Custom «The Mutual Funds Industry» Essay Paper Sample

Background

A mutual fund is an investment fund that is managed professionally and is meant to collect money from many proprietors of businesses to buy securities (U.S. Securities Exchange Commission, 2010). The funds are not legally defined, but the definition is only applicable in investment channels that involve many shareholders and are regulated and offered for sale to the members of the public. Such funds are synonymously called “registered investment companies” or “investment companies”. Mutual funds are differentiated from hedge funds by the condition that the latter can only be sold to selected investors but not to the public. The mutual fund industry is procedural, and there are laws that govern the activities of the fund; in addition, the Securities and Exchange Commission watches over the investment activities. This organization and its structure are very interesting, and it inspires the researcher to study the topic. Below, there are research findings about the mutual fund industry.

The foundation of the first mutual fund can be attributed to a Dutch trader who conceived the idea and set up the first investment in Europe, 1774 (Rouwenhorst, 2004). The trend crossed over to the U.S. in 1890s, and the funds were mainly close-end in nature, with fixed number of shares that were usually sold or bought at a price above the portfolio value (Fink & Mathew, 2008). However, the trend changed, and the first open-end mutual fund, namely the Massachusetts Investors Trust was established in the United States of America in 1924, which allowed its investors to redeem their shares. Nevertheless, open-end funds were not widely recognized as the close-end funds in the 1920s because statistics shows that in 1929, the open-end funds were in possession of only 5% of the mutual fund total assets (Fink & Mathew, 2008). The stock market collapsed in 1929 prompting the Congress to draft and enact a number of Acts meant to govern security markets as a whole, but the main focus was on the mutual funds. In 1933, the Congress introduced the Securities Act stipulating that all investments sold to the members of public including the mutual fund to be recognized and be registered by the Securities Exchange Commission must avail full information regarding the funds to the investors. An additional Act was enacted in 1934; it was named Securities and Exchange Act that compelled the providers of securities to give reports on a regular basis to their investors. The Act further led to the formation of the Securities Exchange Commission to regulate and check the mutual funds. In 1936, the Revenue Act was added into the legislations to specify the conditions for taxes levied on the mutual funds. Additionally, the Investment Company Act 1940 was drafted and incorporated into the rules to govern the structure of mutual funds.

In the 1950s, the stock market restored its confidence and began to flourish again. In 1970, the funds were estimated to be 360 in number, with an asset base of estimated $48 billion (Fink & Mathew, 2008). The introduction of money market funds in 1970s boosted the mutual funds growth, and consequently, the first retail index fund and the first index investment were set up in 1976 by a group known as the Vanguard under the leadership of John Bogle. Nowadays, the group is referred to as “Vanguard 500 Index Fund”; it is in the list of the most prominent mutual funds in the world, and it is in possession of $ 195 billion worth of assets by January 2015 (The Vanguard Group). The mutual fund industry continued advancing in the 1980s and 1990s mainly due to the presence of a big market for bonds and stocks, introduction of new products, as well as a wide fund share distribution (Pozen & Hamacher, 2014). Retirement plans gained prominence as new investment distribution channels whereby mutual funds were incorporated in such plans in the 1980s. The mutual funds assets declined in 2008 due to a crisis in credit.

In 2003, a scam was allegedly detected in the fund whereby the management was accused of giving preferential treatment to some investors, whereby they were allowed to buy/sell shares after the stipulated time had expired, as well as doing the market timing. This case led to the birth of more strict legislations to restore discipline in the funds. In 2013, more than 15,000 mutual funds were reported in the U.S. and the assets in their possession were estimated to be worth $17 trillion (Investment Company Institute, 2014). At the same year, the global mutual fund owned about $30 trillion, and 22% of the household financial assets were attributed to the same investment.

Characteristics of Mutual Funds

Trading of Shares

The investors buy shares from either brokers or the fund itself as opposed to buying from other owners of shares/investors on a different share market, such as the Nasdaq Stock Market or the New York Stock Exchange (U.S. Securities and Exchange Commission, 2010). The buyers are obligated to pay the fund’s estimated Net Asset Value per share, as well as other applicable fees, such as the sales charge.

Redemption of Mutual Funds

Investors are allowed to sell their shares either back to the fund or an appointed broker at the respective Net Asset Value per share less any fee that the fund is likely to charge (U.S. Securities and Exchange Commission, 2010). For instance, redemption fees and deferred sales load among other charges that may be applicable.

