Open-end funds, commonly referred to simply as mutual funds, are portfolios of securities, mainly stocks, bonds, and money market instruments. There are several important aspects of mutual funds. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager of the mutual fund manages the portfolio, that is, buys some securities and sells others (this characteristic is unlike unit investment trusts, discussed later).

Third, the value or price of each share of the portfolio, called the net asset value (NAV), equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors. That is,

Equation 60.1. 

For example, suppose that a mutual fund with 10 million shares outstanding has a portfolio with a market value of $215 million and liabilities of $15 million. The NAV is

Equation 60.2. 

Fourth, the NAV or price of the fund is determined only once each day, at the close of the day. For example, the NAV for a stock mutual fund is determined from the closing stock prices for the day. Business publications provide the NAV each day in their mutual fund tables. The published NAVs are the closing NAVs.

Fifth, and very importantly, all new investments into the fund or withdrawals from the fund during a day are priced at the closing NAV (investments after the end of the day or on a non-business day are priced at the next day's closing NAV).

The total number of shares in the fund increases if there are more investments than withdrawals during the day, and vice versa. This is the reason such a fund is called an "open-end" fund. For example, assume that at the beginning of a day a mutual fund portfolio has a value of $1 million, there are no liabilities, and there are 10,000 shares outstanding. Thus, the NAV of the fund is $100. Assume that during the day $5,000 is deposited into the fund, $1,000 is withdrawn, and the prices of all the securities in the portfolio remain constant. This means that 50 shares were issued for the $5,000 deposited (since each share is $100) and 10 shares redeemed for $1,000 (again, since each share is $100). The net number of new shares issued is then 40. Therefore, at the end of the day there will be 10,040 shares and the total value of the fund will be $1,004,000. The NAV will remain at $100.

If, instead, the prices of the securities in the portfolio change, both the total size of the portfolio and, therefore, the NAV will change. In the previous example, assume that during the day the value of the portfolio doubles to $2 million. Since deposits and withdrawals are priced at the end-of-day NAV, which is now $200 after the doubling of the portfolio's value, the $5,000 deposit will be credited with 25 shares ($5,000/$200) and the $1,000 withdrawn will reduce the number of shares by 5 shares ($1,000/$200).

Thus, at the end of the day there will be 10,020 shares (25 −5) in the fund with an NAV of $200, and the value of the fund will be $2,004,000. (Note that 10,020 shares × $200 NAV equals $2,004,000, the portfolio value.)

Overall, the NAV of a mutual fund will increase or decrease due to an increase or decrease in the prices of the securities in the portfolio, respectively. The number of shares in the fund will increase or decrease due to the net deposits into or withdrawals from the fund, respectively. And the total value of the fund will increase or decrease for both reasons.

The shares of a closed-end fund are very similar to the shares of common stock of a corporation. The new shares of a closed-end fund are initially issued by an underwriter for the fund. And after the new issue, the number of shares remains constant. This is the reason such a fund is called a "closed-end" fund. After the initial issue, there are no sales or purchases of fund shares by the fund company as there are for open-end funds. The shares are traded on a secondary market, either on an exchange or in the over-the-counter market.

Investors can buy shares either at the time of the initial issue (as discussed below), or thereafter in the secondary market. Shares are sold only on the secondary market. The price of the shares of a closed-end fund are determined by the supply and demand in the market in which these funds are traded. Thus, investors who transact closed-end fund shares must pay a brokerage commission at the time of purchase and at the time of sale.

The NAV of closed-end funds is calculated in the same way as for open-end funds. However, the price of a share in a closed-end fund is determined by supply and demand, so the price can fall below or rise above the net asset value per share. Shares selling below NAV are said to be "trading at a discount," while shares trading above NAV are "trading at a premium." Newspapers list quotations of the prices of these shares under the heading "Closed-End Funds." Some sources also list the NAV and the discount or premium of the shares.

Consequently, there are two important differences between open-end funds and closed-end funds. First, the number of shares of an open-end fund varies because the fund sponsor will sell new shares to investors and buy existing shares from shareholders. Second, by doing so, the share price is always the NAV of the fund. In contrast, closed-end funds have a constant number of shares outstanding because the fund sponsor does not redeem shares and sell new shares to investors (except at the time of a new underwriting). Thus, the price of the fund shares will be determined by supply and demand in the market and may be above or below NAV, as discussed above.

