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A LETTER FROM ICI'S
CHIEF ECONOMIST

ICI RESEARCH:
STAFF AND PUBLICATIONS

SECTION 1:
OVERVIEW OF
U.S.-REGISTERED INVESTMENT COMPANIES

SECTION 2:
RECENT MUTUAL FUND TRENDS

SECTION 3:
EXCHANGE-TRADED FUNDS AND INDEX MUTUAL FUNDS

SECTION 4:
CLOSED-END FUNDS

SECTION 5:
MUTUAL FUND FEES AND EXPENSES

SECTION 6:
CHARACTERISTICS OF MUTUAL FUND OWNERS

SECTION 7:
THE ROLE OF MUTUAL FUNDS IN RETIREMENT AND EDUCATION SAVINGS

DATA TABLES

APPENDIX A:
HOW MUTUAL FUNDS AND INVESTMENT COMPANIES OPERATE

APPENDIX B:
ICI STATISTICAL RELEASES AND RESEARCH PUBLICATIONS

TIMELINE:
SIGNIFICANT EVENTS IN FUND HISTORY

FACT BOOK ARCHIVE

The Origins of Pooled Investing

The 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 targeted not only 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 Companies

An investment company is a corporation, trust, or partnership organized under state law that invests pooled shareholder dollars in securities appropriate to the entity's—and its shareholders'—investment objective. The main types of investment companies are: mutual, or "open-end," funds, closed-end funds, unit investment trusts, and exchange-traded funds, a relatively recent adaptation of the investment company concept.

A mutual fund is an investment company that buys a portfolio of securities selected by a professional investment adviser to meet a specified financial goal. Investors buy fund shares, which represent proportionate ownership in all the fund's securities. There is no limit on the number of shares issued by a mutual fund. A mutual fund is referred to as an "open-end" fund for two main reasons: 1) it is required to redeem (or buy back) outstanding shares at any time, at their current net asset value, which is the total market value of the fund's investment portfolio, minus its liabilities and divided by the number of shares outstanding; and 2) virtually all mutual funds continuously offer their shares to the public.

A closed-end fund is an investment company that issues a fixed number of shares that trade on a stock exchange or in the over-the-counter market. Assets of a closed-end fund are professionally managed in accordance with the fund's investment objectives and policies and may be invested in stocks, bonds, or other securities. The vast majority of closed-end funds are externally managed, like mutual funds (see The Organization of a Mutual Fund). As with other publicly traded securities, the market price of closed-end fund shares fluctuates and is determined by supply and demand in the marketplace. For more information on closed-end funds, see page 50.

A unit investment trust (UIT) is an investment company that buys and holds a generally fixed portfolio of stocks, bonds, or other securities, and issues a fixed number of units for sale. Unit investment trusts are also externally managed. "Units" in the trust are sold to investors, or "unit holders," who, during the life of the trust, receive their proportionate share of dividends or interest paid by the trust. Unlike other investment companies, a UIT has a stated date for termination, which varies according to the investments held in its portfolio. At termination, investors receive their proportionate share of the UIT's net assets.

Another fund available to investors is an exchange-traded fund (ETF). Although an ETF is an investment company (either an open-end fund or UIT), its structure and the trading of its shares differ significantly from traditional mutual funds or UITs. Indeed, unlike with other mutual funds or UITs, ETF shares are traded intraday on stock exchanges at market-determined prices. As such, an ETF has the features of an investment company (diversified portfolio, professional management), but its shares trade in the retail market like an equity security. Unlike mutual funds, investors must buy or sell ETF shares through a broker just as they would the shares of any publicly traded company. For more information on ETFs, see Section 3.

The Organization of a Mutual Fund

Individuals 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 money market sweep accounts.

A mutual fund is organized under state law either as a corporation or a business trust. Mutual funds have officers and directors or trustees. In this way, mutual funds are like any other type of operating company, such as IBM or General Motors.

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, either affiliated organizations or independent contractors, to invest fund assets and carry out other business activities. The diagram below shows the types of service providers usually relied upon by a fund.

How a Fund Is Created

Setting 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. It must also register the fund under state law as either a business trust or corporation. In addition, to sell its shares to the public, the fund must first register those shares with the SEC by filing a federal registration statement pursuant to the Securities Act of 1933 and, unless otherwise exempt from doing so, make filings and pay fees to each state (except Florida) in which the fund's shares will be offered to the public.

Broker-dealers and their representatives who sell fund shares to the public are subject to registration and regulation under the Securities Exchange Act of 1934. The investment adviser to the fund must register under the Investment Advisers Act of 1940 and comply with the Act's provisions.

Preparing the federal registration statement, contracts, filings for individual states, and corporate documents typically costs the fund sponsor several hundred thousand dollars. In addition, the Investment Company Act of 1940, a federal statute expressly governing mutual fund operations, requires that a mutual fund register with the SEC as an investment company. It 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.
Mutual funds incur fees and expenses in their ongoing operations, including the servicing of shareholder accounts. In addition to management fees (i.e., the fees paid to the fund's investment adviser to manage the fund's portfolio and perform other services), funds regularly incur transfer agent, custodian, accounting, and other business and brokerage expenses.

