FORMS OF MUTUAL FUNDS
The term “mutual fund” covers a whole gamut of products. Defined as the pooling of money by participants in the attempt to accomplish a specific goal, “mutual funds” covers everything from a joint venture for a specific purpose to a multimillion-dollar investment fund that concentrates on a particular geographical area. Through shares, mutual funds allow investors to participate in a part of the trading world that otherwise would be closed to them because of cost, logistics, or regulations.
Technically, the amassing of capital to achieve a particular objective can be referred to as a mutual fund. Included in that general term are open-end mutual funds, closed-end investment companies, joint ventures, and unit investment trusts. We will look at open-end mutual funds first.
Mutual funds are a long-established product in the financial environment. When most people hear the term, they think of the open-end fund, which buys and sells its shares against the public. An open-end fund does not have a secondary market for trading purposes. When the shares of a mutual fund are acquired, they are bought from the fund and not from a third party, and when the shares are sold, they are sold back to the fund.
Many 401(k)s, 403s, and other retirement plans, which individuals control themselves or which are in the control of a money manager, have mutual funds in them. Many investment advisers use mutual funds as part of their investment decisions or to augment different strategies. The mutual fund segment is itself a crowded and very competitive part of the financial industry.
Open-end mutual fund companies have investment plans that come in all varieties. Some charge a fee known as a sales charge; that charge is reduced as more is invested. The mutual fund’s sales charge is set up with “break points.” These are the investment points that the total invested is required to pass for the sales charge to be reduced to the next lower level. Therefore, a mutual fund could have a sales charge that drops by one eighth of a percent for every $25,000 invested in the particular fund. A client investing $24,900 would pay a higher percentage sales charge than a client who invested $25,100. The Investment Company Act of 1940 mandates that clients be informed as their investment nears a break point.
Some mutual funds, known as no-loads, do not charge a fee, but generally have a higher operating cost than the load funds do. Funds that have load charges have different ways of applying them. These are known as A, B, and C investment plans, and here is what the different classes of plans entail:
Class A has a front-end sales charge. The sales charge is subtracted from every investment the owner makes. Break point sales charges are applicable here.
Class B has a back-end sales charge. This is a contingent deferred sales charge (CDSC), which is subtracted from what the investor was supposed to receive when he or she liquidated the shares if sold during the first six years. In the sixth year, the shares are converted to Class A shares.
Class C has higher operating fees and may be charged a fee as if it were Class A or Class B, but the shares are not converted and remain as Class C shares.
Some mutual funds are sold directly between the fund and the client; other funds are sold to clients through brokerage firms. Some of those brokerage firms maintain the clients’ mutual fund position on their internal records along with other financial assets. The ownership records at the mutual fund do not reflect the beneficial owners’ names but instead carry the nominee name of the broker-dealer. Other brokerage firms pass the transactions to the mutual fund so that the mutual fund knows the investor and not the broker-dealer. One reason behind a broker-dealer’s decision is if the client was to use their fund shares to borrow money against (known as margin). The fund shares become the collateral for the loan and must remain in the broker-dealer’s control and nominee name. It is a business decision made by the broker-dealer as part of its business plan.
Open-end mutual funds are priced once a day, at the end of the trading day, and they are priced at their net asset value (NAV). The net asset value, used to price mutual funds, is a computation made up of the value of the fund’s portfolio, plus money awaiting investment, less expenses, divided by the shares outstanding.
Net Asset Value = (Value of the portfolio + Cash awaiting investment − Expenses) / Number of shares outstanding
Because an open-end fund stands ready to buy or sell its shares against the public, there isn’t any need for a secondary market for trading open-end mutual fund shares. Therefore, orders being given to a mutual fund must be market orders; the mutual fund accumulates these orders and once a night executes buys and sells at the same clean price (not including sales charge or other fees) and sends responses back to the entering parties.
Here’s an example:
Tom Katt owns shares of a mutual fund that was acquired at around $30.00 a share. One morning the fund’s value increases during the day to $40.00 a share, and then the fund falls back to close at $30.00 a share. If Tom wanted to sell the shares during the day, when it was at $40.00 per share, he could not, because open-end mutual funds are officially priced once a day after the close of business. If Tom wanted to sell it, he would receive the closing value of $30.00 per share, or the same price he paid for it. In the case of a different product, such as an exchange-traded fund (ETF), if it opened in the morning trading at $30.00 a share, and that was the price Tom had acquired it at, and during the day it reached $40.00 a share, Tom could sell it at $40.00 a share and not have to worry about where it is going to close.
Another difference between exchange-traded products and mutual funds is that each share of an ETF or ETP is independent. Therefore the shares can be bought or sold as the client wishes. In the case of the mutual fund, since the shares are represented by a pool from the portfolio held by the fund, a sale by another person within the pool could require selling securities to pay that person. In the case of ETFs or ETPs, the buying and selling of shares is independent from the shares owned by others. Therefore there isn’t a tax penalty when someone else sells securities.
