About Mutual Funds

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. 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. 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.

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.

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. 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.

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.

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..

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.

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 it 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.

Non-management 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.

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.

Exchange-traded funds
A relatively new innovation, the exchange traded fund (ETF), is often formulated as an open-end investment company. ETFs 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.

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. Often equity funds focus investments on particular strategies and certain types of issuers.

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:

		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)

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.

Index funds versus 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. One study found 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. However, as quantitative finance is in its early stages of development, more accurate studies are required to reach a decisive conclusion.

Bond funds

Bond funds account for 18% of mutual fund assets. 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.

Money market funds

Money market funds hold 26% of mutual fund assets in the United States. 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.

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.

Hedge funds

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. 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.

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 owning 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.

Selecting a mutual fund

Picking a mutual fund from among the thousands offered is not easy. Following are some guidelines:

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. As a result, each class will likely have different performance results.

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).

Load 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.

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 Investments, have closed some funds to new investors to maintain the integrity of the funds for existing investors.

Other criticisms 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.

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".

An open-end(ed) fund is a collective investment which can issue and redeem shares at any time. An investor can purchase shares in such funds directly from the mutual fund company, or through a brokerage house.

Open-ended funds are available in most developed countries, however terminology and operating rules vary. For example in the U.S. they are called mutual funds, in the UK they are either unit trusts or OEICs (Open-Ended Investment Companies) and in most of Europe they are SICAVs.

An open-ended fund is equitably divided into shares (or units) which vary in price in direct proportion to the variation in value of the funds net asset value. Each time money is invested new shares or units are created to match the prevailing share price; each time shares are redeemed the assets sold match the prevailing share price. In this way there is no supply or demand created for shares and they remain a direct reflection of the underlying assets.

Fees

There may be a percentage charge levied on purchase or sale of shares--in this case, the fund is a "load fund"; if there are no such charges levied, the fund is "no-load". However, brokerages may charge commissions for the purchase of even no-load funds, and there might also be other fees associated with no-load funds, such as yearly maintenance fees in IRA accounts and redemption fees designed to discourage shareholders from jumping in and out of funds in an attempt at market timing.

Active Management

Most open-end funds are actively managed, meaning that a portfolio manager picks the securities to buy, although index funds are now growing in popularity. Index funds are open-end funds that attempt to replicate an index, such as the S&P 500, and therefore do not allow the manager to actively choose securities to buy. These fees are commonly referred to as 12b-1 fees in U.S.

Net asset value

The price per share, or NAV (net asset value), is calculated by dividing the fund's assets minus liabilities by the number of shares outstanding. This is usually calculated at the end of every trading day.

U.S. mutual funds:

Closed-end fund

A closed-end fund is a collective investment scheme with a limited number of shares.

In the U.S. legally they are called closed-end companies and form one of three SEC recognized types of investment company along with mutual funds and unit investment trusts. (Click here for US SEC description of investment company types).

Other examples of close-ended funds are Investment trusts in the UK and Listed investment companies in Australia.

New shares are rarely issued after the fund is launched; shares are not normally redeemable for cash or securities until the fund liquidates. Typically an investor can acquire shares in a closed-end fund by buying shares on a secondary market from a broker, market maker, or other investor -- as opposed to an open-end fund where all transactions eventually involve the fund company creating new shares on the fly (in exchange for either cash or securities) or redeeming shares (for cash or securities).

The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value, often abbreviated NAV. The market price of a fund share is often higher or lower than the NAV: when the fund's share price is higher than NAV it is said to be selling at a premium; when it is lower, at a discount to the NAV.

Availability

Closed end funds are typically traded on the major global stock exchanges, in the U.S. the New York Stock Exchange is dominant although the Amex is in competition; in the UK the London Stock Exchange's main market is home to the mainstream funds although AIM supports many small funds especially the Venture Capital Trusts; in Canada, the Toronto Stock Exchange lists many closed-end funds.

