Mutual Fund

A mutual fund is a collection of stocks and/or bonds which are professionally managed for the benefit of investors in them.

Mutual funds exist because individual investors generally have neither enough money nor experience to properly diversify a portfolio. 12 shares of Coca Cola, 18 shares of Disney, 32 shares of GE, etc. are very expensive to buy individually. A professional money manager aggregates lots of small buyers into a big fat pot of money, which then effectively gets "volume discounts" for the purchases and sales of shares.

Mutual funds are usually sold with "load," which is a fancy term for sales charge, along with a fee for managing the fund. There is a fabulous myth marketed aggressively to retail buyers that consumers get a great deal on "no load" funds. Traditionally, mutual funds were sold through brokers who charged between 1.5 and 7% commission, depending on the size of the purchase and the perceived "quality" or track record of the fund. Mutual funds were in the business of managing money, not selling it, so they were happy with their roles as buyers and sellers of stocks and bonds, and they let brokers...broker.

Then brokers got into the mutual fund business for a variety of reasons, mainly because they thought they could make money doing it. But there was a hole in the market, because many mutual funds underperformed indexes—in theory, more than half, anyway—and brokers felt they had leverage.

Mutual funds fought back (think: Star Wars with finance geeks in glasses fighting with pens) and began to broker their own funds. Fidelity was the most successful of funds becoming "supermarkets" of financial services. Schwab was the most successful broker who went into the funds businesses and/or wholesaled other funds.

Okay, so...how did mutual funds come about? Well, half a century and change ago, a bunch of investors wanted to pool their assets to make investments together. They mutually agreed to abide by a relatively simple set of rules and then gather funds to go invest.

Why would they do this? Scale. You’ve heard of the notion that you get a discount when you buy in volume or bulk, right? 84 pounds of dog food for 5 bucks. Even Fido can appreciate a good deal when he sees it.

Dog food discounts we get...but why would anyone need to buy in bulk when investing in stocks and bonds? Because back in The Day, the only way investors could invest in the stock market was to buy an individual stock directly. Same deal with a bond.

A typical stock might sell for 40 bucks a share. The problem was that, if an investor didn’t buy a round lot of these shares, she was charged a massive commissio...almost like a penalty for not being rich enough to buy a Costco-type portion of shares.

A round lot is any order that comes in blocks of 100 shares, i.e., 200 shares is a round lot; 500 shares is a round lot; 738 shares is not a round lot. Some high-level calculus there. A typical round lot commission might be 5%; an odd lot commission might be 15%...so it made it even harder for the small buyer to get invested in the markets.

Example time.

On a purchase of 100 shares at $40, that’s 4 grand. A lot of money even today. But think about what 4 grand bought you in 1952. More than a few hula hoops and poodle skirts. Inflation adjusted, it’s almost 40 grand today. It bought a home. A super nice one. So how is the Average Josefina able to plunk down 40 grand to buy just one stock? She’s not.

Four grand could be a life’s savings, and if a simple retail investor put all of her money in one stock and that stock tanked, then she was SOL, or sweetly out of luck. So mutual funds allowed that little guy investor with very small amounts of money (and for most it was a minimum of about $250, which still applies today) to pool his money with thousands of other investors, and get exposure to a basket of stocks.

The fancy $5 word is "diversification."

If a thousand investors each put 4 grand, on average, into an investment pot, that gives them 4 million dollars of buying power, and allows them easy access, or liquidity, to have their 4 grand invested in a wide range of stocks and bonds, in whatever form they want. And with a larger pot of money to put to work, might they also get the ear of the company’s CEO for 15 minutes a quarter? Would that make them invest the dough more readily? Well, maybe.

At the end of the year, let’s say that 4 million was invested well, and it has a value of 4.4 million bucks. When the 1,000 partners formed the fund, they agreed that they would divide the fund into slices of pie in the same way that ownership of a company is divided into shares. Remember that Apple has over 5 billion shares outstanding. They trade at 250 bucks per share, give or take, and multiplying the 2 together gives them a total value today of over a tril.

Well, the mutual fund might have 200,000 shares outstanding, so at $4 million of value, to get the net asset value per share, you’d divide that total pie value by the number of slices in it to get 4 million over 200,000...or $20 per share. If the fund goes up 10 percent, the number of shares outstanding in this scenario hasn’t changed, so the net asset value per share would be $22 a share. A gain of 10 percent.

In real life, however, investors buy additional shares in a mutual fund and redeem them. Why?

Well, they buy because rich Uncle Larry died and left them a million bucks, and they already have the cool man cave stereo. And they might sell because the fund had lousy performance and they’re P.O.’d, or they might sell because the fund had great performance, and since they know that most investments regress to the mean, i.e., become just average over time, they want to take their chips off the table today and put the dough elsewhere.

So let’s say a new investor comes in and wants to invest $6,000 in the fund, which closed at the end of today at exactly $20 a share. Let’s also say that, on this given day, everybody was happy with their investment. Nobody wanted to sell and nobody wanted to buy. Well, unlike buying shares in Apple, Walter doesn’t need another already-existing investor to sell him the shares. He can buy $6,000 divided by $20...or 300 shares of the fund. Those shares didn’t come from a disgruntled (or gruntled) other investor. They were sold directly by the fund itself.

The analogous situation would be if Apple sold shares directly to the public. Those things happen; they’re called IPOs and secondary offerings, but they’re not a daily event. Mutual funds selling shares to the public is a daily event, however, and after this transaction, the investor now has 300 shares of this fund...a fund which now has 200,300 shares outstanding.

The value of the fund went up the $6,000 that was put in. So the fund’s value is now 200,300 times $20...or $4,006,000.
And Walter now owns 300 divided by 200,000...or 0.15% of the fund. Which is money we’re sure he’ll spend wisely.