The issuer of a mutual fund stands ready to sell open-end mutual funds to the public and buy back from the public. There isn’t any secondary market. The price of the fund is determined by its net asset value, which means that the value of the portfolio plus money awaiting investment minus expenses divided by the number of shares outstanding will give you the net asset value per share. Closed-end funds are different, and we will discuss them next.
Closed-end mutual funds begin their life in a similar fashion to open-end funds. The sponsor or the fund manager issues shares to potential investors. As the shares are sold, they accumulate the funds. Often, the participants have predetermined either the number of shares they want to have outstanding or the sum of money they are trying to accumulate. As with open-end mutual funds, they must establish ahead of time the products they are going to conduct business in and how they are going to use their portfolios. These choices would be controlled by the charter of the funds, by their prospectus, and in accordance with the Investment Company Act of 1940 and all subsequent rules and regulations.
Once the amount of shares have been issued or the amount of capital raised that meets their goal, the fund closes and trading is done based on supply and demand—either on an exchange or over-the-counter. Buyers and sellers trade among themselves without the mutual fund’s participation. During the period of time the fund is being formed, as with all open-end mutual funds, the price per share is determined by net asset value.
Once the fund closes, it now trades by supply and demand, so the market price can be over or under the net asset value—or to put it another way, it can be a premium or a discount to the net asset value. The closed-end fund trades as if it were common stock going through the same operational processes to settlement. Closed-end fund trades settle in three days, the same as stock, whereas open-end fund trades settle on trade date.
Let’s separate open-end funds from closed-end funds as required by the Securities and Exchange Commission (SEC). Closed-end funds should be called closed-end investment companies; this would distinguish them in type and form from the open-end mutual fund, which is simply called a mutual fund. Since open funds make a continuous investment as outside funds are received, and closed-end investment companies do not, if a customer who owns an open-end fund decides to sell his or her shares by liquidating some security positions, then holders who have nothing to do with this action wind up with a taxable event.
In a closed-end investment company, since the shares are traded among the public, the effect of one person’s selling has no tax consequence for anyone else who owns shares in that fund. In addition, with a closed-end investment company, usually all the orders permitted in that marketplace are also permitted to be used by the closed-end investment company. Since the closed-end company is trading in an active, dynamic marketplace, you can buy and sell or sell and buy securities during the day—a feature you cannot do with mutual funds because of their pricing at night only. Closed-end investment companies offer their funds in a whole range of possible investment opportunities, similar to open-end mutual funds. They have taxable and tax-free bond funds, global issues, sector funds, and mortgage-backed security funds, to name but a few.
Next we’ll look at joint ventures.
Joint ventures are usually one-time formal agreements aimed at achieving certain goals. Money or other assets are pooled together in an attempt to accomplish a nonreoccurring event, such as oil exploration. The venture itself may be an ongoing effort such as a real estate holding. It must have at least two parties, but there’s no maximum limit on the number of participants. As corporations are legally recognized as individuals, one party may be a corporation, the other an individual.
If the effort is successful, other ventures may be formed. If the venture fails, it ceases to exist. If the parties want to continue their relationship after a venture fails, a new one must be formed. The participants all share in the profits or losses. The terms can be on a pro rata basis, service-performed basis, or any other arrangement the parties decide at the time of initial agreement.
Profits from a joint venture are usually taxed at the partnership level. Ownership in a joint venture does not lend itself to trading. Selling interests in the joint venture can be difficult, as it is basically an illiquid product and the disposing of the ownership may require approval from other members. The joint venture agreement may require the seller to sell its ownership back only to the venture, and the agreement may also require potential new owners to be approved by the other owners.
Members of the corporate world who participate in this segment of the market are referred to as venture capitalists.
Unit investment trusts (UITs) are primarily composed of common stock or bonds, the portfolio of which is established by the offering date. Like a joint venture, the UIT is a one-time offering. A sponsor offers a set number of units (shares) to investors. These portfolios are not actively managed; therefore, their contents remain the same throughout the existence of the trust.
All trusts have a set expiration date. In the case of an equity trust, when that time comes, the equities are liquidated and the resulting funds proportionately distributed. In the expiration of a bond or other debt trusts, the contents of debt securities often will have matured by the expiration date. Those that have not matured are sold off, and all funds resulting from maturing bonds and sales of nonmatured bonds are distributed to the bondholders.
The process used for the dividend (equities) or interest (bonds) distributions is expressed in the trust’s indenture. Other items covered in the indenture include the payout periods and the conditions or circumstances under which the management may alter the portfolio voluntarily. Remember, we are looking at three independent layers. There are the securities in the UIT that have their own life, the UIT that has its own modus operandi, and the client that invested in the UIT who is free to buy or sell the UIT. In equity UITs, corporate action taken by the issuer may be voluntary or involuntary. Voluntary action would include the dispensing of an issuer’s rights offering. The trust agreement would state how the trust will respond. The UIT owner doesn’t have a choice. In the involuntary corporate action, such as a bond maturing, the disposition of the proceeds are also covered in the trust agreement. In order to close out their positions in the UIT, the investors simply sell their units back to the sponsor. Some sponsors maintain a secondary market in the units. This permits the seller’s investment to be paid for by the buyer and avoids the need for the sponsor to liquidate investments in the trust to honor the redemption.