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Mutual funds are financial intermediaries that pool the resources of many small investors by selling them shares and using the proceeds to buy securities. Through the asset transformation process of issuing shares in small denominations and buying large blocks of securities, mutual funds can take advantage of volume discounts on brokerage commissions and purchase diversified holdings (portfolios) of securities. Mutual funds allow the small investor to obtain the benefits of lower transaction costs in purchasing securities and to take advantage of the reduction of risk by diversifying the portfolio of securities held. Many mutual funds are run by brokerage firms, but others are run by banks or independent investment advisers such as Fidelity or Vanguard.

Mutual funds have seen a large increase in their market share since 1980 (see Table 1), due primarily to the then-booming stock market. Another source of growth has been mutual funds that specialize in debt instruments, which first appeared in the 1970s. Before 1970, mutual funds invested almost solely in common stocks. Funds that purchase common stocks may specialize even further and invest solely in foreign securities or in specialized industries, such as energy or high technology. Funds that purchase debt instruments may specialize further in corporate, U.S. government, or tax-exempt municipal bonds or in long-term or short-term securities.

Mutual funds are primarily held by households (around 80%) with the rest held by other financial institutions and nonfinancial businesses. Mutual funds have become increasingly important in household savings. In 1980, only 6% of households held mutual fund shares; this number has risen to around 50% in recent years. The age group with the greatest participation in mutual fund ownership includes individuals between 50 and 70, which makes sense because they are the most interested in saving for retirement. Interestingly, Generation X (ages 18-30) is the second most active age group in mutual fund ownership, suggesting that they have a greater tolerance for investment risk than those who are somewhat older. Generation X is also leading the way in Internet access to mutual funds (see the E-Finance box, "Mutual Funds and the Internet").

The growing importance of mutual funds and pension funds, known as institutional investors, has resulted in their controlling more than 50% of the outstanding stock in the United States. Thus institutional investors are the predominant players in the stock

E-Finance. Mutual Funds and the Internet

The Investment Company Institute estimates that as of 2000, 68% of households owning mutual funds use the Internet, and nearly half of those online shareholders visit fund-related web sites. The Internet increases the attractiveness of mutual funds because it enables shareholders to review performance information and share prices and personal account information.

Of all U.S. households that conducted mutual funds transactions between April 1999 and March 2000, 18% bought or sold fund shares online. The median number of funds transactions conducted over the Internet during the twelve-month period was four, while the average number was eight, indicating that a high volume of online transactions were conducted by a small number of shareholders.

Online shareholders were typically younger, had greater household income, and were better educated than those not using the Internet. The median online shareholder was 42 years old, had a household income of $100,900, and was college-educated. The median shareholder not using the Internet was 51 years old, had a household income of $41,000, and did not have a college degree.

The use of the Internet to track and trade mutual funds is rapidly increasing. The number of shareholders who visited web sites offering fund shares nearly doubled between April 1999 and March 2000.

markets, with more than 70% of the total daily volume in the stock market due to their trading. Increased ownership of stocks has also meant that institutional investors have more clout with corporate boards, often forcing changes in leadership or in corporate policies.

Mutual funds are structured in two ways. The more common structure is an open-end fund, from which shares can be redeemed at any time at a price that is tied to the asset value of the fund. Mutual funds also can be structured as a closed-end fund, in which a fixed number of nonredeemable shares are sold at an initial offering and are then traded like a common stock. The market price of these shares fluctuates with the value of the assets held by the fund. In contrast to the open-end fund, however, the price of the shares may be above or below the value of the assets held by the fund, depending on factors such as the liquidity of the shares or the quality of the management. The greater popularity of the open-end funds is explained by the greater liquidity of their redeemable shares relative to the nonredeemable shares of closed-end funds.

Originally, shares of most open-end mutual funds were sold by salespeople (usually brokers) who were paid a commission. Because this commission is paid at the time of purchase and is immediately subtracted from the redemption value of the shares, these funds are called load funds. Most mutual funds are currently no-load funds; they are sold directly to the public with no sales commissions. In both types of funds, the managers earn their living from management fees paid by the shareholders. These fees amount to approximately 0.5% of the asset value of the fund per year.

Mutual funds are regulated by the Securities and Exchange Commission, which was given the ability to exercise almost complete control over them by the Investment Company Act of 1940. Regulations require periodic disclosure of information on these funds to the public and restrictions on the methods of soliciting business.

Until 2003, the mutual fund industry could brag that it had been "untainted by a major scandal for more than 60 years." but that was soon to change. In the fall of 2003 Elliot Spitzer, the New York Attorney General, opened a probe into illegal trading practices in the mutual fund industry (see the Conflicts of Interest box, "The Mutual Fund Trading Scandal"), and there is now a trend toward increased regulation of this industry.

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