How A Mutual Fund Works

By Richard Loth (Contact | Biography)

A fund sponsor - generally a financial intermediary like Fidelity Investments or Vanguard - organizes a mutual fund as a corporation; however, it is not an operating company with employees and a physical place of business in the traditional sense. A fund is a "virtual" company, which is typically externally managed. It relies on third parties or service providers, either fund sponsor affiliates or independent contractors, to manage the fund's portfolio and carry out other operational and administrative activities.

Figure 1, below, has been sourced from the Investment Company Institute's (ICI) 2005 ICI Fact Book to illustrate the organizational structure of a mutual fund.

The fund sponsor raises money from the investing public, who become fund shareholders. It then invests the proceeds in securities (stocks, bonds and money market instruments) related to the fund's investment objective. The fund provides shareholders with professional investment management, diversification, liquidity and investing convenience. For these services, the fund sponsor charges fees and incurs expenses for operating the fund, all of which are charged proportionately against a shareholder's assets in the fund.

The most prevalent and well-known type of mutual fund operates on an open-ended basis. This means that it continually issues (sells) shares on demand to new investors and existing shareholders who are buying. It redeems (buys back) shares from shareholders who are selling.

Mutual fund shares are bought and sold on the basis of a fund's net asset value (NAV). Unlike a stock price, which changes constantly according to the forces of supply and demand, NAV is determined by the daily closing value of the underlying securities in a fund's portfolio (total net assets) on a per share basis. (For more insight, read What is a mutual fund's NAV?)

In some instances, investors can purchase shares directly from the fund, but most funds are sold through an investment intermediary: a broker, investment advisor, financial planner, bank or insurance company. These intermediaries are compensated for their services through a variety of sales charge options (loads) or deferred/ongoing 12b-1 fees. The former come directly out of the investor's pocket (deducted from the amount to be invested) and the latter as a proportionate deduction of the shareholder's fund assets. (For more on fees, read Stop Paying High Fees.)

Shareholders

Board of Directors Oversees the fund\'s activities, including approval of the contract with the management company and certain other services providers.

Mutual Fund

Investment Advisor	Principal Underwriter	Administrator	Transfer Agent	Custodian	Independent Public Accountant
Manages the fund\'s portfolio according to the objectives and policies described in the fund\'s prospectus.	Sells fund shares, either directly to the public or through other firms (such as broker dealers).	Oversees the performance of other companies that provide services to the fund and ensures that the fund\'s operations comply with the applicable federal requirements.	Executes shareholder transactions, maintains records of transactions and other shareholders\' account activities, and sends account statements and other documents to shareholders.	Holds the fund\'s assets, maintaining them separately to protect shareholder interests.	Certifies the fund\'s financial statements.

Figure 1: Investment Company Institute\'s (ICI) 2005 ICI Fact Book

Return to the Main Menu.

Today's Mutual Fund Industry