Although the divergence of the price from NAV is often puzzling, in some cases the reasons for the premium or discount are easily understood. For example, a share's price may be below the NAV because the fund has a large built-in tax liability and investors are discounting the share's price for that future tax liability. (We'll discuss this tax liability issue later in this chapter.) A fund's leverage and resulting risk may be another reason for the share's price trading below NAV. A fund's shares may trade at a premium to the NAV because the fund offers relatively cheap access to, and professional management of, stocks in another country about which information is not readily available to or transactions are difficult or expensive for small investors.

Under the Investment Company Act of 1940, closed-end funds are capitalized only once. They make an initial IPO (initial public offering) and then their shares are traded on the secondary market, just like any corporate stock, as discussed earlier. The number of shares is fixed at the IPO; closed-end funds cannot issue more shares. In fact, many closed-end funds become leveraged to raise more funds without issuing more shares.

An important feature of closed-end funds is that the initial investors bear the substantial cost of underwriting the issuance of the funds' shares. The proceeds that the managers of the fund have to invest equals the total paid by initial buyers of the shares minus all costs of issuance. These costs, which average around 7.5% of the total amount paid for the issue, normally include selling fees or commissions paid to the retail brokerage firms that distribute them to the public. The high commissions are strong incentives for retail brokers to recommend these shares to their retail customers, and also for investors to avoid buying these shares on their initial offering.

Exchange-traded funds (ETFs) pose a threat to both mutual funds and closed-end funds. ETFs, which are the subject of Chapter 61 in Volume I, are essentially hybrid closed-end vehicles, which trade on exchanges but which typically trade very close to NAV.

Since closed-end funds are traded like stocks, the cost to any investor of buying or selling a closed-end fund is the same as that of a stock. The obvious charge is the stock broker's commission. The bid/offer spread of the market on which the stock is traded is also a cost.

A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. Unit trusts typically invest in bonds. They differ in several ways from both mutual funds and closed-end funds that specialize in bonds. First, there is no active trading of the bonds in the portfolio of the unit trust. Once the unit trust is assembled by the sponsor (usually a brokerage firm or bond underwriter) and turned over to a trustee, the trustee holds all the bonds until they are redeemed by the issuer. Typically, the only time the trustee can sell an issue in the portfolio is if there is a dramatic decline in the issuer's credit quality. As a result, the cost of operating the trust will be considerably less than costs incurred by either a mutual fund or a closed-end fund. Second, unit trusts have a fixed termination date, while mutual funds and closed-end funds do not. (There are, however, exceptions. Target term closed-end funds have a fixed termination date.) Third, unlike the mutual fund and closed-end fund investor, the unit trust investor knows that the portfolio consists of a specific portfolio of bonds and has no concern that the trustee will alter the portfolio. While unit trusts are common in Europe, they are not common in the United States.

All unit trusts charge a sales commission. The initial sales charge for a unit trust ranges from 3.5% to 5.5%. In addition to these costs, there is the cost incurred by the sponsor to purchase the bonds for the trust that an investor indirectly pays. That is, when the brokerage firm or bond-underwriting firm assembles the unit trust, the price of each bond to the trust also includes the dealer's spread. There is also often a commission if the units are sold.

In the remainder this chapter of our primary focus chapter is on open-end (mutual) funds.

Sales charges on mutual funds are related to their method of distribution. The current menu of sales charges and distribution mechanisms has evolved significantly and is now much more diverse than it was a decade ago. To understand the current diversity and the evolution of distribution mechanisms, consider initially the circumstances of a decade ago. At that time, there were two basic methods of distribution, two types of sales charges, and the type of the distribution was directly related to the type of sales charge.

The two types of distribution were sales-force and direct. Sales-force distribution occurred via an intermediary, that is via an agent, a stockbroker, insurance agent, or other entity who provided investment advice and incentive to the client, actively "made the sale," and provided subsequent service. This distribution approach is active, that is the fund is typically sold, not bought.

