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Letter from the ICI Research: Chapter 1: Chapter 2: Chapter 3: Chapter 5: Chapter 6: Chapter 7: Appendix A: Appendix C: |
The Origins of Pooled InvestingThe investment company concept dates to Europe in the late 1700s, according to K. Geert Rouwenhorst in The Origins of Mutual Funds, when “a Dutch merchant and broker…invited subscriptions from investors to form a trust…to provide an opportunity to diversify for small investors with limited means.” The emergence of “investment pooling” in England in the 1800s brought the concept closer to U.S. shores. The enactment of two British laws, the Joint Stock Companies Acts of 1862 and 1867, permitted investors to share in the profits of an investment enterprise and limited investor liability to the amount of investment capital devoted to the enterprise. Shortly thereafter, in 1868, the Foreign and Colonial Government Trust formed in London. This trust resembled the U.S. fund model in basic structure, providing “the investor of moderate means the same advantages as the large capitalists…by spreading the investment over a number of different stocks.” Perhaps more importantly, the British fund model established a direct link with U.S. securities markets, helping finance the development of the post–Civil War U.S. economy. The Scottish American Investment Trust, formed on February 1, 1873, by fund pioneer Robert Fleming, invested in the economic potential of the United States, chiefly through American railroad bonds. Many other trusts followed that not only targeted investment in America, but led to the introduction of the fund investing concept on U.S. shores in the late 1800s and early 1900s. The first mutual, or “open-end,” fund was introduced in Boston in March of 1924. The Massachusetts Investors Trust, formed as a common law trust, introduced important innovations to the investment company concept by establishing a simplified capital structure, continuous offering of shares, the ability to redeem shares rather than hold them until dissolution of the fund, and a set of clear investment restrictions and policies. The stock market crash of 1929 and the Great Depression that followed greatly hampered the growth of pooled investments until a succession of landmark securities laws, beginning with the Securities Act of 1933 and concluding with the Investment Company Act of 1940, reinvigorated investor confidence. Renewed investor confidence and many innovations led to relatively steady growth in industry assets and number of accounts.
The Different Types of U.S. Investment CompaniesFund sponsors in the U.S. offer four types of registered investment companies: open-end investment companies (commonly called “mutual funds”), closed-end investment companies, exchange-traded funds (ETFs), and unit investment trusts (UITs). The vast majority of investment companies are mutual funds, both in terms of number of funds and assets under management. Mutual funds can have actively managed portfolios, in which a professional investment adviser creates a unique mix of investments to meet a particular investment objective, or passively managed portfolios, in which the adviser seeks to track the performance of a selected benchmark or index. One hallmark of mutual funds is that they issue “redeemable securities,” meaning that the fund stands ready to buy back its shares at their current net asset value, or NAV. The NAV is calculated by dividing the total market value of the fund’s assets, minus its liabilities, by the number of mutual fund shares outstanding. For more information on mutual funds, see The Organization of a Mutual Fund. Unlike mutual funds, closed-end funds do not issue redeemable shares. Instead, they issue a fixed number of shares that trade intraday on stock exchanges at market-determined prices. Investors in a closed-end fund buy or sell shares through a broker, just as they would trade the shares of any publicly traded company. For more information on closed-end funds, see chapter 4. ETFs are described as a hybrid of other types of investment companies. They are structured and legally classified as mutual funds or UITs (discussed below), but trade intraday on stock exchanges like closed-end funds. ETFs only buy and sell fund shares directly to certain “authorized participants” in large blocks, which are often 50,000 shares or more. For more information on ETFs, see chapter 3. UITs are also a hybrid, with some characteristics of mutual funds and some of closed-end funds. Like closed-end funds, UITs typically issue only a specific, fixed number of shares, called “units.” Like mutual funds, the units are redeemable, but unlike mutual funds, generally the UIT sponsor will maintain a secondary market in the units to avoid depletion of the UIT’s assets. A UIT does not actively trade its investment portfolio, instead buying and holding a set of particular investments until a set termination date, at which time the trust is dissolved and proceeds are paid to shareholders.
