Funds

What Are Funds?

Funds are collective investment vehicles that pool money from multiple investors to purchase a diversified portfolio of securities such as stocks, bonds, and other assets. Managed by professional investment advisers, funds offer individuals and institutions a convenient way to achieve diversification and professional portfolio management without directly owning individual assets. These structured financial products are designed with specific investment objectives, ranging from growth and income to capital preservation.

History and Origin

The concept of pooled investment funds has roots stretching back centuries, with early forms appearing in the Netherlands in the late 18th century as a way for smaller investors to achieve diversification. However, the modern investment fund industry, particularly in the United States, began to take shape in the early 20th century. The first modern mutual funds were established in the U.S. in the 1920s, with MFS's Massachusetts Investors Trust opening in 1924 and remaining the oldest continuously operating mutual fund.

The stock market crash of 1929 and the subsequent Great Depression highlighted the need for greater investor protection and regulatory oversight. This led to the enactment of foundational legislation, notably the Investment Company Act of 1940. This pivotal law regulates the organization and operation of investment companies, including mutual funds, ensuring transparency and minimizing conflicts of interest for the investing public.¹⁰,⁹ The act mandates requirements for registration with the Securities and Exchange Commission (SEC), detailed disclosures, and certain operational constraints.⁸

Key Takeaways

• Funds pool money from many investors to create a diversified portfolio.
• They are managed by professional investment advisers.
• Funds offer access to a wide range of securities and investment strategies.
• The Investment Company Act of 1940 provides the regulatory framework for many types of funds in the U.S.
• Common types include mutual funds, closed-end funds, and unit investment trusts.

Formula and Calculation

While there isn't a single universal "fund formula" that applies to all types of funds, a key metric for many open-end funds like mutual funds is the Net Asset Value (NAV). The NAV represents the per-share value of a fund and is calculated daily.

The formula for Net Asset Value is:

Where:

• Total Assets include the market value of all investments (stocks, bonds, cash, etc.) held by the fund.
• Total Liabilities include all the fund's debts, accrued expenses, and other obligations.
• Number of Shares Outstanding is the total number of shares issued by the fund that are currently held by investors.

This calculation determines the price at which investors can buy or sell shares of a fund directly from the fund company at the end of each trading day.⁷

Interpreting the Funds

Interpreting funds involves understanding their structure, investment strategy, and associated costs. For instance, when evaluating a fund, investors often look at its stated investment objectives to ensure alignment with their own financial goals. A fund aiming for capital growth will have a different asset allocation than one focused on income.

Furthermore, investors scrutinize the fund's expense ratio, which represents the annual cost of operating the fund, expressed as a percentage of its assets. A lower expense ratio generally means more of the investment return is kept by the investor. Understanding how these elements combine helps investors assess whether a particular fund is suitable for their portfolio.

Hypothetical Example

Consider an investor, Sarah, who wants to invest in a diversified portfolio but only has $1,000 to start. Instead of buying individual stocks and bonds, which would be difficult to diversify effectively with such a small amount, she decides to invest in a diversified growth fund.

The fund's objective is long-term capital appreciation, and its portfolio includes a mix of large-cap U.S. stocks, international equities, and some fixed-income securities. On the day Sarah invests, the fund's net asset value (NAV) is $25 per share.

Sarah invests her $1,000, which buys her 40 shares ($1,000 / $25 = 40 shares). As the market fluctuates, the value of the underlying securities in the fund's portfolio changes, causing the NAV per share to go up or down. If, after a year, the fund's NAV rises to $28 per share, Sarah's investment would be worth $1,120 (40 shares * $28). This demonstrates how funds provide an accessible way to gain exposure to a broad market or specific investment strategies.

Practical Applications

Funds are widely used across various aspects of investing, financial planning, and retirement savings. They form the core of many individual retirement accounts (IRAs) and 401(k) plans, allowing employees to invest in a professionally managed, diversified portfolio through payroll deductions. For individuals, funds provide an easy entry point into capital markets, enabling them to pursue specific investment objectives without needing extensive knowledge of individual security analysis.

They are also critical tools for asset allocation, as investors can choose funds that align with their desired exposure to different asset classes, such as equities, bonds, or commodities. For example, a global index funds might track a broad market benchmark, offering exposure to thousands of companies worldwide. Investment advisers frequently use funds to construct client portfolios, tailoring the selection of various share classes and fund types to meet diverse client needs. Funds are also subject to oversight by regulatory bodies like the Securities and Exchange Commission, which ensures compliance with federal securities laws.⁶

Limitations and Criticisms

Despite their widespread use, funds are not without limitations and criticisms. One common critique, particularly leveled against actively managed funds, is the potential for underperformance relative to market benchmarks after accounting for fees. Data from Morningstar's Active/Passive Barometer, a semiannual report measuring the performance of actively managed funds against their passive counterparts, often indicates that a significant percentage of active funds fail to survive and outperform their passive peers over longer time horizons.⁵,⁴ This underperformance is frequently attributed to higher fees associated with active management compared to passive investing strategies like index funds.

Another limitation can be a lack of transparency regarding daily holdings in some fund structures, although mutual funds disclose holdings periodically. Additionally, investors in mutual funds can only buy or sell shares once per day at the end-of-day net asset value, which might not suit those seeking intra-day trading flexibility. While funds offer diversification, they do not eliminate market risk; the value of a fund can still decline significantly during market downturns.

Funds vs. Exchange-Traded Funds (ETFs)

While both funds and Exchange-Traded Funds (ETFs) are pooled investment vehicles, they differ primarily in their trading mechanisms and pricing structures.

John Bogle, founder of Vanguard, famously favored mutual funds over ETFs, expressing concern that the intra-day tradability of ETFs might encourage investors to trade more frequently, potentially undermining a disciplined, long-term buy-and-hold strategy.³,²

FAQs

What is the primary purpose of investing in a fund?

The primary purpose is to achieve diversification and professional portfolio management by pooling money with other investors, allowing access to a broader range of securities than might be feasible for an individual investor alone.

Are all funds the same?

No, funds come in various types, including mutual funds, closed-end funds, and unit investment trusts, each with distinct structures, trading characteristics, and investment strategies. They can be actively managed or follow a passive investing approach, such as replicating an index.

How do funds make money for investors?

Funds generate returns for investors through capital appreciation (when the value of the underlying investments increases), dividends, and interest payments from the securities they hold. These returns are then passed on to investors, typically proportional to their ownership in the fund.

What fees are associated with funds?

Common fees include the expense ratio, which covers management fees, administrative costs, and other operational expenses. Some funds may also charge sales loads (commissions) when you buy or sell shares.

How are funds regulated?

In the United States, most publicly offered funds are regulated under the Investment Company Act of 1940, which is enforced by the SEC. This regulation aims to protect investors by requiring transparency and establishing rules for fund operations and governance.¹