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The Beginners Guide to Investing
What Are Mutual Funds?
The Definition of Mutual Funds
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The Definition of Mutual Funds

An overview of the legal definition and structure of mutual funds.

Most people do not know the actual definition of mutual funds. You have probably heard the term "mutual fund" used before, but maybe you aren't sure exactly what a mutual fund is.

It can help you as an investor to have a clear definition of mutual funds and to understand how the law refers to them.

Here is the most straightforward, concise definition that anyone will be able to provide you with:

A mutual fund is a registered investment company that receives and manages money from investors, pooling it together to invest in securities according to a specific strategy.

Every mutual fund receives money from investors ands acts as a “financial intermediary”.

What is a financial intermediary, you ask?

In the financial world, investors have money, and businesses or governments pay investors dividends to use their money. Mutual funds work between investors, businesses, and governments. That is the role of a financial intermediary.

All mutual funds have the same goal: to invest your money. However, there are some important differences between mutual funds that can affect your money. It is important that you select the right type of mutual fund before you invest.

This page will help you do that. The purpose of this page is to explain the definition of mutual funds and explain how the financial industry classifies them.

The Legal Definition

The United States Congress passed the Investment Company Act in 1940 to create standards for mutual funds and protect investors.

The act outlined what an “investment company” could and could not do. Mutual funds became the most common type of investment company.

The law also made mutual funds subject to regulations and requirements designed to protect investors. In the U.S., mutual funds are regulated by the Securities and Exchange Commission (SEC).

The SEC evaluates all mutual funds to make sure they conduct business according to the definition of mutual funds.

Here are a few of their responsibilities:

Investment advisers manage a mutual fund’s investments, and they are required to register with the SEC. An investment adviser can be one portfolio manager, a group of professionals, or an entire company.

Each mutual fund is required to publicly disclose specific information about the fund, including the investment strategy, risks, and fees. This information is available in the fund’s prospectus.

Mutual funds are also required to keep specific records and perform reporting to the SEC on their accounting practices and employee compensation.

Finally, the SEC also handles investor complains and investigates potential rule violations. Mutual funds are required to comply with any investigations initiated by the SEC.

That explains the legal definition of mutual funds, but how do investors define mutual funds?

For that answer, we need to analyze the structure of mutual funds.

Open-Ended Funds: The Traditional Mutual Fund

Most mutual funds in the U.S. are structured as open-ended funds. When people talk about mutual funds, most of the time they are referring to open-ended mutual funds.

According to the SEC, open-ended mutual funds have a few distinguishing characteristics:

Open-ended mutual funds offer their shares directly to investors on a continuous basis. Investors can only buy or sell shares directly with the fund. Those shares cannot be purchased, sold, or traded on the stock exchange or any other financial market.

Investors can purchase shares anytime if a fund is open to investors. However, an open-ended fund can decide to close to new investors. If that happens, no new investors are permitted to open an account or purchase shares.

With an open-ended fund, investors’ shares are redeemable at any time in exchange for cash. Investors can only sell their shares back to the mutual fund. When selling shares, investors get the Net Asset Value (NAV) price for their shares on the day they sell them.

The investments in a mutual fund’s portfolio are held with a separate custodian, not the mutual fund company. The custodian is a separate company that is designed to protect the interests of shareholders. If a fund company goes bankrupt, the investments are still protected.

Regulation and separate custodianship creates more protection for investors. That is why mutual funds have less risk than hedge funds or other investment programs.

However, there are other types of mutual funds that are structured differently.

Other Structures for Mutual Funds

There are other mutual fund structures in addition to open-ended funds. These investments still follow the same definition of a mutual fund. They simply conduct business differently than open-ended mutual funds.

Here are some other structures for mutual funds:

Exchange-traded funds, or ETFs, are a newer type of mutual fund that can be bought and sold on a stock exchange. Like open-ended funds, ETFs allow investors to easily put their money into a group of different investments at the same time.

Most exchange-traded funds are not actively managed. When you buy an ETF, each share just represents a “basket” of underlying stocks or bonds. The share prices for ETFs move up or down throughout the day, which is also different from an open-ended fund.

Closed-end funds, or CEFs, are different from open-ended funds because they do not continuously offer shares. Closed-end funds only issue shares once. These funds trade on public exchanges, and are purchased through brokerage companies.

Like open-ended funds, closed-end funds are managed by an investment adviser. Closed-end funds do not disclose their investments, do it is difficult to know what you are buying.

Institutional funds are designed specifically for banks, brokerage companies, and large corporations to invest in. Normally these mutual funds have investment minimums of $1 million or more, so they are not meant for individual investors.

Know Your Mutual Funds

Be cautious. It is important to know how your mutual fund works before you invest.

Each mutual fund is unique, and some of them may work very differently than “plain vanilla” mutual funds. It can be confusing to tell the difference.

I like to keep things simple.

This site focuses exclusively on traditional, open-ended funds because of their simplicity and widespread popularity with investors.

Now that you finally understand the definition of mutual funds, you can invest with confidence. The next time someone talks about mutual funds, you will know exactly what they mean.

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