The Basics of Mutual Funds

The concept upon which mutual funds are based has likely been around since securities were created. Here's a simplified explanation of how they work. A group of individuals with similar investment objectives and goals place their funds for investment into a common pool. This money is then used to buy and sell securities. By pooling their resources, the participants enjoy two significant advantages. The first is greater buying power; the group's collective resources enable it to purchase shares in a much broader range of industries or business sectors than any individual in the pool could do alone. The second advantage is lower transaction costs per participant. Because the commissions and other trading fees are spread over more shares, the cost to any one person is reduced significantly.

In the beginning one of the pool's contributors was designated by power of attorney or other legal means to select which securities to buy and sell. Each person in the pool shared in the gains and losses of the investments according to the percentage of that person's participation in the pool.

These unregulated and loosely-run collectives were quite popular in the United States during the bull market of the 1920s. In 1924, the first true mutual fund in the United States was created, known as the Massachusetts Investors Trust. After the crash of 1929, Congress passed legislation designed to better regulate and give a more defined structure to the various types of investment pools in existence (which at that time were called investment companies). Mutual funds received their first legal definition by way of the Investment Company Act of 1940.

One of the types of investment companies identified by the legislation was management companies. These were corporations or trusts whose primary business purpose was to invest and reinvest in securities in accordance with a stated investment objective, building an investment portfolio suitable for those objectives. When an individual buys shares of a management company he or she is actually buying an undivided interest in the portfolio created by that company.

When a management company is formed, it will have either a closed-end or an open-end structure. Basically, the difference between the two is the frequency with which new shares are issued to the public. A closed-end management company creates an investment portfolio and then issues shares of that portfolio to the public only once. Thus, the company's capitalization (or, the total number of shares it has outstanding) remains relatively fixed. An open-end management company also creates a portfolio of securities and issues shares to the public. However, this type of company continually issues new shares and also buys back old shares each business day in response to investors' orders to place more of their money into or pull money out of the underlying portfolio. As such, the company's capitalization continually changes. An open-end management company is the legal name for what is popularly known as a mutual fund.

Each mutual fund is legally registered as a separate management company or trust with the Securities and Exchange Commission (SEC). The entity that creates the fund is called its sponsor. It invests its own money to start the fund's portfolio and also initially selects the fund's portfolio manager. The sponsor then markets the fund to the public to bring additional money into the pool. The more shares it sells the more money it has to sink into other investments.

In Part 2 of this series, we will examine the benefits of investing in mutual funds.

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