The Organization of a Mutual FundIndividuals and institutions invest in a mutual fund by purchasing shares issued by the fund. It is through these sales of shares that a mutual fund raises the cash used to invest in its portfolio of stocks, bonds, and other investments. Each investor owns a pro rata share of the fund’s investments and shares in the returns from the fund’s portfolio while benefiting from professional investment management, diversification, and liquidity. Mutual funds may offer other benefits and services, such as asset allocation programs or check-writing privileges on money market fund accounts. A mutual fund is organized under state law either as a corporation or a business trust (sometimes called a “statutory trust”). Mutual funds have officers and directors or trustees. In this way, mutual funds are like any other type of operating company, such as Exxon or Google. Unlike other companies, however, a mutual fund is typically externally managed; it is not an operating company and it has no employees in the traditional sense. Instead, a fund relies upon third parties or service providers that are either affiliated organizations or independent contractors to invest fund assets and carry out other business activities. The diagram below shows the primary types of service providers usually relied upon by a fund. Although it typically has no employees, a fund is required by law to have its own written compliance program, overseen by an individual designated as a chief compliance officer. This compliance program establishes detailed procedures and internal controls designed to ensure compliance with all relevant laws and regulations. The Structure of a Mutual Fund
How a Fund Is CreatedSetting up a mutual fund is a complicated process performed by the fund’s sponsor, typically the fund’s investment adviser, administrator, or principal underwriter (also known as its distributor). The fund sponsor has a variety of responsibilities. For example, it must assemble the group of third parties needed to launch the fund, including the persons or entities charged with managing and operating the fund. The sponsor provides officers and affiliated directors to oversee the fund, and recruits unaffiliated persons to serve as independent directors. Some of the major steps in the process of starting a mutual fund include organizing the fund under state law as either a business trust or corporation, registering the fund with the SEC as an investment company pursuant to the Investment Company Act of 1940, and registering the fund shares for sale to the public pursuant to the Securities Act of 1933. Unless otherwise exempt from doing so, the fund must also make filings and pay fees to each state (except Florida) in which the fund’s shares will be offered to the public. The Investment Company Act also requires that each new fund have at least $100,000 of seed capital before distributing its shares to the public; this capital is usually contributed by the adviser or other sponsor in the form of an initial investment. For more information on the requirements for the initial registration of a mutual fund, see the SEC’s Investment Company Registration and Regulation Package, available at www.sec.gov/divisions/investment/invcoreg121504.htm. ShareholdersInvestors are given comprehensive information about the fund to help them make informed decisions. A mutual fund’s statutory prospectus describes the fund’s investment goals and objectives, fees and expenses, investment strategies and risks, and informs investors how to buy and sell shares. The SEC requires a fund to provide a prospectus either before an investor makes his or her initial investment or together with the confirmation statement of an initial investment. Beginning in 2009, mutual funds and ETFs may elect to provide investors with a short “summary prospectus” containing certain key information instead of the full statutory prospectus. If funds use a summary prospectus, the full statutory prospectus and additional information must be available on the Internet and in paper upon request. In addition, periodic shareholder reports, which are provided to investors at least every six months, discuss the fund’s recent performance and include other important information, such as the fund’s financial statements. By examining these reports and other publicly available information, an investor can learn if a fund has been effective in meeting the goals and investment strategies described in the fund’s prospectus. Like shareholders of other companies, mutual fund shareholders have specific voting rights. These include the right to elect directors at meetings called for that purpose (subject to a limited exception for filling vacancies). Shareholders must also approve material changes in the terms of a fund’s contract with its investment adviser, the entity that manages the fund’s assets. For example, a fund’s management fee cannot be increased unless a majority of shareholders vote to approve the increase. Furthermore, funds seeking to change investment objectives or fundamental policies must first obtain the approval of the holders of a majority of the fund’s outstanding voting securities. See chapter 6 for more information on shareholders. Fund Entities and Service ProvidersBoard of DirectorsA fund’s board of directors is elected by the fund’s shareholders to govern the fund, and its role is primarily one of oversight. The board of directors typically is not involved in the day-to-day management of the fund company. Instead, day-to-day management of the fund is handled by the fund’s investment adviser or administrator pursuant to a contract with the fund. Investment company directors must exercise the care that a reasonably prudent person would take with his or her own business. They review and approve major contracts with service providers (including, notably, the fund’s investment adviser), approve policies and procedures to ensure the fund’s compliance with the federal securities laws, and undertake oversight and review of the performance of the fund’s operations. As part of this duty, a director is expected to obtain adequate information about issues that come before the board in order to