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What is a Mutual Fund?

by SOMO on .

Mutual funds (or “unit trusts”) are funds operated by a bank or an investment company that invest their money in a portfolio of assets, including company shares, corporate and governmental bonds, options, futures, currencies, or money market securities. They then sell parts of this portfolio to investors by issuing shares much like any other company sells shares to the public. For individual investors, mutual funds can be more attractive than building ones own portfolio because mutual funds are managed by professional asset managers, and they allow individuals to reduce risks through owning a very diversified portfolio. Most mutual funds are open to all kinds of investors, including households.

How it works

Banks and investment firms offer a variety of mutual funds to the public. They can be distinguished on the following grounds:

  • Investment objective or style. Funds vary in their objective (e.g. to provide steady income now, to grow over time, to grow aggressively, etc.). For example, “fixed income funds” are designed to deliver a fixed return at a certain point of time. They are thus the most reliable, but their returns are limited compared to the possible returns on equity investments. The most common “fixed-income” investments are government and corporate bonds. “Equity investments” involve the purchase of assets which makes the holder a partial proprietor of the asset. Mutual funds equity investments are mostly comprised of shares of public companies. “Balanced funds” offer a mix of bonds and equity.
  • Geographical coverage. Investors can choose also funds that differ in geographical scope; they may invest in assets all over the world, in specific regions or countries, in industrialized countries or in emerging markets only.
  • Sector. Some funds specialize in specific sectors, such as high technology. Investors pay the fund manager a fixed fee for managing the portfolio. In addition, a portion of the returns may be paid as a fee to the fund manager. Each share of a mutual fund shares equally in the profits and losses generated by the fund, and investors are allowed to cash in profits or reinvest them into the fund.

Expansion of mutual funds

Mutual funds have dramatically expanded over the past decades. From holding assets worth just under $500 billion in 1985, their value reached almost $12 trillion in 2007, but fell back to just over $9.5 trillion in 2008 as a result of the financial crisis. They have been growing again since then, and held assets worth $11.6 trillion by the end of 2011, according to the Securities Industry and Financial Markets Association.

Trends & Critical Issues

  • Industry has grown enormously. The mutual fund industry has grown enormously in the last decades. In the 1990s and for much of the 2000s, increasing stock prices attracted a lot of individual and institutional investors to buy mutual fund shares, providing banks and mutual funds with income from the management fees.
  • Losses in the financial crisis. Lower stock prices in 2002-2003, and again in 2007-2008, decreased the value of mutual funds substantially. In each cases, some investors lost up to 50% of the value of their portfolios, and in 2007-8 average losses were over 40&. Some mutual funds and banks providing those services subsequently lost a significant source of income, which resulted in some mutual funds closing down completely. Since 2008, the mutual fund industry has grown again and its value now close to its 2007 peak.
  • Enormous impact on local economies. Because of their size, mutual funds investment decisions have an enormous impact on local economies. In the mid 1990s, mutual funds bought heavily into securities of emerging markets. This dramatically affected the upturns and downfalls of those economies. In the quest for short-term gain, funds quickly bought and sold securities, regardless of the impact on the economies in which they invested, and/or of the lost potential for “patient” capital to deliver long-term economic benefits to these countries. For example, the appetite for investments in emerging market countries (EMCs), was dramatically curtailed by the Asian Crisis of 1997, the Russian default and subsequent near financial meltdown of 1998, the resulting problems in Brazil and other countries, and the collapse of the Argentine economy (2001-2003). When mutual funds and traders quickly wanted to sell securities from countries in financial crisis, their actions further decreased the value of all securities. This was the case in South East Asia, and it exacerbated the overall financial crisis.
  • Malpractices at funds. The lack of transparency regarding the difference between the actual cost of managing a mutual fund and the management fee charged to clients has led to various pricing scandals. Fund managers are also increasingly under investigation for not abiding by trading rules, including executing trades after the cut-off time (late trading). These scandals have led to lawsuits and indictments, and have made some mutual funds more accountable to investors.

CSR Issues

Civil society groups and individual investors are increasingly paying attention to the environmental and social impacts of investments. As a result, ‘Socially Responsible Investment’ (SRI) funds (green funds/ ‘ethical funds’) have been popping up all around the world. These funds promise to pay more attention to the social and environmental performance of the companies they invest in. In the Netherlands, investors are exempt from interest and dividend income tax on green funds that fulfill environmental criteria laid down by the government. The success of this program indicates that citizens are interested in green funds if they have the choice, and that tax incentives can create a strong demand for such funds.

Civil society groups continue to be critical of some so called ‘ethical investment’ funds. There is often also no social or environmental regulation of these funds, and thus no guarantee that they are truly sustainable. In the absence of clear, standardized guidelines for SRI, fund managers, and sometimes governments, are setting their own terms of reference. Investor organizations and civil society groups have made proposals on how to improve the accountability of funds towards investors. For example, EuroSIF, the European Social Investment Forum, has stressed the need for more transparency on the exact definition of SRI used by these funds.

Yet the SRI funds are still a niche in the total mutual fund industry. Most mutual fund managers continue to focus only on the portfolios or their companies financial performance, rather than their contribution to environmental sustainability or commitment to human rights.

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