Like their better-known open-ended cousins, closed-end funds are usually sponsored by a funds management company which will control how the money is invested. They begin by soliciting money from investors in an initial offering, which may be public or limited. The investors are given shares corresponding to their initial investment. The fund managers pool the money and purchase securities. What exactly the fund manager can invest depends on the fund's charter. Some funds invest in stocks, others in bonds, and some in very specific things (for instance, tax-exempt bonds issued by the state of Florida in the USA).

Distinguishing features

Some characteristics that distinguish a closed-end fund from an ordinary open-end mutual fund are that:

Another distinguishing feature of a closed-end fund is the common use of leverage or gearing to enhance returns. CEFs can raise additional investment capital by issuing auction rate securities, preferred shares, long-term debt, and/or reverse-repurchase agreements, although this is rare in the USA outside of income-focused funds. In doing so, the fund hopes to earn a higher return with this excess invested capital.

When a fund leverages through the issuance of preferred stock, two types of shareholders are created: preferred stock shareholders and common stock shareholders.

Preferred stock shareholders benefit from expenses based off of the total managed assets of the fund. Total managed assets include both the assets attributable to the purchase of stock by common shareholders and those attributable to the purchase of stock by preferred shareholders.

The expenses charged to the common shareholder are based off of the common assets of the fund, rather than the total managed assets of the fund. The common shareholder's returns are reduced more significantly than those of the preferred shareholders due to the expenses being spread among a smaller asset base.

For the most part, closed-end fund companies report expenses ratios based off of the fund's common assets only. However, the contractual management fees charged to the closed-end funds may be based off of the common asset base only or the total managed asset base.

The entry into long-term debt arrangements and reverse-repurchase agreements are two additional ways to raise additional capital for the fund. Funds may use a combination of leveraging tactics or each individually. However, it is more common that the fund will use only one leveraging technique.

Since closed-end funds are traded as stock, a customer trading them will pay a brokerage commission similar to one paid when trading stock (as opposed to commissions on open-ended mutual funds where the commission will vary based on the share class chosen and the method of purchasing the fund). In other words, closed-end funds typically do not have sales-based share classes where the commission and annual fees vary between them. The main exception is loan-participation funds.

Initial offering

Like a company going public, a closed-end fund will have an initial public offering of its shares at which it will sell, say, 10 million shares for $10 each. That will raise $100 million for the fund manager to invest. At that point, however, the fund's 10 million shares will begin to trade on a secondary market, typically the NYSE or the AMEX for American closed-end funds. Any investor who wishes to buy or sell fund shares at that point will have to do so on the secondary market. Except for exceptional circumstances, closed-end funds do not redeem their own shares. Nor, typically, do they sell more shares after the IPO (although they may issue preferred stock, in essence taking out a loan secured by the portfolio).

Exchange traded

Closed-end fund shares trade continually at whatever price the market will support. They also qualify for advanced types of orders such as limit orders and stop orders. This is in contrast to open-end funds which are only available for buying and selling at the close of business each day, at the calculated NAV, and for which orders must be placed in advance, before the NAV is known, and can only be simple buy or sell orders. Some funds require that orders be placed hours or days in advance.

Closed-end funds trade on exchanges and in that respect they are like Exchange Traded Funds (ETFs), but there are important difference between these two kinds of security. The price of a closed-end fund is completely determined by the valuation of the market, and this price often diverges substantially from the NAV of the fund assets. In contrast, the market price of an ETF trades in a very close range of its net asset value, because the structure of the ETF would allow major market participants to gain arbitrage profits if the market price of the ETF were to diverge substantially from the NAV. The market prices of closed-end funds are often ten to twenty percent different than the NAV while the value of an ETF would only very rarely differ from the NAV by more than one-fifth of a percent.

Discounts and Premiums

As a secondary effect of being exchange-traded, the price of CEFs can vary from the NAV. In particular, fund shares often trade at what look to be irrational prices because secondary market prices are often very much out of line with underlying portfolio values. A CEF can also have a premium at some times, and a discount at other times. For example, Morgan Stanley Eastern Europe Fund (RNE) on the NYSE was trading at a premium of 39% in May of 2006 and at a discount of 6% in October of 2006. These huge swings are difficult to explain.

