Mutual Fund

A mutual fund is a professionally managed investment company that pools money from many investors and invests it in a portfolio of securities. The Securities and Exchange Commission's investor education defines it as "an SEC-registered open-end investment company that pools money from many investors" to invest in stocks, bonds, short-term money market instruments, other securities or assets, or some combination of them. Each investor owns shares of the fund and therefore owns a proportional interest in everything inside it, rather than owning any particular holding directly.

The name is worth explaining rather than glossing over, because "mutual fund" appears nowhere in the governing statute. Under the Investment Company Act of 1940, the entity class is an open-end company, defined as a management company "which is offering for sale or has outstanding any redeemable security of which it is the issuer." Redeemable is the load-bearing word: the fund itself will buy your shares back from you. "Mutual fund" is the ordinary-usage name for exactly that legal creature, so an open-end fund and a mutual fund are the same thing rather than one being a type of the other. (Note also that the Investment Company Act of 1940 governs the funds themselves and is a different statute from the Investment Advisers Act of 1940, which governs the firms that advise them and advise you.)

Redeemability is not a detail of paperwork. It is the cause of nearly everything a beginner notices about owning one of these funds, and it is what separates a mutual fund from the two things it is most often compared with. Because your counterparty is the fund rather than another investor, there is no market of buyers and sellers setting a price through the day. The SEC states the mechanism directly: investors buy and sell mutual fund shares from or to the fund itself, or through a broker or investment adviser, rather than, in the SEC's words, "from/to other investors on national securities markets."

Three consequences follow, and all three are ordinary experiences that puzzle people who do not know the cause. First, pricing is forward-looking. Because the fund must value everything it holds before it can know what a share is worth, orders are priced at the next net asset value computed after the order is received, normally once each business day after markets close. A mutual fund order therefore cannot be placed at a price you have already seen. Second, the fund's share count is not fixed. It issues new shares to new money and extinguishes shares when investors redeem, so the fund grows and shrinks with demand. Third, redemptions have to be funded. If enough investors leave at once, the manager may have to sell holdings to raise the cash, which is a transaction the remaining shareholders bear rather than the departing ones. A closed-end fund is the direct contrast on all three points: it issues a fixed number of shares, does not redeem them, and leaves shareholders to trade with each other on an exchange, where the price can drift above or below the value of the underlying holdings.

The distinction that saves the most confusion is that a mutual fund is a container rather than an investment strategy. The SEC groups funds by what they hold, naming stock funds, bond funds (also called income funds), money market funds, and target-date funds that hold a mix scheduled to change over time. But "index fund" is not a fourth category alongside those; it describes a strategy that a mutual fund or an exchange-traded fund can equally follow. A total-market index fund sold as a mutual fund and the same index tracked in an exchange-traded fund hold the same companies. The container affects how you trade it and how it is taxed; it does not determine what is inside. Cost is a third, separate question, measured by the fund's expense ratio, and it varies enormously within every one of these categories.

One point on this page is genuinely safety-critical rather than merely useful, because it turns on a pair of names that differ by a single word. A money market fund is a mutual fund, and the SEC is explicit about what that means: "Money invested in a money market fund is not guaranteed by the FDIC like bank accounts are. There is therefore a risk you may lose some or all of the money you invested." A money market account is a deposit at a bank or credit union and carries federal deposit insurance. The two are commonly offered by the same institution, sit next to each other on the same screens, and are not the same kind of thing at all.

A fund company registers the fund with the SEC, publishes a prospectus stating what the fund may invest in and what it charges, and hires an SEC-registered investment adviser to manage the portfolio. Investors send money and receive shares; the fund invests the money according to its stated objective. Each business day, after markets close, the fund values its holdings, subtracts what it owes, and divides by the shares outstanding to arrive at the day's net asset value per share. Purchases and redemptions received that day are priced at that figure. Income the fund receives and gains it realizes are distributed to shareholders, who owe tax on them in a taxable account whether or not they reinvest.

A hypothetical example of forward pricing, which is the part that catches new investors. Marcus places a $3,000 purchase order at 11 a.m. The fund's net asset value at the close of the previous day was $50.00 a share, so he reasonably expects about 60 shares. Markets rise 2% that day and the fund's holdings rise with them, so the net asset value computed that evening is $51.00. His order is priced at $51.00, and $3,000 buys 58.82 shares instead of 60. Nothing has gone wrong and no fee has been charged. He simply bought at a price that did not exist when he decided to buy, because the fund had to value what it owned before it could sell him a share of it. Had markets fallen 2% instead, the same $3,000 would have bought about 61.22 shares.

Pros

• One transaction buys a diversified portfolio, so a small investor can own hundreds of securities without assembling them individually.
• Professional management by an SEC-registered investment adviser, under a prospectus that must state what the fund may hold and what it charges.
• The fund is obliged to redeem your shares, so there is no need to find a buyer and no risk of the price drifting below the value of the holdings the way it can with a closed-end fund.
• Fractional shares are ordinary, so a fixed dollar amount can be invested without being rounded to whole shares.

Cons

• You cannot transact at a known price. Orders fill at the next computed net asset value, so intraday moves work for or against you unpredictably.
• Redemptions by other shareholders can force the manager to sell holdings, and the consequences of that are borne by the shareholders who stayed.
• Costs vary enormously between funds holding nearly identical portfolios, and some share classes add sales charges on top of the annual expense ratio.
• Many funds impose an initial minimum investment.
• A money market fund inside this structure is a security, not an insured deposit, and the similarity of its name to a bank money market account misleads people every year.