Mutual funds are the most popular investment choice in the U.S., and for good reason. These products make it easy for anyone to invest in a diverse mix of financial securities.
While most investors have some amount of money in mutual funds, far fewer understand exactly how these funds work. That doesn't have to be the case. Whether you've already got some money in mutual funds, or just curious what all the buzz is about, this breakdown will lift the veil and illuminate what makes these mutual funds tick.
Why Mutual Funds Are so Popular
The financial institutions that provide mutual funds cast a wide net, creating funds to match virtually any need. Some funds specialize in giving investors a safe place to store your temporary cash savings, while others focus on earning dividends and capital gains on long-term global stocks. This combination of convenience and choice has helped spark an explosive growth in the mutual fund industry.
As of 2020, the U.S. mutual fund industry is worth about $29.3 trillion, making it one of the most important aspects of the financial market. According to some estimates, nearly a third of Americans own mutual funds. Even if you don't have mutual funds in your brokerage account, you may unknowingly be invested in mutual funds through your 401(k), 403(b), Roth IRA, Traditional IRA, SEP-IRA, or Simple IRA.
Mutual Fund Organization
A mutual fund is organized as a regular corporation or a trust, depending on which method the founders prefer. If the fund agrees to pay out all of its dividend, interest, and capital gains profits to shareholders, the IRS won't make it pay corporate taxes. The mutual fund itself consists of only a few things:
- A board of directors or board of trustees: If the company is a corporation, the people who watch over it for the shareholders are known as directors and serve on a board of directors. If it is a trust, they are known as trustees and serve on a board of trustees. There is no difference between the two. The law mandates that at least 75% of the directors or trustees must be disinterested, meaning they have no relationship to the person or firm that will manage the money. That doesn't mean they aren't making money. The directors and trustees behind major mutual funds can receive salaries of hundreds of thousands of dollars.
- The cash, stocks, and bonds the fund holds: The actual financial products that a mutual fund holds. These include stocks, bonds, cash, and other assets. The exact mix depends on the type of mutual fund, and the choices made by the investment managers or advisers.
- Contracts: The fund itself has no employees, so any duties not covered by the board are handled by a contractor.
Examples of Contract Services
Organizations and individuals are contracted to perform services for the mutual fund, usually in exchange for a fee that's taken out of the fund's cash reserves. These contract positions include:
- Custody: A bank is needed to hold all of the cash, bonds, stocks, or assets the fund owns. Banks that specialize in holding institutional assets are called "custodian banks," or simply "custodians."
- Transfer agent: These people keep track of individual purchases and sales of the mutual fund shares. They're also the ones ensuring that mutual fund owners get their dividend checks and account statements.
- Audit and accounting: This is a neutral third party accounting firm that attests the mutual fund's accounting and financial statements are reasonably stated. The contracted accounting firm will review the mutual fund's books and records to assess how likely it is fairly stated.
- Investment management or investment adviser company: This is the company that actively manages the money. It's the one determining when assets are bought, sold, or held onto. The investment management company is paid a percentage of the assets, rather than a flat rate. For instance, if it is paid a fee of 1.5%, the company would be paid 1/365th of 1.5% each day, based on the weighted average assets of the fund. This is a high-stakes position, and they can be fired by the mutual fund's board of directors with very little notice.
How the Mutual Fund Process Works
Let's say you have $10,000 to invest in a fund. You fill out an account application from the mutual fund's website and submit that along with a check or bank routing instructions. A few days later, your account is open. Here's a simplified explanation of what happens to your money.
First, the fund will ensure that your money is deposited into a bank or custody account. Once the amount is verified, you will be issued shares of the mutual fund. The amount of shares corresponds to the size of your deposit.
Even though you've been issued mutual fund shares, your cash is still technically cash at this point; it just isn't your cash. Instead, that cash shows up in the fund account where it becomes visible to the portfolio manager that represents the adviser company. Portfolio managers constantly get reports on the money coming into or out of the fund. They use these reports to determine how much to invest in additional stocks, bonds, or other securities.
When the portfolio manager is ready to buy, they coordinate the order with the trading department of their advising company. For example, let's say they want to buy shares of Coca-Cola. They will work with stockbrokers, investment banks, clearing networks, and other sources of liquidity to find Coca-Cola stockholders willing to sell for the lowest possible price.
Once a deal is struck and a trade is secured, a few days will pass until the settlement date. That settlement date is the actual day that a mutual fund takes its cash (including your recent deposit) out of its bank account. That money is handed over to a person or institution in exchange for shares. These shares are stored either physically or electronically with a custodian.
From then on, when Coca-Cola pays a dividend, it will send the money to the custodian, who will make sure it is credited to the mutual fund's account.
The mutual fund will likely hold the dividend payments in cash so it can pass along the money to you as a dividend at the end of the year.