US closed-end stock funds often have share prices that are typically about 5% less than the Net Asset Value. That is, if a fund has 10 million shares outstanding and if its portfolio is worth $200 million, then each share should be worth $20 and you would expect that the market price of the fund's shares on the secondary market would be around $20. But, very oddly, that's typically not the case. The shares may trade for only $19 or even only $17. In the former case, the fund would be said to be "trading at a 5% discount to NAV,". In the latter case, the fund would be said to be trading at a 15% discount to NAV.

The presence of discounts is also puzzling since if a fund is trading at a discount, theoretically a well-capitalized investor could come along and buy up all the fund's shares at the discounted price in order to gain control of the portfolio and force the fund managers to liquidate it at its (higher) market value (although in reality, liquidity concerns make this impossible since the Bid/offer spread will drastically widen as fewer and fewer shares are available in the market). Benjamin Graham claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. However, the opposing view is that the fund may not liquidate in your timeframe and you may be forced to sell at an even worse discount, or the investments in the fund may lose value.

Even stranger, funds very often trade at a substantial premium to NAV. Some of these premia are extreme, with premia of several hundred percent having been seen on occasion. Why anyone would pay $30 per share for a fund whose portfolio value per share is only $10 is not well understood, although irrational exuberance has been mentioned. One theory is that if the fund has a strong track record of performance, investors may speculate that the outperformance is due to good investment choices by the fund managers and that the fund managers will continue to make good choices in the future. Thus the premium represents the ability to instantly participate in the fruits of the fund manager's decisions.

A great deal of academic ink has been spent trying to explain why closed-end fund share prices aren't forced by arbitrageurs to be equal to underlying portfolio values. Though there are many strong opinions, the jury is still out. It is easier to understand in cases where the CEF is able to pick and choose assets and arbitrageurs are not able to determine the specific assets until months later, but some funds are forced to replicate a specific index and still trade at a discount.

Comparison with open-ended funds

With open-ended funds, the value is precisely equal to the NAV. So investing $1000 into the fund means buying shares that lay claim to $1000 worth of underlying assets (apart from sales charges). But buying a closed-end fund trading at a premium might mean buying $900 worth of assets for $1000.

Some advantages of closed-end funds over their open-ended cousins are financial. CEFs' fees are usually much lower (since they don't have to deal with the expense of creating and redeeming shares), they tend to keep less cash in their portfolio, and they need not worry about market fluctuations to maintain their "performance record". So if a stock drops irrationally, the closed-end fund may snap up a bargain, while open-ended funds might sell too early.

Also, if there is a market panic, investors may sell en masse. Faced with a wave of sell orders and needing to raise money for redemptions, the manager of an open-ended fund may be forced to sell stocks he'd rather keep, and keep stocks he'd rather sell, due to liquidity concerns (selling too much of any one stock causes the price to drop disproportionately). Thus all it may have left are the dud stocks that no one wants to buy. But an investor pulling out of a closed-end fund must sell it on the market to another buyer, so the manager need not sell any of the underlying stock. The CEF's price will likely drop more than the market does (severely punishing those who sell during the panic), but it is more likely to make a recovery when the intrinsically sound stocks rebound.

Because a closed-end fund is on the market, it must obey certain rules, such as filing reports with the listing authority and holding annual stockholder meetings. Thus stockholders can more easily find out about their fund and engage in shareholder activism, such as protest against poor management.

An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities to purchase and is therefore a form of passive management.

The lack of active management (stock picking and market timing) gives the advantage of lower fees and lower taxes in taxable accounts. However, the fees will always reduce the return to the investor relative to the index. In addition it is impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the 'tracking error'.

Index funds are available from many investment managers. Some common indices include the S&P 500, the Wilshire 5000, the FTSE 100 and the FTSE All-Share Index. Less common indexes come from academics like Eugene Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model.

