In the United States, a mutual fund is registered with the Securities and Exchange Commission (SEC) and is overseen by a board of directors (if organized as a corporation) or board of trustees (if organized as a trust). The board is charged with ensuring that the fund is managed in the best interests of the fund's investors and with hiring the fund manager and other service providers to the fund. The fund manager, also known as the fund sponsor or fund management company, trades (buys and sells) the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment advisor. Funds that are managed by the same fund manager and that have the same brand name are known as a "fund family" or "fund complex".
The Investment Company Act of 1940 (the 1940 Act) established three types of registered investment companies or RICs in the United States: open-end funds, unit investment trusts (UITs); and closed-end funds. Recently, exchange-traded funds (ETFs), which are open-end funds or unit investment trusts that trade on an exchange, have gained in popularity. While the term "mutual fund" may refer to all three types of registered investment companies, it is more commonly used to refer exclusively to the open-end type.
Hedge funds are not considered a type of mutual fund. While they are another type of commingled investment scheme, they are not governed by the Investment Company Act of 1940 and are not required to register with the Securities and Exchange Commission (though many hedge fund managers now must register as investment advisors).
Mutual funds are not taxed on their income as long as they comply with certain requirements established in the Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute most of their income to their investors annually, and earn most of the income by investing in securities and currencies. Mutual funds pass taxable income on to their investors. The type of income they earn is unchanged as it passes through to the shareholders. For example, mutual fund distributions of dividend income are reported as dividend income by the investor. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors.
Outside of the United States, mutual fund is used as a generic term for various types of collective investment vehicles available to the general public, such as unit trusts, open-ended investment companies (OEICs, pronounced "oyks"), unitized insurance funds, UCITS (Undertakings for Collective Investment in Transferable Securities, pronounced "YOU-sits") and SICAVs (société d'investissement à capital variable, pronounced "SEE-cavs").
Advantages of mutual funds
Mutual funds have advantages compared to direct investing in individual securities.These include:
ß Increased diversification
ß Daily liquidity
ß Professional investment management
ß Ability to participate in investments that may be available only to larger investors
ß Service and convenience
ß Government oversight
ß Ease of comparison
Disadvantages of mutual funds
Mutual funds have disadvantages as well, which include[
ß Less control over timing of recognition of gains
ß Less predictable income
ß No opportunity to customize
Leading mutual fund complexes
At the end of 2009, the top 10 mutual fund complexes in the United States were:
1. Fidelity Investments
2. Vanguard Group
3. Capital Research & Management (American Funds)
4. JP Morgan Chase & Co.
5. BlackRock Funds
6. PIMCO Funds
7. Franklin Templeton Investments
8. Federated Investors
9. Bank of New York Mellon
10.Goldman Sachs & Co.
Types of mutual funds
There are three basic types of registered investment companies defined in the Investment Company Act of 1940: open-end funds, unit investment trusts (UITs); and closed-end funds. exchange-traded funds (ETFs)are open-end funds or unit investment trusts that trade on an exchange.
Open-end mutual funds must be willing to buy back their shares from their investors at the end of every business day at the net asset value computed that day. Most open-end funds also sell shares to the public every business day; these shares are also priced at net asset value. A professional investment manager oversees the portfolio, buying and selling securities as appropriate. The total investment in the fund will vary based on share purchases, redemptions and fluctuation in market valuation.Closed-end funds
Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.
Unit investment trusts
Unit investment trusts or UITs issue shares to the public only once, when they are created. Investors can redeem shares directly with the fund (as with an open-end fund) or they may also be able to sell their shares in the market. Unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT and does not change. UITs generally have a limited life span, established at creation.
A relatively recent innovation, the exchange-traded fund or ETF is often structured as an open-end investment company, though ETFs may also be structured as unit investment trusts, partnerships, investments trust, grantor trusts or bonds (as an exchange-traded note). ETFs combine characteristics of both closed-end funds and open-end funds. Like closed-end funds, ETFs are traded throughout the day on a stock exchange at a price determined by the market. However, as with open-end funds, investors normally receive a price that is close to net asset value. To keep the market price close to net asset value, ETFs issue and redeem large blocks of their shares with institutional investors.
