Sunday, March 22, 2009

What is a mutual fund?

I’m starting a new Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many people own units of mutual funds in retirement savings without knowing much about them. Here’s a little story that is hopefully more useful than the usual dry definition.

We are bombarded with messages in ads and from financial planners telling us to buy mutual funds. But, what are mutual funds? It’s a good idea to have a basic understanding of what mutual funds are before ploughing years worth of hard-earned income into them.

To start with, let’s go back to a time years ago when there weren’t any mutual funds. An average guy we’ll call Jim heard some good things about the stock market, got curious, and spoke to a stock broker about buying 5 shares of Buggy-Whips-R-Us. The stock broker seemed friendly at first, but when he asked if Jim meant 500 shares, Jim started to feel uncomfortable. The broker went on to explain that his company charges commissions whenever people buy and sell stocks, and that these charges would be nearly as much as the cost of the 5 shares Jim wanted. So, Jim left feeling small and foolish.

Undeterred, our hero had an idea. What if he got several of his friends together to pool their money? If ten people wanted to buy 5 shares each, they could spread out the commission charge on buying 50 shares. After the Buggy-Whips-R-Us stock went way up, they could sell all the shares and split the money.

So far, all I have described is an investment club, but we just need to add a few more things to get to the modern mutual fund.

Jim’s investment club was wildly successful and eventually grew to hundreds of members. They bought and sold many types of stocks and had fair rules in place to determine what fraction of the stocks each member owned. However, it became increasingly difficult for the members to agree on what stocks to buy and sell. Most members had little to contribute, but several members would argue fiercely. Jim realized that they needed an executive committee elected by the members to run the club and an investment committee chosen by the executives to choose the stocks to buy and sell.

As the club continued to grow, it controlled a lot of money, and Jim decided that the club could afford to pay a clever guy named Ted to do the stock picking. The idea was that a professional would make more money than the existing investment committee on the investments, and this extra money would be more than Ted’s salary; the members would make more money.

At first Ted seemed to work out well. It was hard to tell over a short time whether he was doing a good job, but Ted always explained his decisions to the membership and patiently answered questions. However, there were some rough periods, and Ted got nervous whenever the club discussed replacing him or going back to the old system of volunteer members doing the stock picking. Ted began to spend as much time protecting his job as he did on stock picking. He would take credit for the club’s stocks increasing in value even when it was just because the whole stock market had gone up and had nothing to do with Ted’s brilliance. Whenever the club’s stocks went down, Ted would talk about the current “difficult period in investing” and the “troubled waters” in these “turbulent and frightening times”.

Because working for the investment club was Ted’s full time job, he was able to put a lot more effort into achieving his goals than the volunteers on the club’s executive committee who had other jobs. Over time, Ted was able to increase his pay significantly, hire assistants, and control who served on the executive committee.

As the club continued getting bigger it became a mutual fund with the club members owning units in the fund. Ted’s role was filled by a company that specialized in money management, and although the mutual fund was officially being run by its board of directors chosen by the fund’s owners, in reality the club was being run by the money management company. Jim no longer had any meaningful say in how his club ran.

Fortunately, the government enacted laws to protect mutual fund owners. The management company has to make certain key information about investment style and risks available to new purchasers of mutual fund units, and there are rules about how the fund’s investment returns can be presented.

As we can see, the basic ideas behind mutual funds and the motivations of the various players involved are a lot simpler than it might seem from looking at the vast array of information available about mutual funds.

3 comments:

  1. I really like this post. Not only did you explain what a mutual fund is, you very succinctly explained how easily politics can get in the way.

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  2. Thanks, Preet. This first post I wrote is still my favourite.

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  3. Good post, and a good start. You could do almost a month of going in depth about MER, Window Dressing, and other Mutual Fund issues too.

    Good read!

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