The Sale of Mutual Fund Shares

Although some funds may halt the sales, shares are sold throughout if a given threshold of assets under the management of the fund is attained. This implies that investors may buy shares at any given time so long as the suspension is not in place.

Management of Portfolio

The portfolios of the funds are under different management entities referred to as “investment advisors” who are recognized by the Security and Exchange Commission (U.S. Securities and Exchange Commission, 2010). The funds are also registered by the Security and Exchange Commission and are controlled by the regulations set by the committee.

Fund Varieties

The funds exist in different types that include stock funds, index funds, money market funds as well as bond funds all of which possess different investment portfolio, methods of operation as well as the aims. The risks, fees and expenses of the fund varieties vary from one to another and the same is applicable to their volatility.

Benefits of Mutual Funds

The Mutual funds are more advantageous as compared to the individual direct securities (Pozen & Hamacher 2014), and thus, it is advisable for people to invest in such form of securities so as to obtain maximum benefit. The benefits can be attributed to the stringent rules passed to regulate the fund industry hence cushioning investors from fraud. The benefits are as described below.

Minimal Risk

The mutual funds industries invest in a wide range of securities leading to the diversification of investment, which is desirable for the purposes of risk reduction (Pozen & Hamacher, 2014). When an industry invests in a variety of areas, the probability of loss is minimized because there is no possibility of all the investments failing. Therefore, if an investment fails, its consequences are diluted by the other investments; hence, the mutual fund industry has shielded its investors from losses through diversification of investment.

Liquidity of Investment

The shares in open-end funds are redeemable at any given time, and thus, if the investor wishes to redeem them or to reduce them, he/she is allowed to sell the shares to an appointed broker or back to the fund. The close-end funds also allow the investors to sell the shares to other investors so that when an individual is in dire need of the money invested in such shares, it is possible to dispose the shares and get back the cash, but the redemption charges are deducted from the redeemed amount (Pozen & Hamacher, 2014).

Proper Management

The mutual fund investments are managed by professionals/portfolio managers who oversee the activities and transactions to ensure that the shareholders are given the best services (Pozen & Hamacher, 2014). The managers also offer investment advisory so as to ensure that the industry does not venture into unworthy businesses that could attract losses. Therefore, the investors are guaranteed of security, and thus, the mutual fund investment is worth.

Empowering Investors

The mutual fund industry enables an individual investor to invest in large investments that are only available for large investors. For instance, through the mutual funds, investors are enabled to invest in foreign markets that they cannot afford to invest on their own. Therefore, the fund enables the individual to flex his/her investment stamina.

Supervision by the Government

All mutual funds are compelled by law to register with the Securities Exchange Commission, which is mandated by the Securities and Exchange Act 1934 to monitor the activities of the funds (Fink & Mathews, 2008). This supervision cushions the investors from the losses that could be caused by either fraud or mismanagement of the funds, such as in 1929, when the stock market crashed. Therefore, this is an assurance to the investors as well as the potential investors that the investment is free from fraud as well as misappropriation of funds.

The Ease of Comparison

The mutual investment funds are obligated by the law to communicate investment reports as well as other necessary information to the investors so as to keep them updated with the information related to their shares. Such information enables the investors to compare the fund’s investment with other investments hence enabling them to assess and judge the performance.

Disadvantages of the Mutual Fund Investment

The mutual fund industry is two sided, and therefore, apart from the advantages, it has disadvantages, as well (Pozen & Hamacher, 2014). The disadvantages are as follows.

Unpredictable Income

The investors may not be able to foretell their earnings because the profit is determined by the management of the investments are in the hands of different entity/portfolio managers. The earnings are also influenced by the conditions prevailing in the stock markets, which makes it hard to predict the income.

Inability of the Investor to Customize Investment

The mutual fund entails investment by a great number of different people, and the management is done by an entity that is different from the fund itself. This makes the individual investor unable to design the investment strategies as he/she would wish; and thus, control over the investment is limited.