Money market funds
Money market funds invest in money market instruments, which are fixed income securities with a very short time to maturity and high credit quality. Investors often use money market funds as a substitute for bank savings accounts, though money market funds are not government insured, unlike bank savings accounts.
Money market funds strive to maintain a $1.00 per share net asset value, meaning that investors earn interest income from the fund but do not experience capital gains or losses. If a fund fails to maintain that $1.00 per share because its securities have declined in value, it is said to "break the buck". Only two money market funds have ever broken the buck: Community Banker's U.S. Government Money Market Fund in 1994 and the Reserve Primary Fund in 2008.
At the end of 2009, money market funds accounted for 30% of the assets in all U.S. mutual funds
Bond funds invest in fixed income securities. Bond funds can be subclassified according to the specific types of bonds owned (such as high-yield or junk bonds, investment-grade corporate bonds, government bonds or municipal bonds) or by the maturity of the bonds held (short-, intermediate- or long-term). Bond funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds).
At the end of 2009, bond funds accounted for 20% of the assets in all U.S. mutual funds. 
Stock or equity funds
Stock or equity funds invest in common stocks. Stock funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds). They may focus on a specific industry or sector.
A stock fund may be subclassified along two dimensions: (1) market capitalization and (2) investment style (i.e., growth vs. blend/core vs. value). The two dimensions are oftened displayed in a grid known as a "style box."
Market capitalization or market cap is the value of a company's stock and equals the number of shares outstanding times the market price of the stock. Market capitalizations are divided into the following categories:
ß Micro cap
ß Small cap
ß Mid cap
ß Large cap
While the specific definitions of each category vary with market conditions, large cap stocks generally have market capitalizations of at least $10 billion, small cap stocks have market capitalizations below $2 billion, and micro cap stocks have market capitalizations below $300 million. Funds are also classified in these categories based on the market caps of the stocks that it holds.
Stock funds are also subclassified according to their investment style: growth, value or blend (or core). Growth funds seek to invest in stocks of fast-growing companies. Value funds seek to invest in stocks that appear cheaply priced. Blend funds are not biased toward either growth or value.
At the end of 2009, stock funds accounted for 45% of the assets in all U.S. mutual funds. 
Hybrid funds invest in both bonds and stocks or in convertible securities. Balanced funds, asset allocation funds, target date or target risk funds and lifecycle or lifestyle funds are all types of hybrid funds.
Hybrid funds may be structured as funds of funds, meaning that they invest by buying shares in other mutual funds that invest in securities. Most fund of funds invest in affiliated funds (meaning mutual funds managed by the same fund sponsor), although some invest in unaffiliated funds (meaning those managed by other fund sponsors) or in a combination of the two.
At the end of 2009, hybrid funds accounted for 6% of the assets in all U.S. mutual funds. 
Index (passively-managed) versus actively-managed
An index fund or passively-managed fund seeks to match the performance of a market index, such as the S&P 500 index, while an actively managed fund seeks to outperform a relevant index through superior security selection.
Mutual fund expenses
Investors in mutual funds pay fees. These fall into four categories: distribution charges (sales loads and 12b-1 fees), the management fee, other fund expenses, shareholder transaction fees and securities transaction fees. Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value. Recurring expenses are included in a fund's expense ratio.
Distribution charges pay for marketing and distribution of the fund's shares to investors.
Front-end load or sales charge
A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested (including the front end load), known as the "public offering price." The front-end load often declines as the amount invested increases, through breakpoints. Front-end loads are deducted from an investor's account and reduce the amount invested.
Some funds have a back-end load, which is paid by the investor when shares are redeemed depending on how long they are held. The back-end loads may decline the longer the investor holds shares. Back-end loads with this structure are called contingent deferred sales charges (or CDSCs). Like front-end loads, back-end loads are deducted from an investor's account.
A mutual fund may charge an annual fee, known as a 12b-1 fee, for marketing and distribution services. This fee is computed as a percentage of a fund's assets, subject to a maximum of 1% of assets. The 12b-1 fee is included in the expense ratio.
A no-load fund does not charge a front-end load under any circumstances, does not charge a back-end load under any circumstances and does not charge a 12b-1 fee greater than 0.25% of fund assets.
