purchased are sold within a year.
Load funds are sold through financial intermediaries such as brokers, financial planners, and other types of registered representatives who charge a commission for their services. Shares of front-end load funds are frequently eligible for breakpoints (i.e., a reduction in the commission paid) based on a number of variables. These include other accounts in the same fund family held by the investor or various family members, or committing to buy more of the fund within a set period of time in return for a lower commission "today".
It is possible to buy many mutual funds without paying a sales charge. These are called no-load funds. In addition to being available from the fund company itself, no-load funds may be sold by some discount brokers for a flat transaction fee or even no fee at all. (This does not necessarily mean that the broker is not compensated for the transaction; in such cases, the fund may pay brokers' commissions out of "distribution and marketing" expenses rather than a specific sales charge. The purchaser is therefore paying the fee indirectly through the fund's expenses deducted from profits.)
No-load funds include both index funds and actively managed funds. The largest mutual fund families selling no-load index funds are Vanguard and Fidelity, though there are a number of smaller mutual fund families with no-load funds as well. Expense ratios in some no-load index funds are less than 0.2% per year versus the typical actively managed fund's expense ratio of about 1.5% per year. Load funds usually have even higher expense ratios when the load is considered. The expense ratio is the anticipated annual cost to the investor of holding shares of the fund. For example, on a $100,000 investment, an expense ratio of 0.2% means $200 of annual expense, while a 1.5% expense ratio would result in $1,500 of annual expense. These expenses are before any sales commissions paid to purchase the mutual fund.
Many fee-only financial advisors strongly suggest no-load funds such as index funds. If the advisor is not of the fee-only type but is instead compensated by commissions, the advisor may have a conflict of interest in selling high-commission load funds.
[edit] Criticism of managed mutual funds
Historically, actively managed mutual funds, over long periods of time, have not returned as much as comparable index mutual funds. This, of course, is a criticism of one type of mutual fund over another.
Another criticism concerns sales commissions on load funds, an upfront or deferred fee as high as 8.5 percent of the amount invested in a fund. No-load funds typically charge a 12b-1 fee in order to pay for shelf space on the exchange the investor uses for purchase of the fund, but they do not pay a load directly to a mutual fund broker. Critics point out that high sales commissions represent a conflict of interest, as high commissions benefit the sales people but hurt the investors. High commissions can also cause sales people to recommend funds that maximize their income. Again, this is a criticism of one type of mutual fund over another.
Mutual funds are also seen by some to have a conflict of interest with regard to their size. Fund companies charge a management fee of anywhere between 0.5 percent and 2.5 percent of the fund's total assets. Theoretically, this should motivate the fund managers, since a well performing fund will cause the amount invested in the fund to rise and increasing the fee earned. It also could motivate the fund company to focus on advertising to attract more and more new investors, as new investors would also cause the fund assets to increase.
Many analysts, however, believe that the larger the pool of money one works with, the harder it is to manage actively, and the harder it is to squeeze good performance out of it. Thus a fund company can be focused on attracting new customers, thereby hurting its existing investors' performance. A great deal of a fund's costs are flat and fixed costs, such as the salary for the manager. Thus it can be more profitable for the fund to try to allow it to grow as large as possible, instead of limiting its assets. Some fund companies, notably the Vanguard Group and Fidelity, have closed some funds to new investors to maintain the integrity of the funds for existing investors.
Other critisicms of mutual funds are that some funds allow market timing (although many fund companies tightly control this) and that some fund managers accept extravagant gifts in exchange for trading stocks through certain investment banks, which presumably charge the fund more for transactions than would non-gifting investment bank. As a result, many fund companies strictly limit -- or completely bar -- such gifts.
[edit] Scandals
In September 2003, the United States mutual fund industry was beset by a scandal in which major fund companies permitted and facilitated "late trading" and "market timing". See: Mutual-fund scandal (2003)
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