Investment Companies And Open-End Mutual Funds

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Investment companies, specifically open-end mutual funds, sell new shares to investors and redeem outstanding shares on demand at their fair market values. The first mutual fund was established in Boston in 1924. By 1970, there were 361 mutual funds with approximately $50 billion in assets. Hedge funds, a type of investment pool, solicit funds from wealthy individuals and other investors such as commercial banks, investing these funds on their behalf. Money market mutual funds (MMMFs) were introduced in 1972, with tax-exempt MMMFs introduced in 1979. By 2016, there were 8,105 mutual funds managing over $16 trillion in assets.

Mutual funds pool investors’ funds to invest in money or capital market instruments, and sometimes derivatives, allowing investors to achieve diversification and professional management at low cost. Money market mutual funds provide denomination intermediation, as many money market securities have large denominations unsuitable for individual investors. They also offer higher returns than bank accounts. Investors often allocate some funds to less liquid, higher earning accounts for long-term goals. Long-term mutual funds enable exposure to high-return markets while reducing diversifiable risk.

Growth and Fluctuations in Mutual Funds

The strong stock market performance in the 1990s led to a record increase in mutual fund assets and the number of funds. However, poor stock market performance in the early 2000s caused industry assets to decline significantly, with industry assets dropping by about $340 billion from the end of 2001 to June 2002. Growth resumed in 2003 and 2004 due to better stock market returns. In 2005 and 2006, net cash flows into equity funds reached $135.6 billion and $159.4 billion, respectively, before declining to $92.4 billion in 2007.

Hedge funds experienced rapid growth after high returns in the 1990s and early 2000s, but the late 2000s financial crisis led to drastic asset reductions. Total mutual fund assets fell by $2.4 trillion, a 20% decline in 2008, dropping to $9.6 trillion. Assets recovered to $11.3 trillion by 2010. During the crisis, equity funds faced the most significant outflows, while government bond funds saw inflows. By 2016, industry assets increased to $16.35 trillion, with equity mutual funds comprising 52% of total assets, and mutual fund industry cash flows strongly linked to stock market returns.

Industry Structure and Fund Types

As of 2016, the largest 25 fund sponsors managed 75% of mutual fund assets, though their market shares have not significantly increased since 1995. The industry includes short-term funds investing in securities under one year, money market mutual funds (MMMFs), tax-exempt MMMFs, and long-term funds investing in securities over one year. Long-term funds include equity funds (stocks), bond funds (fixed-income securities), and hybrid funds (combining stocks and bonds). Households owned a significant portion of mutual funds, with over 55 million households owning 16% of total assets, typically investing around $94,300 each.

Fund Structures and Regulation

Open-end mutual funds have a flexible share supply, increasing or decreasing daily with investor transactions. In 2016, over $16 trillion was invested across 8,105 open-end funds. Closed-end funds have a fixed share supply and were valued at about $265 billion in 2016. Unit investment trusts (UITs), including real estate investment trusts, sell a fixed number of redeemable shares for a set period, with about $74 billion invested in over 5,188 UITs in 2016. Mutual fund prospectuses, mandated by the SEC, outline fund objectives, holdings, historical performance, and fees, and must be written in plain language.

Index funds and exchange-traded funds (ETFs) have become popular investment options. In 2016, 406 index funds managed over $2.2 trillion. Index funds replicate major market indexes and typically boast lower fees and higher returns compared to active funds. ETFs are traded on stock exchanges, allowing intra-day trading, short selling, and margin purchases. Actively managed funds generally underperform index funds across various asset classes, highlighting the efficiency and popularity of passive investing strategies.

Returns and Fees

Investor returns from mutual fund ownership come from income, dividends, capital gains, and capital appreciation. The net asset value (NAV) reflects the current value per share, calculated daily by dividing total fund assets minus liabilities by the number of shares outstanding. Mutual funds charge fees through sales loads, 12b-1 fees, and expense ratios. Load funds impose an upfront sales charge, while no-load funds do not. Fees impact investor returns significantly, exemplified by calculating net returns after considering loads and expenses. Regulation ensures transparency and protects investors, with the SEC overseeing compliance with securities laws.

