You may be a seasoned investor who can easily navigate your way through the deep end of the investment pool. Or you may be a novice investor who’s simply testing the shallow waters of different investment pools. As a novice, you’ll quickly learn what long-time investors already know – investment fund structures vary, depending on the type of investment. The organizational structure of mutual funds is not a haphazard hierarchy; it’s a finely tuned machine with well-defined parts and mandated accountability.
Twofold Mutual Funds Definition
When you consider investing in a mutual fund, you may focus on the word “fund” and picture the actual monetary investment. And mutual funds certainly represent investments, but the term also refers to the actual company (or other entity) that offers the investment. When you invest in mutual funds, you’re actually purchasing part of the issuing company.
Structure of Mutual Funds
A mutual fund company combines money from a pool of investors toward a common investing goal. The fund may invest in a variety of investment vehicles such as stocks, bonds, money-market instruments or other types of securities. A mutual fund may also be comprised of a combination of different investments. Investors purchase shares, which represent part ownership in the company, directly from the fund or through a broker.
A heads-up about mutual funds is that they are not insured against loss by the Federal Deposit Insurance Corporation, or any other agency.
Fee Structure of Mutual Funds
Mutual funds are sometimes organized into groups called fund “classes.” Load classes represent mutual funds that investors purchase through a broker, also called front-end load, back-end load and level-load shares. No-load classes typically represent mutual funds that investors purchase directly from a company or purchase from financial professionals whom they pay outside other fund fees.
No-load funds may carry asset-based fees, which means that an investor pays brokers or other financial professionals based on a percentage of the investor’s assets that the broker manages. If investors don’t pay a broker directly for a no-load fund, they may pay some or all of the asset-based fees through the fund in the form of a 12b-1 fee.
Governance of Mutual Funds
Mutual fund companies must be registered by the U.S. Securities and Exchange Commission, and they are also mandated by the SEC. Investment advisers, separate entities that manage mutual fund portfolios, typically must also register with the SEC. Mutual fund issuers must file a prospectus with the SEC, which is a legal report that discloses all the details about the fund and offers transparency about the possible risks of the investment. A fund prospectus includes a table of fees in addition to the objectives, investment strategies and a history of the issuer’s fund management.
Another governing body, the Financial Industry Regulatory Authority, provides accountability for the marketing of mutual funds. Although FINRA doesn't actually regulate the mutual fund companies, it does regulate the financial representatives and brokers who sell mutual funds. FINRA specifically enforces the rules of marketing, advertising and sales practices. Brokers cannot omit information if the omission has the potential for communicating anything that could be misleading
Management of Mutual Funds
Mutual fund companies aren’t companies in the traditional sense. They don’t have employees, and they’re generally managed by external service providers that can be independent contractors or organizations. Fund companies hire SEC-registered investment advisers to manage their fund portfolios.
Investment advisers are tasked with designing and implementing fund compliance policies and procedures. To accomplish this goal, advisers provide a variety of services, which include performing research to make an informed decision as to which securities the fund will buy and sell. Advisers also oversee third-party service providers to ensure regulatory compliance.
Organization of Mutual Funds
The organization of mutual funds is a multi-pronged configuration, figuratively arranged like the spokes of a wheel. At the hub of the wheel is the fund itself, and the other components support the fund to keep it running smoothly (and legally). Of primary importance are the mutual fund shareholders, without which the fund couldn't exist.
Mutual Fund Shareholders
Because shareholders of mutual funds own part of the fund company, they have certain voting rights that actually offer quite a bit of latitude to shape the parameters of a fund. Shareholders elect the fund’s board of directors. And with a majority vote, they can also keep the fund’s management fee from increasing and disallow the fund’s objective or policies from changing. The collective rights of shareholders allow them to work closely with the fund’s investment adviser in somewhat of a check-and-balance relationship that holds the fund company accountable for its actions.
The Board of Directors
The primary role of a fund’s board is to oversee the fund, without having a hand in the day-to-day management of the fund. A mutual fund’s board includes directors, 75 percent of whom must be independent directors as mandated by Congress through the Investment Company Act of 1940.
“Independent” means separate from the management of the fund company by not having any substantial business dealings with the fund adviser or underwriter. When the fund’s adviser drafts contracts, the board is tasked with reviewing and approving them. Directors also oversee a fund’s compliance with federal laws and review the fund’s performance.
The Investment Adviser
The investment adviser handles the fund’s business affairs and directs its investments. An investment adviser also has a team of employees, some of whom represent the interests of the shareholders. The adviser manages the fund’s portfolio by deciding which securities to buy and sell that align with the fund’s objectives and conform to the fund’s policies.
An investment adviser is often the fund’s first shareholder who creates the fund by providing seed money. Advisers and their employees are held to strict standards of compliance, which include guidelines that prevent them from allowing transactions that present a conflict of interest.