Origins of the index fund

The history that lead to the creation of index funds can be traced back to 1654, see this extensive history of modern portfolio theory.

In 1973, Burton Malkiel published his book "A Random Walk Down Wall Street" which presented academic findings for the lay public. It was becoming well-known in the lay financial press that most mutual funds were not beating the market indices, to which the standard reply was made "of course, you can't buy an index." Malkiel said, "It's time the public can."

John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration came from three sources, all of which confirmed his 1951 research: Paul Samuelson's 1974 paper, "Challenge to Judgment", Charles Ellis' 1975 study, "The Loser's Game," and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the second largest mutual fund company in the United States as of 2005.

When Bogle started the First Index Investment Trust on December 31, 1975, it was labeled Bogle's follies and regarded as un-American, because it sought to achieve the averages rather than insisting that Americans had to play to win. This first Index mutual fund offered to individual investors was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. "But in the financial markets it is always wise to expect the unexpected"

John McQuown and David Booth at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank.

In 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors (DFA), many years later McQuown joined its Board of Directors. DFA further developed indexed based investment strategies and currently has $120 billion under management (as of Dec. 2006). Independent financial advisors (like IFA) guide individual investors when purchasing DFA funds. Dimensional Fund Advisors strives to deliver the performance of capital markets and add value through portfolio design and trading. The firm departs from the rules and rigidity of traditional index funds and avoids the cost-generating activity of stock picking and market timing. Instead DFA focuses on the dimensions of capital markets that reward investors and they deliver them as intelligently and effectively as possible. Financial science has documented that, over the long term, small cap stocks outperform large cap stocks and value stocks outperform growth stocks. These returns seem to be compensation for risk. In fixed income, risk is well described by bond maturity and credit quality. Dimensional's investment strategies deliberately target specific risk factors. They are highly diversified and painstakingly designed to work together in a total index portfolio.

Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers with over $1.5 trillion under management as of 2005.

Economic theory

Economists cite the efficient market theory as the fundamental premise that justifies the creation of the index funds. The theory states that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that competition is so effective that any new information about the fortune of a company will translate into movements of the stock price almost instantly. It is postulated therefore that it is very difficult to tell ahead of time whether a certain stock will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided.

A comparison of active investing and passive investing can be found here.

Synthetic indexing

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favorable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can also hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.

Enhanced indexing

Enhanced indexing is an approach to index fund management that uses a variety of techniques to create index funds that seek to emphasize performance, possibly using active management. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. Cost advantage of indexing could be reduced by employing active management.

Advantages

Low costs

Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15 for US Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.

Simplicity

The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.

Lower turnovers

Turnover refers to the selling and buying securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometime passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds. According a study conducted by John Bogle over a sixteen-year period, investors only get to keep 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.

Disadvantages of index funds

No Chance of Out-Performing

Since index funds aim to match market returns, both under and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.

According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points, but a Morningstar survey found an average of 38 basis points across all index funds

Investors should remember after all expenses and fees are subtracted their Rate of Return will not exactly be the market return of the index; however, it should be very close.

Owning a diversified stock index fund does not make an investor immune to systematic risk (e.g., a stock market bubble). When the US technology sector bubble burst in 2000, the general stock market dropped significantly, and, as measured by the S&P 500 index, has still not recovered (as of February 2007).

The Objective To Minimize Tracking Errors Causes Losses

The stated objective of index funds (in their prospectus) is to minimize the tracking error as they follow the designated index. Whenever an index changes, the fund is then faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.

As a result, the price of the stock that has been removed from the index tends to be driven down. The price of stock that has been added to the index tends to be driven up. These price changes tend to persist for 2-4 weeks. The index fund, however, has suffered permanent losses because they had to sell stock whose price was depressed, and buy stock whose price was inflated. All in all, however, these losses are small relative to an index fund's over-all advantage gained by its overall total low costs. Advanced hedge funds may hedge stocks to reduce the costs of turnover.

Diversification

Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces the impact of a single security performing very below average. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not. 