exercise his or her “business judgment,” a legal concept that involves a good-faith effort by the director. Independent DirectorsMutual funds are required by law to have independent directors on their boards in order to better enable the board to provide an independent check on the fund’s operations. Independent directors cannot have any significant relationship with the fund’s adviser or underwriter. For more information about fund boards and directors, see appendix B. Investment AdvisersInvestment advisers have overall responsibility for directing the fund’s investments and handling its business affairs. The investment advisers have their own employees, including investment professionals who work on behalf of the funds’ shareholders and determine which securities to buy and sell in the funds’ portfolio, consistent with the funds’ investment objectives and policies. To protect investors, a fund’s investment adviser and the adviser’s employees are subject to numerous standards and legal restrictions, including restrictions on transactions that may pose conflicts of interest. Like the mutual fund, investment advisers are required to have their own written compliance programs that are overseen by chief compliance officers and establish detailed procedures and internal controls designed to ensure compliance with all relevant laws and regulations. In addition to managing the fund’s portfolio, the adviser often serves as administrator to the fund, providing various back office services. As noted above, a fund’s investment adviser is often the fund’s initial sponsor and its initial shareholder through the “seed money” it invests to create the fund. AdministratorsA fund’s administrator handles the many “back office” functions for a fund. For example, administrators often provide office space, clerical and fund accounting services, data processing, bookkeeping and internal auditing, and preparing and filing SEC, tax, shareholder, and other reports. Fund administrators also help maintain compliance procedures and internal controls, subject to oversight by the fund’s board and chief compliance officer. Principal UnderwritersInvestors buy and redeem fund shares either directly or indirectly through the principal underwriter, also known as the fund’s distributor. Principal underwriters are registered under the Securities Exchange Act of 1934 as broker-dealers, and, as such, are subject to strict rules governing how they offer and sell securities to investors. The principal underwriter contracts with the fund to purchase and then resell fund shares to the public. A majority of both the fund’s independent directors and the entire fund board must approve the contract with the principal underwriter. CustodiansTo protect fund assets, the Investment Company Act requires all mutual funds to maintain strict custody of fund assets, separate from the assets of the adviser. Although the Act permits other arrangements, nearly all funds use a bank custodian for domestic securities. A fund’s custody agreement with a bank is typically far more elaborate than that used for other bank clients. The custodian’s services generally include safekeeping and accounting for the fund’s assets, settling securities transactions, receiving dividends and interest, providing foreign exchange capabilities, paying fund expenses, reporting failed trades, reporting cash transactions, monitoring corporate actions, and tracking loaned securities. Foreign securities are required to be held in the custody of a foreign bank or securities depository. For more information about custody, see appendix B. Transfer AgentsMutual funds and their shareholders also rely on the services of transfer agents to maintain records of shareholder accounts, calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances, and maintain customer service departments, including call centers, to respond to shareholder inquiries. Fund Pricing: Net Asset Value and the Pricing ProcessBy law, investors are able to redeem mutual fund shares each business day. As a result, fund shares are very liquid investments. Most mutual funds continually offer new shares to investors. Many fund companies also allow shareholders to transfer money—or make “exchanges”—from one fund to another within the same fund family. Mutual funds process investors’ sales, redemptions, and exchanges as a normal part of daily business activity and must ensure that all transactions receive the appropriate price. The price per share at which shares are redeemed is known as the net asset value (NAV). NAV is the current market value of all the fund’s assets, minus liabilities (e.g., fund expenses), divided by the total number of outstanding shares (see illustration below). This calculation ensures that the value of each share in the fund is identical. An investor may determine the value of his or her pro rata share of the mutual fund by multiplying the number of shares owned by the fund’s NAV. Federal law requires that a fund’s NAV be calculated at least once each trading day. The price at which a fund’s shares may be purchased is its NAV per share plus any applicable front-end sales charge (the offering price of a fund without a sales charge would be the same as its NAV per share). The 1940 Act requires “forward pricing,” meaning that shareholders who purchase or redeem shares must receive the next computed share price (NAV) following the fund’s receipt of the transaction order. Under forward pricing, orders received prior to 4:00 p.m. receive the price determined that same day at 4:00 p.m.; orders received after 4:00 p.m. receive the price determined at 4:00 p.m. on the next business day. The NAV must reflect the current value of the fund’s securities. The value of these securities is determined either by a market quotation for those securities in which a market quotation is readily available, or if a market quotation is not readily available, a fair value as determined in good faith. Determining Share Price