Mutual Fund Structure

Comparison of the Open-End Funds and the Close-End Funds

The open-end funds allow investors to sell back the shares to the fund on a daily business day basis at the Net Asset Value that is enumerated in the respective day. The shares are also sold to investors on a daily basis at the Net Asset Value, and the trade is supervised by a professional manager. In this fund type, there is a variance in the investment fund based on fluctuation in market valuation, shares redemption as well as share purchases. The volume of shares that can be traded is not legally limited, and thus, the investors can buy as much as they want. In 2013, the open-ended mutual funds summed up to 7,707 in the U.S., with an asset value of $ 15trillion (Investment Company Institute, 2014). On the other hand, close-end funds sell shares to investors only one time after they have been created. The shares are listed for sale or purchase in a stock exchange market, and the investors are not allowed to sell back their shares to the fund, but they can sell to other shareholders. The price of the sold shares may differ from the Net Asset Value by either being higher or low, but the trading is overseen by a professional manager. In 2013, the U.S. had 599 close-end funds, which owned $ 279 billion worth of assets (Investment Company Institute, 2014).

Other Structures

The Unit Investment Trusts are availed to the public only once and have a controlled validity period that is set on the date of creation. The fund allows investors to sell back their shares to the fund at any given time, and no professional portfolio manager is involved in the transactions. The Exchange-traded Funds also exist, and they have similarities with the Unit Investment Trust, but they are a larger variety of investment vehicles known as the “exchange-traded products”. The products have both the characteristics of the close-end and the open-end funds, and they are sold or purchased on a stock exchange throughout the day, with a price that is nearly the same as Net Asset Value (Investment Company Institute, 2014).

The Fees Structure of Investment Funds

The costs of running the activities of the fund include the distribution charges, management fee, securities transaction fee, and the funds service fee are met by the shareholders. Some of the charges are deducted from the investor’s account while others are catered for by the fund/deducted from the Net Asset Value. The fees are described below.

Management Fees

This money is paid as a service fee to the company that manages and organizes the funds, or offers investment advisory as well as management of the portfolio, and the amount reduces as the assets increase. The fund pays the fee, and it is incorporated into the fund’s expense ratio. The amount is reviewed by the board that manages the fund and the shareholders vote on any proposed increase of the fee, but the management can reduce the fee so as to cut costs.

Distribution Charges

These cater for the distribution of fund shares, marketing as well as services offered to the shareholders. The sponsor/funds manager may offer subsidies so as to reduce the expense ratio of the fund. These charges include the following.

Front-End Load/Sales Charges. These refer to the amount paid to the agency that acts as a broker when the shares are on sale. The figure is calculated as a given percentage of the total amount of investment, or total “public offering price”, which is equivalent to the Net Asset Value combined with the front-end load per share. The load reduces as the invested amount increases and upon reaching a breaking point. The front-end load is paid by the shareholder through deductions from his/her investment.

Back-End Load Charges. These are paid by the shareholder upon redemption of shares. The figure declines as investors retain their shares for a long period. The figure is charged on the redeemed amount of the given shareholder. In a nut shell, the amount is meant to cater for the transactions involved in the sales of shares by the investor.

12b-1 Fees. The charges are paid every year and are meant to pay the seller of shares/brokers for offering the sales service to the shareholders. The Securities and Exchange Commission must approve the fee, after which the fund is allowed to pay by reducing the Net Asset Value.

Securities Transaction Fees. The mutual fund caters for costs related to the trading of securities in its portfolio such as the brokerage commission charge. Security fees inflate the cost of procured investment and decreases the procedures obtained from the sale of such stuff. The fees are not incorporated in the funds income statement or its expense ratio, and it correlates with the volume of the shares in the sales transaction.

Shareholder Transaction Fee. The investors are required to pay fees for specific transactions, and such fees include the flat charge for maintaining an investment account in the fund and redemption fees for the sale of shares whose holder has recently acquired, among others. The fees are not incorporated in the expense ratio of the fund.

Fund Services Charges. The charges include the payments for the board of directors, a custody fee paid to the bank for collecting and keeping the proceeds on behalf of the fund, registration fees for the Security and Exchange Commission, as well as professional services fees such as payment for attorneys and auditors. The funds administration fees that entail charges for preparation of reports and statements, Securities Exchange Commission filings, calculation of returns and filing of tax returns also applies in the fund. The shareholders also cater for communication fees that are meant for printing and mailing of reports and other information. The fund also pays an accounting fee meant to cater for the calculation of the Net Asset Value as well as other accounting services. Transfer agent service fee is also necessary for record keeping, providing statements as well as telephone and internet services. The miscellaneous fee is also applicable to cater for extra needs that may arise in the fund.