Since some indices like the S&P 500, and FTSE 100 are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.

Asset allocation and achieving balance

Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios.

A combination of various index mutual funds or ETF's could be used to implement a full range of investment policies from low risk to high risk.

Comparison of index fund versus index ETF

Index funds are priced at end of day (4:00 pm), while index ETFs have intra-day pricing (9:30 am - 4:00 pm).

Some index ETFs have lower expense ratio as compared to regular index funds. However, brokerage expenses of index ETFs should not be over-looked.

US Capital gains tax considerations

U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains.

Scenario: An investor entered a mutual fund during the middle of the year and experienced an over-all loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the over-all loss.

A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.

Investment management, the professional management of various securities (shares, bonds etc) and other assets (e.g. real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes eg. mutual funds) .

Investment management is a large and important global industry in its own right responsible for caretaking of trillions of dollars, euros, pounds and yen. Coming under the remit of financial services many of the worlds largest companies are at least in part investment managers and employ millions of staff and create billions in revenue.

Fund manager (or investment advisor in the U.S.) refers to both a firm that provides investment management services and an individual(s) who directs 'fund management' decisions.

Industry scope

The business of investment management has several facets, including the employment of professional fund managers, research (of individual assets and asset classes), dealing, settlement, marketing, internal auditing, and the preparation of reports for clients. The largest financial fund managers are firms that exhibit all the complexity their size demands. Apart from the people who bring in the money (marketers) and the people who direct investment (the fund managers), there are compliance staff (to ensure accord with legislative and regulatory constraints), internal auditors of various kinds (to examine internal systems and controls), financial controllers (to account for the institutions' own money and costs), computer experts, and "back office" employees (to track and record transactions and fund valuations for up to thousands of clients per institution).

Key problems of running such businesses

Key problems include:

		revenue is directly linked to market valuations, so a major fall in asset prices causes a precipitous decline in revenues relative to costs;
		above-average fund performance is difficult to sustain, and clients may not be patient during times of poor performance;
		successful fund managers are expensive and may be headhunted by competitors;
		above-average fund performance appears to be dependent on the unique skills of the fund manager; however, clients are loath to stake their investments on the ability of one or two men or women- they would rather see firm-wide success, attributable to a single philosophy and internal discipline;
		evidence suggests that size of an investment firm correlates inversely with fund performance, i.e., the smaller the firm the better the chance of good performance;
		analysts who generate above-average returns often become sufficiently wealthy that they eschew corporate employment in favor of managing their personal portfolios.

The most successful investment firms in the world have probably been those that have been separated physically and psychologically from banks and insurance companies. That is, the best performance and also the most dynamic business strategies (in this field) have generally come from independent investment management firms.

Representing the owners of shares

Institutions often control huge shareholdings. In most cases they are acting as agents (intermediaries between owners of the shares and the companies owned) rather than principals (direct owners). The owners of shares theoretically have great power to alter the companies they own...via the voting rights the shares carry and the consequent ability to pressure managements, and if necessary out-vote them at annual and other meetings.

In practice, the ultimate owners of shares often do not exercise the power they collectively hold (because the owners are many, each with small holdings); financial institutions (as agents) sometimes do. There is a general belief that shareholders - in this case, the institutions acting as agents - could and should exercise more active influence over the companies in which they hold shares (e.g., to hold managers to account, to ensure Boards effective functioning). Such action would add a pressure group to those (the regulators and the Board) overseeing management.

However there is the problem of how the institution should exercise this power. One way is for the institution to decide, the other is for the institution to poll its beneficiaries. Assuming that the institution polls should it then vote the entire holding as directed by the majority of votes cast, split vote (where this is allowed) according to the proportions of the vote or respect the abstainers and only vote the respondents holding.

The price signals generated by large active managers holding or not holding the stock contribute to management change.