The other approach is direct (from the fund company to the investor), whereby there is no intermediary or sales-person to actively approach the client, provide investment advice and service, or make the sale. Rather, the client approaches the mutual fund company, most likely by a toll-free telephone number, in response to media advertisements or general information, and opens the account. Little or no investment counsel or service is provided either initially or subsequently. With respect to the mutual fund sale, this is a passive approach, although these mutual funds may be quite active in their advertising and other marketing activities. Funds provided by the direct approach are bought, not sold.

There is a quid pro quo, however, for the service provided in the sales-force distribution method. The quid pro quo is a sales charge borne by the customer and paid to the agent. The sales charge for the agent-distributed fund is called a load. The traditional type of load is called a front-end load, since the load is deducted initially or "up front." That is, the load is deducted from the amount invested by the client and paid to the agent/distributor. The remainder is the net amount invested in the fund in the client's name. For example, if the load on the mutual fund is 5% and the investor invests $100, the $5 load is paid to the agent and the remaining $95 is the net amount invested in the mutual fund at NAV. Importantly, only $95, not $100, is invested in the fund. The fund is, thus, said to be "purchased above NAV" (that is, the investor pays $100 for $95 of the fund). The $5 load compensates the sales agent for the investment advice and service provided to the client by the agent. The load to the client, of course, represents income to the agent.

Let's contrast this with directly placed mutual funds. There is no sales agent and, therefore, there is no need for a sales charge. Funds with no sales charges are called no-load mutual funds. In this case, if the client provides $100 to the mutual fund, $100 is invested in the fund in the client's name. This approach to buying the fund is called buying the fund "at NAV," that is, the whole amount provided by the investor is invested in the fund.

Previously, many observers speculated that load funds would become obsolete and no-load funds would dominate because of the sales charge. Increasingly financially sophisticated individuals, the reasoning went, would make their own investment decisions and not need to compensate agents for their advice and service. But the actual trend has been quite different.

Why has the trend not been away from the more costly agent distributed funds as many expected? There are two reasons. First, many investors have remained dependent on the investment counsel and service, and perhaps more importantly, the initiative of the sales agent. Second, sales-force distributed funds have shown considerable ingenuity and flexibility in imposing sales charges, which both compensate the distributors and are acceptable to the clients. Among the adaptations of the front end sales load are back-end loads and level loads. While the front-end load is imposed at the time of the purchase of the fund, the back-end load is imposed at the time fund shares are sold or redeemed. Level loads are imposed uniformly each year. These two alternative methods both provide ways to compensate the agent. However, unlike with the front-end load, both of these distribution mechanisms permit the client to buy a fund at NAV—that is, not have any of their initial investment debited as a sales charge before it is invested in their account.

The most common type of back-end load currently is the contingent deferred sales charge (CDSC). This approach imposes a gradually declining load on withdrawal. For example, a common "3,3,2,2,1,1,0" CDSC approach imposes a 3% load on the amount withdrawn within one year, 3% within the second year, 2% within the third year, and so on. There is no sales charge for withdrawals after the sixth year. Thus, the sales charge is postponed or deferred, and it is contingent upon how long the investment is held.

The third type of load is neither a front-end load at the time of investment nor a (gradually declining) back-end load at the time of withdrawal, but a constant load each year (e.g., a 1% load every year). This approach is called a level load. Most mutual fund families are strictly either no-load (direct) or load (sales-force).

Many load type mutual fund families often offer their funds with all three types of loads—that is, front-end loads (usually called "A shares"); back-end loads (often called "B shares"); and level loads (often called "C shares"). These families permit the distributor and its client to select the type of load they prefer. [See O'Neal (1999).] These different types of load shares are called share "classes." A recent type of share class is "F shares." F shares have no front, level or back loads. In this way they are like C shares. But F shares have considerably lower annual expenses than C shares, as will be seen below. F shares are designed for financial planners who charge annual fees (called fee-based financial planners) rather than sales charges such as commissions or loads. F shares of a fund family may only be sold by investment dealers and their representatives which have an arrangement with the fund family.

According to the National Association of Securities Dealers (NASD), the maximum allowable sales charge is 8.5%, although most funds impose lower charges.

