The $50+ trillion world of mutual funds

An overview of the industry background and mechanics of analyzing and investing in these vehicles. Consider this a primer…

History & overview

In one form or another, mutual fund companies have existed in the United States since 1924 with the advent of the Massachusetts Investors Trust managed by Massachusetts Financial Services and, later, the formation of State Street Investment Corporation. Mutual funds themselves, as investment vehicles, predate the establishment of these companies. In many ways, the general idea has remained the same ever since: offer small investors, or savers, access to diversified portfolios as a low-risk means of growing financial wealth.

Like other financial services vendors, these investment intermediaries match savers with borrowers and provide both parties with risk sharing, liquidity, and reduced information costs. By an Investment Company Institute estimate, mutual funds worldwide accounted for over $40 trillion USD in investment dollars as of the end of the first quarter of 2018 (excluding ETFs and institutional funds).

The industry is significant, needless to say, and these investment vehicles are a lazy strategy favorite. This is to serve as a primer on mutual fund companies and funds, complete with a summary of some key judgment metrics and their real-world application.

Most broadly, these institutions utilize pooled investment funds from numerous customers to service and grow diversified portfolios of securities, from stocks to bonds to commercial paper to treasuries. These portfolios can be industry or sector specific, index-based, or location-oriented, and can be geared towards long or short-term holding periods. For instance, one fund may hold long-term tax-exempt New Jersey municipal bonds, another may focus on shares of mining and precious-metals firms, and yet another may be composed of shares of companies listed on the S&P 500.

In return for investing your savings, you receive shares in mutual funds of your choice. Purchasing shares can be mechanically quite similar to buying shares in a publicly traded company; you can research the funds using ticker symbols, you can review their performance and holdings (among other bits of information), and, in many cases, you can purchase them through the same brokers you use to purchase stocks. Or, you can purchase them directly from the mutual fund companies themselves.

However, it should be noted that mutual fund shares are not “traded” on the same exchanges we turn to in order to deal in publicly-traded stocks, although their exchange-traded fund (ETF) counterparts are. Furthermore, there is usually a minimum investment required (often $3,000 for Vanguard funds), while no such minimum is typically required for investing in a given ETF.

Mutual fund companies provide the following benefits to their clients:

  • They can reduce your risk as an investor via the mechanism of portfolio diversification.
  • They provide liquidity per your ability to quickly and easily sell your fund shares or, as is the case with many money market mutual funds, even write checks against your holdings.
  • You save on information costs by leaving the information gathering and investment research to the company managing the fund in question.
  • Through diversified portfolio holdings, mutual fund companies also reduce your transaction costs as it is much more economical to buy into a mutual fund than it would be to attempt to acquire all of a fund’s holdings on your own, piecemeal.
  • What’s more, mutual funds offer you exposure to investments that may have been previously unavailable to you because of restrictions such as net worth.

The reality that mutual fund companies match savers and borrowers is especially clear when it comes to money market mutual funds. Such funds hold short-term investments, like treasuries and commercial paper, providing you, the saver, with the aforementioned benefits and providing borrowers, such as corporations and local and federal governments, with funds for their operations. Other clear-cut examples include municipal bond funds where savers invest in the debt of municipalities.

Mutual fund structures

When discussing mutual funds, we must distinguish between closed- and open-end, and load and no-load, funds. Whereas closed-end mutual fund shares are not redeemable, or cannot be sold back to the fund but rather are traded in over-the-counter (OTC) markets, open-end fund shares are redeemable and allow you to sell them back to the fund, or redeem them. Thus, the value of closed-end fund shares depends not only on the value of the underlying assets, be they stocks or bonds or other securities, but also on how easily traded, or how liquid, those fund shares are, not to mention how well-managed the fund is itself.

In these ways, closed-end fund shares more closely resemble common stock than open-end fund shares do, though the latter likewise derive their value from the assets they are based on. However, at the same time, closed-end fund shares resemble bonds in that they can be sold at a premium or at a discount, since again their value depends on more than just the underlying assets.

Generally-speaking, mutual fund shares are priced according to their net asset value (NAV), or the value of the underlying assets, plus any charges, such as fees. Performed at the end of each trading day by the mutual fund company, the calculation is as follows:

net asset value (NAV) = [(market value of assets — liabilities) / shares outstanding]

Then there is the load (front-end and back-end), no-load distinction, which can be summarized as the difference between a fund that charges you broker commissions on trading transactions and one that instead charges you fees. Examples of said fees include management fees and, in the case of 12b-1 funds, “distribution” fees that may include costs of advertising, promotional literature, and commissions to fund-selling brokers passed on to you by the fund.

The term 12b-1 is derived from the SEC rule originating with the Investment Company Act of 1940 that allows for the existence of such plans. As an aside, said fees have come under increased scrutiny in 2018 for repeated disclosure violations by investment advisers.


Just as the financial system poses risks to you, mutual funds face financial risks as well. Ironically, one risk stems from a previously mentioned benefit to you, the client — liquidity. The ease with which you can redeem your mutual fund shares may actually pose a risk to the mutual fund itself, especially if you and other investors collectively lose confidence in the markets or if you, as a group, fall upon hard times that require you to withdraw funds to cover expenses.

We saw this occur in 2008 — low investor confidence drove many to redeem their mutual fund shares rather than risk further investment losses. Too many customers attempting to redeem shares at one time can have a similar effect to a run on a bank, potentially leaving the mutual fund at least temporarily unable to satisfy customer redemptions.