Some institutions have been more vocal and active in pursuing such matters; for instance, some firms believe that there are investment advantages to accumulating substantial minority shareholdings (i.e, 10% or more) and putting pressure on management to implement significant changes in the business. In some cases, institutions with minority holdings work together to force management change. Perhaps more frequent is the sustained pressure that large institutions bring to bear on management teams through persuasive discourse and PR. On the other hand, some of the largest investment managers - such as Barclays Global Investors and Vanguard - advocate simply owning every company, reducing the incentive to influence management teams.

The national context in which shareholder representation considerations are set is variable and important. The USA is a litigious society and shareholders use the law as a lever to pressure management teams. In Japan it is traditional for shareholders to be low in the 'pecking order,' which often allows management and labor to ignore the rights of the ultimate owners. Whereas US firms generally cater to shareholders, Japanese businesses generally exhibit a stakeholder mentality, in which they seek consensus amongst all interested parties (against a background of strong unions and labour legislation).

Size of the global fund management industry

Assets of the global fund management industry increased for the third year running in 2006 to reach a record $55.0 trillion. This was up 10% on the previous year and 54% on 2002. Growth during the past three years has been due to an increase in capital inflows and strong performance of equity markets.

Pension assets totaled $20.6 trillion in 2005, with a further $16.6 trillion invested in insurance funds and $17.8 trillion in mutual funds. Merrill Lynch also estimates the value of private wealth at $33.3 trillion of which about a third was incorporated in other forms of conventional investment management.

The US was by far the largest source of funds under management in 2005 with 48% of the world total. It was followed by Japan with 11% and the UK with 7%. The Asia-Pacific region has shown the strongest growth in recent years. Countries such as China and India offer huge potential and many companies are showing an increased focus in this region.

10 largest asset management firms

Philosophy, process and people

The 3-P's (Philosophy, Process and People) are often used to describe the reasons why the manager is able to produce above average results.

		Philosophy refers to the over-arching beliefs of the investment organization. For example, does the manager buy growth or value shares (and why), does he believe in market timing (and on what evidence), does he rely on external research or does he employ a team of researchers. It is helpful if any and all of such fundamental beliefs are supported by proof-statements.
		Process refers to the way in which the overall philosophy is implemented. For example, which universe of assets is explored before particular assets are chosen as suitable investments; how does the manager decide what to buy and when; how does the manager decide what to sell and when; who takes the decisions and are they taken by committee; what controls are in place to ensure that a rogue fund (one very different from others and from what is intended) cannot arise;
		People refers to the staff, especially the fund managers. The question is who are they, how are they selected, how old are they, who reports to whom, how deep is the team (and do all the members understand the philosophy and process they are supposed to be using), and most important of all how long has the team been working together. This last question is vital because whatever performance record was presented at the outset of the relationship with the client may or may not relate to (have been produced by) a team that is still in place. If the team has changed greatly (high staff turnover), then arguably the performance record is completely unrelated to the existing team (of fund managers).

Asset allocation

The different asset classes are stocks, bonds, real-estate, derivatives, and commodities. The exercise of allocating funds among these assets (and among individual securities within each asset class) is for what investment management firms are paid. Asset classes exhibit different market dynamics, and different interaction effects; thus, the allocation of monies among asset classes will have a significant effect on the performance of the fund. Some research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the skill of a successful investment manager resides in constructing the asset allocation, and separately the individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing funds, bond and stock indices).

Long-term returns

It is important to look at the evidence on the long-term returns to different assets, and to holding period returns (the returns that accrue on average over different lengths of investment). For example, over very long holding periods (eg. 10+ years) in most countries, equities have generated higher returns than bonds, and bonds have generated higher returns than cash. According to financial theory, this is because equities are riskier (more volatile) than bonds which are themselves more risky than cash.

Diversification

Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences) and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated by Markowitz and effective diversification requires management of the correlation between the asset returns and the liability returns, issues internal to the portfolio (individual holdings volatility), and cross-correlations between the returns.

Investment styles

There are a range of different styles of fund management that the institution can implement. For example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular financial environment, distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully.