A single mutual fund may give investors a choice of different combinations of front-end loads, back-end loads and 12b-1 fees, by offering several different types of shares, known as share classes. All of the shares classes invest in the same portfolio of securities, but each has different expenses and, therefore, a different net asset value and different performance results. Some of these share classes may be available only to certain types of investors.
Typical share classes for funds sold through brokers or other intermediaries are:
ß Class A shares usually charge a front-end sales load together with a small 12b-1 fee.
ß Class B shares don't have a front-end sales load. Instead they, have a high contingent deferred sales charge, or CDSC that declines gradually over several years, combined with a high 12b- 1 fee. Class B shares usually convert automatically to Class A shares after they have been held for a certain period.
ß Class C shares have a high 12b-1 fee and a modest contingent deferred sales charge that is discontinued after one or two years. Class C shares usually do not convert to another class. They are often called "level load" shares.
ß Class I are subject to very high minimum investment requirements and are, therefore, known as "institutional" shares. They are no-load shares.
ß Class R are for use in retirement plans such as 401(k) plans. They do not charge loads, but do charge a small 12b-1 fee.
No-load funds often have two classes of shares:
ß Class I shares do not charge a 12b-1 fee.
ß Class N shares charge a 12b-1 fee of no more than 0.25% of fund assets.
Neither class of shares charges a front-end or back-end load.
The management fee is paid to the fund manager or sponsor who organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand name to the fund. The fund manager may also provide other administrative services. The management fee often has breakpoints, which means that it declines as assets (in either the specific fund or in the fund family as a whole) increase. The management fee is paid by the fund and is included in the expense ratio.
Other fund expenses
A mutual fund pays for other services including:
ß Board of directors' (or board of trustees') fees and expenses
ß Custody fee: paid to a bank for holding the fund's portfolio in safekeeping
ß Fund accounting fee: for computing the net asset value daily
ß Professional services: legal and accounting fees
ß Registration fees: when making filings with regulatory agencies
ß Shareholder communications: printing and mailing required documents to shareholders
ß Transfer agent services: keeping shareholder records and responding to customer inquiries
These expenses are included in the expense ratio.
Shareholder transaction fees
Shareholders may be required to pay fees for certain transactions. For example, a fund may charge a flat fee for maintaining an individual retirement account for an investor. Some funds charge redemption fees when an investor sells fund shares shortly after buying them (usually defined as within 30, 60 or 90 days of purchase); redemption fees are computed as a percentage of the sale amount. Shareholder transaction fees are not part of the expense ratio.
Securities transaction fees
A mutual fund pays any expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. Securities transaction fees increase the cost basis of the investments. They do not flow through the income statement and are not included in the expense ratio. The amount of securities transaction fees paid by a fund is normally positively correlated with its trading volume or "turnover".
The expense ratio allows investors to compare expenses across funds. The expense ratio equals the 12b-1 fee plus the management fee plus the other fund expenses divided by average net assets. The expense ratio is sometimes referred to as the "total expense ratio" or TER.
Critics of the fund industry argue that fund expenses are too high. They believe that the market for mutual funds is not competitive and that there are many hidden fees, so that it is difficult for investors to reduce the fees that they pay.
Many researchers have suggested that the most effective way for investors to raise the returns they earn from mutual funds is to reduce the fees that they pay. They suggest that investors look for no-load funds with low expense ratios.
Definitions of key terms.
Net asset value or NAV
A fund's net asset value or NAV equals the current market value of a fund's holdings minus the fund's liabilities (sometimes referred to as "net assets"). It is usually expressed as a per-share amount, computed by dividing by the number of fund shares outstanding. Funds must compute their net asset value every day the New York Stock Exchange is open.
Valuing the securities held in a fund's portfolio is often the most difficult part of calculating net asset value. The fund's board of directors (or board of trustees) oversees security valuation.
Average annual total return
The SEC requires that mutual funds report the average annual compounded rates of return for 1-year, 5-year and 10-year periods using the following formula:
P(1+T)n = ERV
P = a hypothetical initial payment of $1,000.
T = average annual total return.
n = number of years.
ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).