Financial turmoil, as was experienced then, can pose risks to mutual funds in other ways. Take the bankruptcy of Lehman Brothers. When the financial services firm went belly-up, more than one money market fund that was holding Lehman debt securities had to take a loss on the securities and “broke-the-buck,” meaning the net asset value (NAV) of each share fell below $1, which is the minimum at which an investor is supposed to be able to redeem shares.

As the financial crisis continued, many customers preferred cash to investments, meaning that mutual funds actually saw negative growth for a term. The second quarter of 2008, for instance, saw a negative $156.2 billion in net share issues of money market mutual funds.

Moreover, in times of financial distress, mutual fund managers may be faced with fewer choices when it comes to worthwhile investments, threatening the diversity of their portfolios and exposing mutual funds to even more risk.

Then, there is the ever-present risk posed by poor management. In good times or in bad, poor management can hurt a mutual fund’s returns and reputation.


Mutual funds have been under the regulatory umbrella of the SEC since the passage of the Investment Company Act of 1940, which lays out how a mutual fund may advertise itself; where it may do business; how it is to be structured; and what details it must disclose about itself to investors, among other things.

The SEC’s Division of Investment Management oversees the regulation of investment institutions like mutual fund companies. Historically, the market crash of 1929 served as the catalyst for regulation of the investment industry, including mutual funds. The financial crisis of 2008 saw the SEC vote in favor of expanding its regulatory requirements of mutual funds.

A real-world application of some key judgment metrics

Let’s look at one narrowly-focused mutual fund and one broad-based one vis-à-vis several key judgment metrics you’ll want to rely upon, at least in part, in analyzing funds (consider the data presented here just a snapshot as of the publication of this story):

  1. Hennessy Gas Utility Fund Investor Class (ticker GASFX), a smaller, rather unique fund dedicated to distribution-focused natural gas companies
  2. Vanguard Total Stock Market Idx I (ticker VITSX), a massive fund with the objective of granting the customer exposure to the universe of all equities publicly traded in the United States

(Please note that these funds are not meant to be directly compared. They were selected for illustrative purposes only. For your information, they are open-end, no-load funds.)

Expense ratio: In a word, costs. This metric captures how expensive it is for you to own shares of a particular mutual fund. The costlier the fund, the less bang for your investment buck. It is the percentage of assets held by the fund in question that is lost to operating expenses. Remember that costs of ownership will eat into any returns earned. In order to get the most realistic picture of how costly a fund is to own, be sure to find the sum of all costs and fees, including 12b-1 fees. When deciding between comparable funds, show preference for a fund with a low expense ratio.

  1. GASFX currently has a 1.01 expense ratio, which is below average. Expense ratios can get much lower, though.
  2. VITSX currently sports a 0.04 expense ratio, which is industry-defeating low.

Fund lifespan: A fund that has been around a long time is more tried and true than one born yesterday. You don’t want to get caught up in an investment fad. Plus, a longer lifespan means the availability of more performance data. While historical returns never indicate future results — never ever — fund performance data can prove helpful in understanding how certain investments have weathered storms, for instance, and in conjunction with other data points, can help to prove the benefits of diversification, among other things. When deciding between comparable funds, show preference for a fund with a longer lifespan.

  1. GASFX has an inception date of May 10, 1989. It is not a new kid on the block.
  2. VITSX has an inception date of July 7, 1997. It has also clearly been around for some time now, which bodes well for the customer.

Management tenure: High management turnover is ordinarily not a good sign under any circumstances in any industry. Avoid funds that seem to have a new captain every year. Otherwise, you may find yourself the investor in a fund with an unclear and inconsistent investment strategy or a fund that is in trouble for other reasons. When deciding between comparable funds, show preference for a fund with low management turnover.

  1. GASFX maintains one fund manager at a time, and they tend to head the fund for years at a time.
  2. VITSX has more than one fund manager at the helm, and they tend to stay put for years at a time, as well.

Sharpe ratio: Has the fund performed well and does it have a history of rewarding the investor for taking risk? The Sharpe ratio, otherwise known as the reward-to-variabilty (RTV) ratio, is one metric that can provide us with some insight into that aspect of investment analysis. The Sharpe ratio is a rewards-to-variance ratio that is enhanced by mean variance optimization.

In plain language, we are looking at the expected excess return or performance of a portfolio with respect to how much its historical return has varied, or how volatile it’s been. Specifically, in its most basic form, it is calculated as:

Sharpe ratio = [(expected mean return — risk-free rate) / standard deviation of returns]

This relationship describes how well an investor is being compensated for taking on the additional risk of entering into the investment. Note that this ratio is frequently utilized in constructing and examining portfolios. When deciding between comparable funds, show preference for a fund with a higher Sharpe ratio.

  1. GASFX has a 5-year Sharpe ratio of 0.71.
  2. VITSX has a 5-year Sharpe ratio of 1.26.

Total assets under management: In short, its size. This is an indication of the popularity of, investor confidence in, and potential staying power of the fund. The shares of a larger fund are also more liquid. When deciding between comparable funds, show preference for a fund with more assets under management.

  1. GASFX has $1.0 billion under management.
  2. VITSX has $701.2 billion under management.

Turnover ratio: The frequency with which a fund turns over its investments, or how often it trades. It’s measured as the percentage of a fund’s purchases or sales (the smaller of the two) against the average market value of the fund’s long-term investments. The higher the turnover, most likely the greater the expense ratio since trading costs money and those costs get passed on to you, hurting your returns. Plus, passive strategies tend to beat active ones over time. When deciding between comparable funds, show preference for a fund with lower turnover.

  1. GASFX currently has a turnover of 18%.
  2. VITSX currently has a turnover of 3%.