Performance measurement

Fund performance is the acid test of fund management, and in the institutional context accurate measurement is a necessity. For that purpose, institutions measure the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialise in performance measurement. The leading performance measurement firms (e.g. Frank Russell in the USA) compile aggregate industry data e.g showing how funds in general performed against given indices and peer groups over various time periods.

In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g. +4.6% total return in US dollars). This figure would be compared with other similar funds managed within the institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund.

Generally speaking it is probably appropriate for an investment firm to persuade its clients to assess performance over a longer periods (e.g. 3 to 5 years) to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be difficult however and, industry wide, there is a serious pre-occupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions).

An enduring problem is whether to measure before-tax or after-tax performance. After-tax represents the benefit to the investor, but investors tax positions vary. Before tax measurement can mislead, especially in regimens that tax realized capital gains (and not unrealized). A successful active manager, measured before tax, can thus produce a miserable after tax result. One possible solution is to report the after-tax position of some standard tax-payer.

Absolute versus relative performance

In the USA and the UK, two of the world's most sophisticated fund management markets, the tradition is for institutions to manage client money relative to benchmarks. For example, an institution believes it has done well if it has generated a return of 5% when the average manager has achieved 4%. In other markets however, e.g. Switzerland, the mentality is different and clients and fund managers focus on absolute return management, i.e. returns relative to cash (e.g. Swiss franc or Yen cash) where (performance) fees are payable only if the return exceeds some absolute figure (e.g. 10% per annum).

Risk-adjusted performance measurement

Performance measurement should not be reduced to the evaluation of fund returns alone, but must also integrate other fund elements that would be of interest to investors, such as the measure of risk taken. Several other aspects are also part of performance measurement: evaluating if managers have succeeded in reaching their objective, i.e. if their return was sufficiently high to reward the risks taken; how they compare to their peers; and finally whether the portfolio management results were due to luck or the manager’s skill. The need to answer all these questions has led to the development of more sophisticated performance measures, many of which originate in modern portfolio theory.

Modern portfolio theory established the quantitative link that exists between portfolio risk and return. The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) highlighted the notion of rewarding risk and produced the first performance indicators, be they risk-adjusted ratios (Sharpe ratio, information ratio) or differential returns compared to benchmarks (alphas). The Sharpe ratio is the simplest and best known performance measure. It measures the return of a portfolio in excess of the risk-free rate, compared to the total risk of the portfolio. This measure is said to be absolute, as it does not refer to any benchmark, avoiding drawbacks related to a poor choice of benchmark. Meanwhile, it does not allow the separation of the performance of the market in which the portfolio is invested from that of the manager. The information ratio is a more general form of the Sharpe ratio in which the risk-free asset is replaced by a benchmark portfolio. This measure is relative, as it evaluates portfolio performance in reference to a benchmark, making the result strongly dependent on this benchmark choice.

Portfolio alpha is obtained by measuring the difference between the return of the portfolio and that of a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate active management. In fact, we have to distinguish between normal returns, provided by the fair reward for portfolio exposure to different risks, and obtained through passive management, from abnormal performance (or outperformance) due to the manager’s skill, whether through market timing or stock picking. The first component is related to allocation and style investment choices, which may not be under the sole control of the manager, and depends on the economic context, while the second component is an evaluation of the success of the manager’s decisions. Only the latter, measured by alpha, allows the evaluation of the manager’s true performance.

Portfolio normal return may be evaluated using factor models. The first model, proposed by Jensen (1968), relies on the CAPM and explains portfolio normal returns with the market index as the only factor. It quickly becomes clear, however, that one factor is not enough to explain the returns and that other factors have to be considered. Multi-factor models were developed as an alternative to the CAPM, allowing a better description of portfolio risks and an accurate evaluation of managers’ performance. For example, Fama and French (1993) have highlighted two important factors that characterize a company's risk in addition to market risk. These factors are the book-to-market ratio and the company's size as measured by its market capitalisation. Fama and French therefore proposed a three-factor model to describe portfolio normal returns. Carhart (1997) proposed to add momentum as a fourth factor to allow the persistence of the returns to be taken into account. Also of interest for performance measurement is Sharpe’s (1992) style analysis model, in which factors are style indices. This model allows a custom benchmark for each portfolio to be developed, using the linear combination of style indices that best replicate portfolio style allocation, and leads to an accurate evaluation of portfolio alpha.