Status as a registered investment company allows the fund to be treated as a "pass-through" investment vehicle for tax purposes. In other words, the fund's income flows through to shareholders without being taxed at the fund level. (See Tax Features of Funds for more information.)

Although a mutual fund is created from the seed money of a fund sponsor, it is managed for the benefit of all those investors who decide to buy shares once the fund is created and its shares offered to the public.

Shareholders

Investors are given comprehensive information about the fund to help them make informed decisions. A mutual fund's 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. 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 can be increased only when 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 Section 6 or visit the Institute's website for more information on shareholders.

Fund Entities and Service Providers

Boards of Directors

A 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 are expected to exercise sound business judgment, 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 well as of the operations of the fund's service providers with respect to the services they provide to the fund.

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 Directors. Mutual 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.

Investment Advisers

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. The investment adviser invests the fund's assets in accordance with the fund's investment objectives and policies as stated in the registration statement it files with the SEC.

As a professional money manager, the investment adviser also provides a level of money management expertise usually beyond the scope of the average individual investor. The investment adviser has its own employees—typically, a team of experienced investment professionals—who work on behalf of the fund's shareholders and determine which securities to buy and sell in the fund's portfolio.

An adviser's investment decisions are based on a variety of factors, including the fund's investment objectives, its risk parameters, and extensive research of the market and financial performance of specific securities (e.g., the performance and risks associated with a particular company's securities). To protect investors from the adviser's self-dealings, a fund's investment adviser and the adviser's employees are subject to numerous standards and legal restrictions, including restrictions on transactions between the adviser and the fund it advises.

A primary function of the investment adviser is to ensure that the fund's investments are appropriately diversified as required by federal laws and/or as disclosed in the fund's prospectus. Diversification of the fund's investment portfolio reduces the risk that the poor performance of any one security will dramatically reduce the value of the fund's entire portfolio. The allocation of a fund's assets among investments is constantly monitored and adjusted by the fund's investment adviser to protect the interests of shareholders in the fund as dictated by its investment objectives.

Administrators

A fund's administrator can be either an affiliate of the fund, typically the investment adviser, or an unaffiliated third party. The services it provides to the fund include overseeing other companies that provide services to the fund, as well as ensuring that the fund's operations comply with applicable federal requirements. Fund administrators typically pay for office space, equipment, personnel, and facilities; provide general accounting services; and help establish and maintain compliance procedures and internal controls. Often, they also assume responsibility for preparing and filing SEC, tax, shareholder, and other reports. For these services, they are compensated by the fund.

Principal Underwriters

Investors 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 initial contract with the underwriter.

The role of the principal underwriter is crucial to a fund's success and viability, in large part, because the principal underwriter is charged with attracting investors to the fund. Although many investors are long-term investors, an industry that competes on service and performance—combined with a shareholder's ability to redeem on demand—makes attracting new shareholders crucial. See page 82 for more information on how investors buy and sell fund shares today.

Custodians

Mutual funds are required by law to protect their portfolio securities by placing them with a custodian. Nearly all mutual funds use banks as their custodians. The SEC requires any bank acting as a mutual fund custodian to comply with various regulatory requirements designed to protect the fund's assets, including provisions requiring the bank to segregate mutual fund portfolio securities from other bank assets.

Transfer Agents

Mutual 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 Process

By law, investors are able to redeem mutual fund shares each business day. As a result, fund shares are very liquid investments. Most mutual funds also 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 held by the fund's NAV. Federal law requires that a fund's NAV be calculated 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 pm receive the price determined that same day at 4 pm; orders received after 4 pm receive the price determined at 4 pm 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, at fair value as determined in good faith by the fund.

Most funds price their securities at 4 pm 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).

The vast majority of mutual funds submit their daily NAVs to NASDAQ by 6 pm Eastern time so they may be published in the next day's morning newspapers. As NASDAQ receives prices, they are instantaneously transmitted to newswire services and other subscribers. Daily fund prices are available in newspapers and other sources, such as through a fund's toll-free telephone service or website.

Tax Features of Funds

Unlike most corporations, a mutual fund generally distributes all of its earnings to shareholders each year and is taxed only on amounts it retains. This specialized "pass-through" tax treatment was established under the Revenue Act of 1936 and endures today under Subchapter M of the Internal Revenue Code of 1986.

To qualify for specialized tax treatment under the Code, mutual funds must meet, among other conditions, various investment diversification standards and pass a test regarding the source of their income.

The Code's asset tests require that at least 50 percent of the fund's assets must be invested in 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. Furthermore, not 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) or of one or more qualified publicly traded partnerships.

Types of Distributions

Mutual 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. Legislation enacted in 2003 lowered the top tax rate on qualified dividend income to 15 percent, and legislation enacted in 2006 extended these lower rates through 2010.

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 are ultimately responsible for paying tax on 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:

• after taxes on fund distributions only (pre-liquidation); and
• after taxes on fund distributions and an assumed redemption of fund shares (post-liquidation).

Types of Taxable Shareholder Transactions

An 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 or loss.

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 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—for 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 Funds

Tax-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 is generally 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 may also be subject to the federal alternative minimum tax.

For more information on tax issues affecting fund shareholders, visit the Institute's website.