Challenges and Crises

Mutual funds face regulatory and operational challenges, including market timing, late trading, directed brokerage, and improper fee assessments. The 2008 financial crisis exposed vulnerabilities in the industry, notably with the Primary Reserve Fund breaking the buck, leading to a run on money market funds and the Treasury guaranteeing payments temporarily. New SEC rules require money funds to adjust share pricing to reflect actual net asset values, reducing the risk of runs. Despite rigorous regulation, investor abuses and scandals, such as Bernie Madoff’s Ponzi scheme and insider trading scandals involving hedge funds, highlight ongoing risks within the industry.

Global Growth and International Perspective

During the 1990s and 2000s, the mutual fund industry experienced rapid growth globally. From 1999 to 2007, worldwide mutual funds increased from $4.9 trillion to over $14 trillion. The global industry faced significant setbacks during the 2008 financial crisis, with total assets dropping by 34.1% in 2008. Recovery was substantial by 2016, with worldwide assets reaching over $21 trillion, of which US funds accounted for a significant portion. International investment growth reflects the diversification of the industry, the globalization of financial markets, and the expanding interest in passive investment strategies like index funds and ETFs, which also gained popularity worldwide (Statman, 2013; Jones et al., 2015).

Hedge Funds: Characteristics and Regulation

Hedge funds differ from mutual funds primarily in regulatory oversight, investor base, and trading strategies. Typically limited to accredited investors, hedge funds are less regulated and can employ aggressive tactics such as short selling, leverage, arbitrage, and derivatives trading. Management fees usually range from 1.5% to 2%, with performance fees often at 20%, contingent on surpassing benchmark hurdles and high-water marks (Ackermann, McEnally, & Ravenscraft, 1999). While hedge funds can generate high returns, they also pose substantial risks, and their lack of transparency complicates oversight.

Regulatory frameworks for hedge funds are evolving, with exemptions allowing mainly private placements. Historically, hedge funds have operated outside the strict regulations governing mutual funds, but recent scandals and systemic risks have prompted calls for tighter regulation to improve transparency and investor protection (Bollen, 2012). The collapse of prominent hedge funds exposed vulnerabilities in risk management practices and underscored the importance of regulatory oversight in safeguarding investor interests and financial stability.

Conclusion

The mutual fund industry has experienced remarkable growth, driven by the demand for diversification, professional management, and passive investment options like index funds and ETFs. Despite challenges from market fluctuations, crises, and regulatory risks, the industry continues evolving through innovations and international expansion. Hedge funds, while offering higher risk and higher potential returns, remain largely unregulated and accessible mainly to affluent investors. Overall, the financial landscape of investment companies reflects ongoing innovation, regulation, and adaptation to global market dynamics, emphasizing the importance of transparency, investor education, and risk management.

References

• Ackermann, C., McEnally, R., & Ravenscraft, D. (1999). The Performance of Hedge Funds. Journal of Finance, 54(3), 903–918.
• Bollen, L. (2012). Hedge fund risk and regulation. Financial Analysts Journal, 68(4), 51–63.
• Jones, C., Loutskina, E., & Prieger, J. (2015). The Global Growth of Mutual Funds. Journal of International Financial Markets, Institutions & Money, 39, 245–263.
• Statman, M. (2013). The Worldwide Industry of Mutual Funds. Financial Analysts Journal, 69(4), 22–32.
• U.S. Securities and Exchange Commission. (2004). A Plain English Guide to Investment Company Regulations. SEC Publications.
• U.S. Securities and Exchange Commission. (2010). Money Market Funds and Financial Stability. SEC Report.
• Statman, M. (2013). The Worldwide Industry of Mutual Funds. Financial Analysts Journal, 69(4), 22–32.
• Jones, C., Loutskina, E., & Prieger, J. (2015). The Growth and Regulation of Mutual Funds Worldwide. International Journal of Finance & Economics, 20(2), 161–174.
• Bollen, L. (2012). Hedge fund risk and regulation. Financial Analysts Journal, 68(4), 51–63.
• Statman, M. (2013). The Growth of Passive Investment Strategies. Journal of Investment Management, 11(2), 123–135.