Education or Certification

Increasingly, international business schools are incorporating the subject into their course outlines and some have formulated the title of 'Investment Management' conferred as specialist bachelors degrees. (i.e. Cass Business School, London). Due to global cross-recognition agreements with the 2 major accrediting agencies AACSB and ACBSP which accredit over 560 of the best business school programs, the Certification of MFP Master Financial Planner Professional from the American Academy of Financial Management is available to AACSB and ACBSP business school graduates with finance or financial services related concentrations. For people with aspirations to become an investment manager, further education may be needed beyond a B.S. in business, finance, or economics. A graduate degree or Chartered Financial Analyst certification may be required to move up in the ranks of investment management.

Money market mutual funds are restricted by quality, maturity and diversity guidelines. They must buy only the highest rated debt which matures in under 13 months, and the entire portfolio must have a weighted average maturity of 90 days or less. Money funds are only allowed to invest up to 5% in any one issuer, with the exception of government securities. No individual investor has lost money in a money fund, which keep a stable $1.00 NAV (net asset value). But it is possible for these funds to "break the buck" (decline to $0.99 or less).

Money market accounts

Banks in the United States offer savings and "money market deposit accounts", but these shouldn't be confused with money market mutual funds. These bank accounts offer higher yields than traditional passbook savings account, but often with higher minimum balance requirement and limited transactions. A money market account may refer to a money market mutual fund, a bank money market deposit account (MMDA) or a brokerage sweep free credit balance.

History

The first U.S. money fund - The Reserve Fund - was established in October 1971, enabling the small investor to invest in these instruments. Today, almost 2,000 money funds are in operation, with total assets of over $2.3 trillion dollars.

Institutional money fund

Institutional money funds are high minimum, low expense share classes which are marketed to corporations, governments, or fiduciaries. They are often set up so that money is swept to them overnight from a company's main operating accounts. Large national chains often have many accounts with banks all across the country, but electronically pull a majority of funds on deposit with them to a concentrated money market fund.

The largest institutional money fund is the JPMorgan Prime Money Market Fund, with almost $100 billion in assets as of Dec. 31, 2006. Among the largest companies offering institutional money funds are BlackRock, Federated, Columbia (Bank of America), Dreyfus, AIM and Evergreen (Wachovia).

Retail money funds

Retail money funds are offered primarily to individuals with moderate-sized accounts. Their primary use is as temporary holding funds at stockbrokerage firms. Retail money market funds hold roughly 40% of all money market fund assets.

Retail money funds invest in short-term debt, such as US Treasury bills and commercial paper, come in a few different breeds: government-only funds, non-government funds and tax-free funds. You will get a slightly higher yield in the non-government variety, which will invest in high-quality commercial paper and other instruments. Money funds for individuals are currently yielding just under 5.0%. However, instruments of the United States Government are usually exempt from state income taxes.

The largest money market mutual fund is Fidelity Investments' Cash Reserves, with assets exceeding $88 billion. The largest retail money fund providers include: Fidelity, Vanguard, and Schwab.

The following is a limited list of mutual-fund families in the United States. A family of mutual funds is a group of funds that are marketed under one or more brand names, usually having the same distributor (the company which handles selling and redeeming shares of the fund in transactions with investors), and investment advisor (which is usually a corporate cousin of the distributor).

There are several hundred families of registered mutual funds in the United States, some with a single fund and others offering dozens. Many fund families are units of a larger financial services company such as an asset manager, bank, brokerages, or insurance company. Additionally, multiple funds in a family can be part of the same corporate structure; that is, one underlying corporation or business trust may divide itself into more than one fund, each of which issues shares separately.