Mutual Funds – An Introduction and Brief History

None of us have the expertise or time to build and manage an investment portfolio. There is an excellent alternative – mutual funds.

A mutual fund is an investment broker that allows people to pool their money and invest it according to a predetermined goal.

Each investor in the mutual fund receives a share of the pool in proportion to their initial investment. The capital of the mutual fund is divided into stocks or shares and investors receive a number of shares in proportion to their investment.

The investment objective of the mutual fund is always set in advance. Mutual funds invest in bonds, stocks, money market instruments, real estate, commodities or other investments, or often a combination of these.

The details of the funds’ policies, objectives, fees, services, etc. are all available in the fund’s prospectus and every investor should read the prospectus before investing in any mutual fund.

The investment decisions for the pool capital are made by a fund manager (or managers). The fund manager decides which securities are to be bought and in what quantity.

The value of the shares changes with the change in the total value of the investments made by the mutual fund.

The value of each share or unit of the mutual fund is known as NAV (Net Asset Value).

Different funds have different risk/return profiles. A mutual fund that invests in stocks is a riskier investment than a mutual fund that invests in government bonds. The value of stocks can fall, resulting in a loss for the investor, but money invested in bonds is safe (unless the government defaults – which is rare). At the same time, the greater risk associated with equities also offers the opportunity for higher returns. Stocks can go up to any limit, but government bond yields are capped at the interest rate offered by the government.

History of Mutual Funds:

The first ‘pooling of funds’ for investments occurred in 1774. After the financial crisis of 1772-1773, a Dutch merchant Adriaan van Ketwich invited investors to join forces to form an investment trust. The Trust’s aim was to reduce the risks associated with investing by offering diversification to retail investors. The funds invested in various European countries such as Austria, Denmark and Spain. Investments were mainly in bonds and equities formed a small part. The trust was called Eendragt Maakt Magt, which means ‘Unity creates strength’.

The fund had many features that attracted investors:

– It had an embedded lottery.

– There was a guaranteed dividend of 4%, which was slightly below average rates at the time. The interest income thus exceeded the required payments and the difference was converted into a cash reserve.

– The cash reserve was used to retire some shares annually at a premium of 10% and therefore the remaining shares earned a higher rate of interest. As a result, the cash reserve continued to increase over time – further accelerating share redemptions.

– The trust should be dissolved after 25 years and the capital divided among the remaining investors.

However, a war with England caused many bonds to default. In 1782, due to the decline in investment income, the redemption of shares was discontinued and later the interest payments were also reduced. The fund was no longer attractive to investors and disappeared.

After developing for a few years in Europe, the idea of ​​mutual funds reached the United States at the end of the 19th century. In 1893 the first closed fund was launched. It was called “The Boston Personal Property Trust”.

The Alexander Fund in Philadelphia was the first step toward open-ended funds. It was founded in 1907 and had new issues every six months. Investors were allowed to make redemptions.

The first true open-ended fund was the Massachusetts Investors’ Trust of Boston. It was founded in 1924 and went public in 1928. 1928 also saw the creation of the first balanced fund – the Wellington Fund, which invested in both stocks and bonds.

The concept of index-based funds was developed in 1971 by William Fouse and John McQuown of Wells Fargo Bank. Based on their concept, John Bogle launched the first index fund for private clients in 1976. It was called First Index Investment Trust. It is now known as the Vanguard 500 Index Fund. In November 2000, it surpassed $100 billion in assets, becoming the largest fund in the world.

Today, mutual funds have come a long way. Almost every second household in the USA invests in mutual funds. The popularity of mutual funds is also increasing in developing countries like India. They have become the preferred investment vehicle for many investors who appreciate the unique combination of diversification, low costs and simplicity that the funds offer.