The Principal Underwriter
If an investor purchases shares of a mutual fund through a broker-dealer, that broker-dealer must be authorized to sell shares through a sales agreement with the fund. The principal underwriter of a fund acts as the agent who executes these sales agreements and ensures compliance of broker-dealers. And even though the underwriters are not acting as broker-dealers, and they typically do not offer or sell shares to investors, they are still required to register as broker-dealers because of the Securities Exchange Act of 1934.
The Board's Administrators
A mutual fund’s board may hire numerous administrators, which may be individuals or organizations. Administrators handle the details of office operations by providing office space and clerical services such as accounting, bookkeeping, data processing and auditing. The fund’s board oversees administrators to make sure they adhere to compliance procedures and maintain internal controls.
The Transfer Agent
A transfer agent provides one of the services that mutual fund shareholders enjoy the most – distributing the dividends to them. But transfer agents perform other tasks such as preparing the dividend statements and calculating the tax information. Transfer agents also track the trading activities of the fund. Some transfer agents may also oversee customer service departments to handle shareholder questions.
Because a mutual fund typically does not issue tangible certificates (for example, as a stock fund does), the responsibility of transfer agents is crucial. The transfer agent must correctly record the ownership of shares in the fund's extensive computer recordkeeping database, and agents must be certified with the SEC.
The Mutual Fund's Custodian
In simplistic terms, the custodian of a mutual fund maintains “custody” of the fund, which typically means that a bank keeps the funds. (If the fund holds foreign securities, an international foreign bank or securities depository acts as the custodian). Strict custody rules mandated by the Investment Company Act require that the fund’s securities must be kept separately from the investment adviser’s securities. Custodial duties include receiving dividends and interest for safekeeping, paying the fund’s expenses, tracking loaned securities and reporting all cash transactions.
The bank custodian also maintains a detailed fund custody agreement that includes reconciliation of fund assets to help safeguard against fraud and theft. An additional safeguard against fraud and theft is the requirement that the fund must have a fidelity bond to protect shareholders against the possibility of employee embezzlement or larceny.
The Independent Public Accountant
Reporting to a fund’s audit committee, which is part of the board, the independent public accountant is responsible for conducting audits on the fund’s financial statements. A comprehensive audit includes a review of how the fund controls its reporting and how it implements measures to keep the fund’s securities safe.
Mutual Fund Diversification
A mutual fund is typically attractive to investors who take a conservative approach to investing. Instead of, for example, investing in one corporation by purchasing its stock, you can invest in one mutual fund that is often comprised of hundreds of different types of securities. By investing in one fund that collectively distributes the total investment of all fund shareholders over a variety of investment vehicles, losses are minimized.
It's similar to the adage "don't put all your eggs in one basket." If you invest all your "eggs" into one basket (for example, through shares of stock in a corporation), you may have no "investment eggs" left if the corporation takes a nose-dive and experiences a critical financial downturn. But if you invest in mutual funds, which spreads your investment eggs into a lot of baskets, you'll typically still be left holding some baskets if the eggs in one basket fall to the ground.
Mutual Fund Objectives
One important reason to review a mutual fund's prospectus is to identify the fund's objectives. Although many mutual funds are tailored with low-risk investment objectives to meet their goal, other funds offer a higher-risk option for their investors. Because the organizational structure of mutual funds is mandated by the SEC, you'll be able to evaluate the objectives of different funds, which is a required part of each fund's prospectus.
Where to Find a Prospectus
If you’re already an investor in mutual funds, you should already have a copy of its prospectus. The SEC requires each fund to provide its investors with a prospectus when it issues shares of the fund and to periodically update the prospectus to keep it current. But you’ll also want to review a prospectus before you invest in a fund. A simple way to read a prospectus is to visit the fund’s website where you should be able to view, download and print the fund’s prospectus. (Optionally, some funds provide a phone number on their websites that you can call to request your copy.)
Because the SEC requires mutual funds to issue prospectuses, you can also go directly to the SEC to view, download or print a copy of a prospectus. Access the SEC’s Electronic Data Gathering, Analysis and Retrieval database by visiting Investor.gov and typing “EDGAR” into the search box. Follow the prompts to find the specific fund that you want to research.
- Mutual Funds | Investor.gov
- FINRA: Take a Deeper Dive - How Mutual Funds Are Structured
- SEC: Mutual Funds and ETFs - A Guide for Investors
- Investor.gov: Mutual Funds
- Investment Company Institute: 2018 Investment Company Fact Book
- Investor.gov: Investment Adviser
- Prospectus (finance) - Wikipedia
- FINRA: Mutual Funds
- SEC.gov | Laws and Rules
- FDIC: Trust Examination Manual
- Investor.gov: Using EDGAR - Researching Public Companies