The Fund Industry: How Your Money is Managed, 2nd Edition

CHAPTER 2

How Mutual Funds Work

Now that we've discussed how mutual funds can help investors, let's take a quick look inside mutual funds to understand exactly how they are organized and operate. At first glance, there doesn't seem to be anything out of the ordinary about a mutual fund. Each mutual fund is a separate corporation, often referred to as an investment company or registered investment company, or RIC.¹ Like other corporations, mutual funds issue shares to the public. These shares represent proportional ownership of the fund: Own 10 percent of a fund's shares, and you effectively own 10 percent of both its assets and its liabilities. Investors who decide to place their money in a particular fund do so through buying its shares, becoming shareholders in the process. This is why the terms investors and shareholders are used interchangeably throughout the fund industry.

On closer examination, however, mutual funds are quite unusual public companies. Their shares do not trade on a stock exchange. As a general rule, they neither pay taxes nor have any employees. In addition, they are protected by particularly strict ethical standards. Let's take a closer look at each of these features and see how they compare to other options for investing.

This chapter reviews:

• How investors buy and sell fund shares at net asset value.
• The pass-through tax status of mutual funds.
• How funds organize their daily operations under the supervision of a board of directors.
• The ethical standards ...