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MUTUAL FUND CONCEPT
By: ICAP, CMDCI and SEC

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What are mutual funds?
- Are investment companies that pool money from numerous investors, with the same investment objective. Through the issuance of its shares to the public, the pooled funds are then invested by professional fund managers in a diversified portfolio of securities or investment instruments.

- Shareholders are entitled to a proportionate share in investment income and risk exposure.

- Mutual funds are registered and regulated by the Securities and Exchange Commission (SEC).

- Since mutual funds are not bank products, they invest only in marketable securities and therefore do not need to be covered by the Philippine Depository Insurance Corporation (PDIC).

- To safe guard and protect the interests of the investing public, mutual funds also follow investment guidelines set by the SEC, that includes investment restrictions.

STRUCTURE AND OPERATIONS OF MUTUAL FUNDS

Fund Shareholders
Mutual fund investors are the owners of the fund and are entitled to basically the same rights as common stockholders of ordinary companies. These include the right to receive dividends when paid, the right to examine the books of the corporation, and the right to vote at annual meetings to elect the members of the Board of Directors. A right that can be considered unique to mutual fund shareholders, is the right of redemption or the right to have their shares redeemed or bought back by the company at their option.

Board of Directors
The Board of directors of an investment company is responsible for the overall operation of the fund. The board has the responsibility of establishing the fundamental and investment policies of the company and ensuring that these policies are carried out by the fund’s investment adviser. The board of directors also decides whether to distribute earnings of the fund by declaring cash dividends or to retain such earnings for re-investment. The board however, does not run the day-to-day operation of the fund. This is the job of the fund’s investment adviser or management company.

Investment Adviser/Management Company
The directors of a mutual fund may choose to hire officers or employees to run the company on a day-to-day basis. This is a rarity, however, as most funds instead enter into a management contract with a management company to perform this function. What is the rationale for this type of arrangement? It may seem at first that it is the Board of Directors of the fund that decides which management company to hire. In reality, however, it is the other way around. It is the management company that determines who sits on the Board of the fund. This is because the management company is usually the proponent (the one who puts up the seed capital) of the fund and therefore has the power to select the people who will serve as the directors of the fund.

The most important role of the management company is to act as the fund’s investment adviser. This investment advisory function must, of course, be conducted along the policies and guidelines established by the board of directors. The person who decides what securities to trade and when is called the portfolio manager while the person who executes the purchase and sell instructions of the portfolio manager is called the trader. Another important member of the portfolio team is the research analyst. His job is to sift through tons of information from newspaper articles, press releases, annual reports, company visits, shareholder meetings, etc. He analyzes these data and submits his findings (of what’s hot and what’s not) to the portfolio manager, who, of course, has the final say on what and when to trade.

Another significant role of the management company is to serve as the fund’s administrator. This administrative function includes such services as: accounting and bookkeeping; preparation and distribution of prospectuses, reports and notices to shareholders; compliance with government regulations and reportorial requirements; representing the fund in dealings with the custodian bank, transfer agent, and auditors; and providing office space, facilities, personnel and supplies. In some cases, the management company sub-contracts some of these functions to other companies specializing in these services. Still in some instances, the fund itself hires the fund administrator directly, leaving the management company to concentrate on its more important task of managing the assets of the fund. In the Philippines, the investment advisory and administrative functions are usually performed by one company. For its services, the management company gets a management fee which is usually a percentage of the fund’s average net assets. Some investment advisers also charge incentive fees if the performance of the fund exceeds certain benchmarks or hurdle rates.

Distributor
The company mainly responsible for selling the fund’s shares is called the principal distributor or principal underwriter. The principal distributor usually has its own group of salesmen. More often than not, the principal distributor and management company of a fund are either one and the same company or affiliated companies.
The principal distributor derives its income from the front-end load (or entry/joining fees). A portion of this income is given as commissions to the salesmen. Back-end loads (or exit fees), if applicable only, also go to the principal distributor to discourage short-term investors in the fund.

Custodian Bank/Transfer Agent
Can the management of a mutual fund run away with the fund’s assets? This is highly unlikely, as mutual funds are required by law to appoint a custodian, usually a commercial bank, to hold all the fund’s assets (cash and securities) for safekeeping. The custodian receives the certificates of new acquisitions made by the portfolio manager, pays for securities purchased, delivers securities sold, releases cash to pay fund expenses, and accepts dividends and interest payments from the issuers of securities held in the fund’s portfolio.

Very often, the custodian is hired to perform other functions as well, including acting as transfer agent. A fund’s transfer agent facilitates the transfer of mutual fund shares, disbursement of dividends, and maintenance of shareholder records. The custodian, however, is not permitted to as the fund’s investment adviser for obvious reasons.

Auditors
The job of independent auditors is to review the financial statements of a company and determine whether such statements reflect the true financial position of that company. In the case of mutual funds, auditors pay particular attention to the valuation of the company’s assets, making sure that the fund conforms to generally accepted accounting principles and industry standards.

TYPES OF MUTUAL FUNDS:
I. STOCK FUNDS
- also called equity funds; invests primarily in shares of stock.
II. BOND FUNDS
- invest mainly in long-term debt instruments or government securities or other fixed-income instruments.
III. BALANCED FUNDS
- invest in both shares of stock and debt instruments.
IV. MONEY MARKET FUNDS
- invest purely in short-term or one year or less debt instruments.

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