The sales charge for a fund applies to most, even very small, investments (although there is typically a minimum initial investment). For large investments, however, the sales charge may be reduced. For example, a fund with a 4.5% front-end load may reduce this load to 3.0% for investments over $1 million. At some level of investment the front-end load will be 0%. There may be in addition further reductions in the sales charge at greater investments. The amount of investment needed to obtain a reduction in the sales charge is called a breakpoint—the breakpoint is $1 million in this example. There are also mechanisms whereby the total amount of the investment necessary to qualify for the breakpoint does not need to be invested up front, but only over time (according to a "letter of intent" signed by the investor). (See Inro, Jaing, Ho, and Lee, 1999.) Fund returns are calculated without subtracting sales charges since different individual investors have different sales charges (e.g., may have different breakpoints).

The sales charge is, in effect, paid by the client to the distributor. How does the fund family, typically called the sponsor or manufacturer of the fund, cover its costs and make a profit? This is the topic of the second type of "cost" to the investor, the fund annual operating expense.

The operating expense, also called the expense ratio, is debited annually from the investor's fund balance by the fund sponsor. The three main categories of annual operating expenses are the management fee, distribution fee, and other expenses.

The management fee, also called the investment advisory fee, is the fee charged by the investment adviser for managing a fund's portfolio. If the investment adviser is part of a company separate from the fund sponsor, some or all of this investment advisory fee is passed on to the investment adviser by the fund sponsor. In this case, the fund manager is called a subadviser. The management fee varies by the type of fund, specifically by the risk of the asset class of the fund. For example, the management fee as well as the risk may increase from money market funds to bond funds, to U.S. growth stock funds, to emerging market stock funds, as illustrated by examples to come.

In 1980, the Securities and Exchange Commission (SEC) approved the imposition of a fixed annual fee, called the 12b-l fee, which is, in general, intended to cover distribution costs, also including continuing agent compensation and manufacturer marketing and advertising expenses. Such 12b-l fees are now imposed by many mutual funds. By law, 12b-l fees cannot exceed 1% of the fund's assets per year. The 12b-l fee may also include a service fee of up to 0.25% of assets per year to compensate sales professionals for providing services or maintaining shareholder accounts. The major rationale for the component of the 12b-l fee which accrues to the selling agent is to provide an incentive to selling agents to continue to service their accounts after having received a transaction-based fee such as a front-end load. As a result, a 12b-l fee of this type is consistent with sales-force sold, load funds, not with directly sold, no-load funds. The rationale for the component of the 12b-l fee which accrues to the manufacturer of the fund is to provide incentive and compensate for continuing advertising and marketing costs.

Other expenses include primarily the costs of (1) custody (holding the cash and securities of the fund), (2) the transfer agent (transferring cash and securities among buyers and sellers of securities and the fund distributions, etc.), (3) independent public accountant fees, and (4) directors' fees.

The sum of the annual management fee, the annual distribution fee, and other annual expenses is called the expense ratio or annual operating expense. All the cost information on a fund, including selling charges and annual expenses, are included in the fund prospectus. In addition to the annual operating expenses, the fund prospectus provides the fees which are imposed only at the time of a fund transaction.

As we explained earlier, many agent-distributed funds are provided in different forms, typically the following:

(1) A shares: front-end load; (2) B shares: back-end load (contingent deferred sales charge); (3) C shares: level load; and (4) F shares: fee based program. These different forms of the same fund are called share classes. Table 60.1 provides an example of hypothetical sales charges and annual expenses of funds of different classes for an agent distributed stock mutual fund. The sales charge accrues to the sales agent. The management fee accrues to the mutual fund manager. The 12b-l fee accrues to the sales agent and the fund sponsor. Other expenses, including custody and transfer fees and the fees of managing the fund company, accrue to the fund sponsor to cover expenses. All of these expenses are deducted from fund returns on an annual basis.

Share classes were first offered in 1989 following the SEC's approval of multiple share class. Initially share classes were used primarily by sales-force funds to offer alternatives to the front-end load as a means of compensating brokers. Later, some of these funds used additional share classes as a means of offering the same fund or portfolio through alternative distribution channels in which some fund expenses varied by channel. Offering new share classes was more efficient and less costly than setting up two separate funds. [See Reid (2000).] By the end of the 1990s, the average long-term sales-force fund offered nearly three share classes. Direct market funds tended to continue to offer only one share class.

