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:
| Type | Characteristics |
|---|---|
| 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
| Rule | Description |
|---|---|
| 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
| Fund Type | Investment Focus | Risk Level |
|---|---|---|
| Growth Funds | Capital appreciation; growth stocks | High |
| Value Funds | Undervalued stocks; dividends | Moderate |
| Blend Funds | Mix of growth and value | Moderate |
| Large-Cap Funds | Companies with market cap > $10B | Lower |
| Small-Cap Funds | Companies with market cap < $2B | Higher |
| Sector Funds | Specific industries (tech, healthcare) | Higher |
Fixed-Income Funds
| Fund Type | Investment Focus | Risk Level |
|---|---|---|
| Government Bond Funds | Treasury, agency securities | Lower |
| Corporate Bond Funds | Investment-grade corporate debt | Moderate |
| High-Yield Funds | Below investment-grade bonds | Higher |
| Municipal Bond Funds | State and local government debt | Tax-advantaged |
| Short-Term Bond Funds | Maturities < 3 years | Lower |
Specialized Funds
| Fund Type | Investment Focus | Key Feature |
|---|---|---|
| Balanced Funds | Mix of stocks and bonds | Built-in asset allocation |
| Index Funds | Mirror a specific index | Passive management; low costs |
| Money Market Funds | Short-term debt securities | Seek stable $1.00 NAV |
| International Funds | Foreign securities only | Currency risk |
| Global Funds | Both U.S. and foreign | Geographic diversification |
| Target-Date Funds | Asset mix adjusts over time | "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
| Type | Investments | NAV |
|---|---|---|
| Government Money Market | Treasury bills, agency securities | Fixed $1.00 |
| Prime Money Market | Commercial paper, CDs, repos | Floating NAV (institutional) |
| Tax-Exempt Money Market | Short-term municipal securities | 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
| Index | What It Tracks |
|---|---|
| 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
| Feature | Active Management | Passive Management |
|---|---|---|
| Goal | Beat the benchmark | Match the benchmark |
| Expense Ratio | Higher (0.5%-1.5%+) | Lower (0.03%-0.20%) |
| Turnover | Higher | Lower |
| Tax Efficiency | Lower | Higher |
| Examples | Stock-picking funds | 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
| Distribution Type | Source | Tax Treatment |
|---|---|---|
| Ordinary Dividends | Interest, dividends received | Ordinary income (or qualified rates) |
| Capital Gains | Profits from selling securities | Short-term or long-term rates |
| Return of Capital | Distribution of investor's own capital | 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
The Net Asset Value (NAV) of a mutual fund is calculated:
An investor places an order to purchase mutual fund shares at 2:30 PM Eastern Time. At what price will the shares be purchased?
Which type of mutual fund uses passive management and typically has the lowest expense ratio?
6.2 Mutual Fund Costs & Fees
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