Most funds price their securities at 4:00 p.m. eastern time, when the New York Stock Exchange closes. A mutual fund typically obtains the prices for securities it holds from a market data vendor, which is a company that collects prices on a wide variety of securities. Fund accounting agents internally validate the prices received from a vendor by subjecting them to various control procedures. In many instances, funds may use more than one pricing service either to ensure accuracy or to receive prices for a wide variety of securities held in its portfolio (e.g., stocks or bonds). Mutual funds release their daily NAVs to investors and others after they complete the pricing process, generally around 6:00 p.m. eastern time. Daily fund prices are available through fund toll-free telephone services, websites, and other means. Tax Features of FundsMutual funds are subject to special tax rules set forth in subchapter M of the Internal Revenue Code. Unlike most corporations, mutual funds are not subject to taxation on their income and capital gains at the entity level, provided that they meet certain gross income, asset, and distribution requirements. To qualify as a “regulated investment company,” or a “RIC,” under subchapter M, at least 90 percent of a mutual fund’s gross income must be derived from certain sources, including dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock or securities or foreign currencies. In addition, at the close of each quarter of the fund’s taxable year, at least 50 percent of the value of the fund’s total net assets must consist of cash, cash items, government securities, securities of other funds, and investments in other securities which, with respect to any one issuer, do not represent more than 5 percent of the assets of the fund nor more than 10 percent of the voting securities of the issuer. Further, no more than 25 percent of the fund’s assets may be invested in the securities of any one issuer (other than government securities or the securities of other funds), the securities (other than the securities of other funds) of two or more issuers which the fund controls and are engaged in similar trades or businesses, or the securities of one or more qualified publicly traded partnerships. If a mutual fund satisfies the gross income and asset tests and thus qualifies as a RIC, the fund is not subject to tax on its income and capital gains, provided that the RIC distributes at least 90 percent of its income (other than net capital gains) each year. A RIC may retain up to 10 percent of its income and all capital gains, but the retained income is taxed at regular corporate tax rates. Therefore, mutual funds generally distribute substantially all of their income and capital gains each year. The Internal Revenue Code also imposes a 4 percent excise tax on RICs, unless a RIC distributes by December 31 at least 98 percent of its ordinary income earned during the calendar year, and 98 percent of its net capital gain earned during the 12-month period ending on October 31 of the calendar year. Mutual funds typically seek to avoid this charge by electing to distribute their income each year.
Types of DistributionsMutual funds make two types of taxable distributions to shareholders: ordinary dividends and capital gains. Dividend distributions come primarily from the interest and dividends earned by the securities in a fund’s portfolio and net short-term gains, if any, after expenses are paid by the fund. These distributions must be reported as dividends on an investor’s tax return and are taxed at the investor’s ordinary income tax rate. Legislation enacted in 2003 lowered the top tax rate on certain “qualified dividend” income to 15 percent, and legislation enacted in 2006 extended these lower rates through 2010. Some dividends paid by mutual funds may qualify for this lower tax rate. Long-term capital gain distributions represent a fund’s net gains, if any, from the sale of securities held in its portfolio for more than one year. The 2003 legislation also lowered the long-term capital gains tax paid by fund shareholders; in general, these gains are taxed at a 15 percent rate, although a lower rate applies to some taxpayers. Fund investors ultimately are responsible for paying tax on their share of a fund’s earnings, whether they receive the distributions in cash or reinvest them in additional fund shares. To help mutual fund shareholders understand the impact of taxes on the returns generated by their investments, the SEC requires mutual funds to disclose standardized after-tax returns for one-, five-, and 10-year periods. After-tax returns, which accompany before-tax returns in fund prospectuses, are presented in two ways:
Types of Taxable Shareholder TransactionsAn investor who sells mutual fund shares usually incurs a capital gain or loss in the year the shares are sold; an exchange of shares between funds in the same fund family also results in either a capital gain Investors are liable for tax on any capital gain arising from the sale of fund shares, just as they would be if they sold a stock, bond, or other security. Capital losses from mutual fund share sales and exchanges, like capital losses from other investments, may be used to offset other capital gains in the current year and thereafter. The amount of a shareholder’s gain or loss on fund shares is determined by the difference between the “cost basis” of the shares (generally, the purchase price—including sales loads—of the shares, whether acquired with cash or reinvested dividends) and the sale price. Many funds provide cost basis information to shareholders or compute gains and losses for shares sold. Tax-Exempt FundsTax-exempt bond funds pay dividends earned from municipal bond interest. This income is exempt from federal income tax and, in some cases, state and local taxes as well. Tax-exempt money market funds invest in short-term municipal securities or equivalent instruments and also pay exempt-interest dividends. Even though income from these funds generally is tax-exempt, investors must report it on their income tax returns. Tax-exempt funds provide investors with this information in a year-end statement and typically explain how to handle tax-exempt dividends on a state-by-state basis. For some taxpayers, portions of income earned by tax-exempt funds also may be subject to the federal alternative minimum tax. |
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