As explained earlier in this chapter, at the beginning of the 1990s there were two primary distribution channels, direct sales to investors and sales through brokers. Since then, fund companies and fund distributors developed and expanded sales channels beyond the two traditional channels. By the end of the 1990s, fund companies' use of multiple distribution channels resulted in a blurring of the distinction between direct and sales-force funds that had characterized funds at the beginning of the decade.

Fund companies and distribution companies developed new outlets for selling mutual funds and expanded their traditional sales channels. The changes that occurred are evident in the rising share of sales through third parties and intermediaries. Significant market trends account for these changes. In particular, many funds that had previously marketed only directly turned increasingly toward third parties and intermediaries for distribution.

Like direct-market funds, funds that were traditionally sold through a sales force moved increasingly to non-traditional sources of sales such as employer-sponsored pension plans, banks and life insurance companies, and fee-based advisers during the 1990s.

Below we describe the various nontraditional distribution channels.

Supermarkets

The introduction of the first mutual fund supermarket in 1992 marked the beginning of a significant change in the distribution of direct market funds. Specifically, during 1992, Charles Schwab & Co. introduced its OneSource service. With this and other supermarket programs, the organizer of the supermarket offers no-load funds from a number of different mutual fund companies. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company. The organizer of the supermarket also provides the investor with consolidated recordkeeping and a simple account statement.

These services provide a non-transaction-fee (NTF) program to provide access to multiple fund families under one roof and to help service the back-office needs of financial advisers. Through this service, investors can access many mutual fund families through one source and buy all the funds with no transaction fee (that is, no load).

On the one hand, these services make a mutual fund family more accessible to many more investors. On the other hand, they break the direct link between the mutual fund and the investor. According to these services, the mutual fund company does not know the identity of its investors through the supermarkets; only the supermarket, which distributes the funds directly to the investor knows their identity. These supermarkets fit the needs of fee-based financial planners very well. For individual investors and planners as well, supermarkets may offer one-stop shopping including the current "best of the breed."

Wrap Programs

Wrap accounts are managed accounts, typically mutual funds "wrapped" in a service package. The service provided is often asset allocation counsel; that is, advice on the mix of managed funds. Thus, mutual fund wrap programs provide investors with advice and assistance for an asset-based fee rather than the traditional front-end load. Wrap products are currently offered by many fund and nonfund companies. Wrap accounts are not necessarily alternatives to mutual funds, but may be different ways to package the funds.

Traditional direct market funds as well as sales-force funds are marketed through this channel.

Fee-Based Financial Advisers

Fee-based financial advisers are independent financial planners who charge investors a fee, typically as a percentage of assets under management, or an hourly charge. In return, they provide investment advice to their clients by selecting portfolios of mutual funds, ETFs, and securities. While many planners recommend mutual funds to their clients, others recommend portfolios of planner-selected securities.

Variable Annuities

Variable annuities represent another distribution channel. Variable annuities are "mutual funds in an insurance wrapper." Among their insurance features are the tax deferral of investment earnings until they are withdrawn, and higher charges (including a mortality charge for an insurance feature provided). Variable annuities are sold through insurance agents and other distributors as well as directly through some fund companies.

Until recently, fund manufacturers distributed only their own funds; fund distributors distributed only one manufacturer's funds; and typically employer defined contribution plans, such as 401(k)s, offered funds from only one distributor. However, the investors' demands for choice and convenience, and also the distributors' need to appear independent and objective, have incented essentially all institutional users of funds and distribution organizations to offer funds from other fund families in addition to their own (that is, if they also manufacture their own funds). In addition, mutual fund supermarkets distribute funds of many fund families with considerable facility and low costs. Many fund families offer funds from other families. When a distributor or distribution system sells the investment products of many mutual fund families, it is referred to as "open architecture."

The balance of power between fund manufacturers and distributors currently significantly favors distribution. That is, in general there are more funds available than distributors to sell them. In the mutual fund business, "distribution is king."