Section 4.2: Mutual Funds

  • Definition

    • A mutual fund is a type of investment company that pools investor money to purchase a diversified portfolio of securities based on the fund’s stated objective (e.g., growth, income, balanced).

    • Mutual funds issue common stock and are part of the open-end management company category.

1. Key Characteristics of Mutual Funds:

  • No secondary market trading — shares are bought directly from or redeemed with the fund.

  • The fund must redeem shares upon request → highly liquid.

  • Ownership is undivided — all shareholders share proportionally in profits and losses.

  • Dividends and capital gains may be distributed to investors, who can:

    • Take them in cash, or

    • Reinvest them at the current NAV (still taxable, reported to IRS).

  • Shares can be purchased in full or fractional shares.

  1. 📘 Example:
    If a fund’s share price (NAV) = $12.34 and an investor invests $4,000:
    → $4,000 ÷ $12.34 = 324.149 shares

    • Managed by professional investment advisers.

    • Offer investors diversification and professional management.

    • The maximum sales charge (sales load) under FINRA rules is 8.5% of the Public Offering Price (POP).

2. Investor Rights (Similar to Corporate Shareholders):

  • Mutual fund shareholders can vote on:

    • Members of the board of directors

    • Approval or renewal of the investment adviser contract

    • Changes in the fund’s investment objective

    • Changes to sales charges

    • Liquidation or merger of the fund

Share Classes

Mutual funds offer different share classes, which determine how sales charges (loads) are paid.

Type / Sales Charge Type / When Paid / Other / Best for

  • Class A Shares / Front-End Load / At purchase / Sales charge deducted from amount invested. Example: 5% load on $10,000 → $9,500 invested. Lower annual fees. / Large investments, long-term horizon

  • Class B Shares / Back-End Load (CDSC) / At redemption / Declining sales charge over time (e.g., 8% year 1 → 7% year 2 → 0% after 5–7 years). Converted to Class A shares after the CDSC period. Higher ongoing expenses. / Smaller investments, long-term horizon

  • Class C Shares / Level Load / Ongoing (annual fee, ~0.25%) / May include 1% CDSC if redeemed within 1 year. No front-end load, but higher annual expenses that never go away. / Short-term horizon (1–5 years)

  • No-Load Shares / None / N/A / Sold directly to investors at NAV. May still charge small fees (purchase, account, exchange, redemption). / Cost-conscious investors, direct buyers

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Sales Loads Overview:

  • Front-End Load (Class A): Paid when buying shares; reduces invested amount.

  • Back-End Load (Class B): Paid when selling shares; declines over time (Contingent Deferred Sales Charge — CDSC).

  • Level Load (Class C): Ongoing small charge; higher long-term expenses.

  • No-Load: No sales charge; purchased directly from fund.

Feature / Mutual Fund Characteristic

  • Structure / Open-End Management Company

  • Shares Issued / Common Stock

  • Trading / Redeemable with fund (not secondary market)

  • Pricing / Priced at NAV (end of each business day)

  • Management / Professionally managed

  • Liquidity / Highly liquid

  • Max Sales Charge / 8.5% of POP

  • Voting Rights / Yes

  • Dividends & Gains / May be reinvested or paid out (taxable)

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✺ Review questions ✺

  • A. Bonds
    B. Preferred stock
    C. Common stock
    D. Notes
    ✅ Answer: C

  • A. They trade on stock exchanges
    B. The fund must redeem shares on request
    C. They pay daily interest
    D. They have a fixed maturity date
    ✅ Answer: B

  • A. 6.25% of POP
    B. 7.0% of NAV
    C. 8.5% of POP
    D. 10% of NAV
    ✅ Answer: C

  • A. 1 year
    B. 3 years
    C. 5–7 years
    D. Never
    ✅ Answer: C

  • A. Class A
    B. Class B
    C. Class C
    D. No-load shares
    ✅ Answer: C

  • A. 0% (but may charge small service fees)
    B. 5% front-end load
    C. 8.5% of POP
    D. Declining back-end load
    ✅ Answer: A