How Mutual Funds Work

Buying and Selling Fund Shares Issues Shares Investors The fund issues shares to the public at net asset value (NAV) Each share represents proportional ownership of fund assets Investors put their money into fund by buying shares and becoming fund shareholders Investors can sell their shares back to the fund at NAV Each fund is a separate corporation, called a (registered) investment company

NAV is computed at the end of every business day Net Asset Value (NAV) Net Asset Value (NAV) Assets minus Liabilities Number of Shares outstanding NAV is computed at the end of every business day Investor may sell their shares back to fund (redeem) at the end of every business day

Buying and Selling Fund Shares To ensure that funds have the ability to raise cash quickly to pay redeeming shareholders, the 1940 Act requires that funds:​ Limit borrowings.​ Limit holdings of illiquid securities.​ In addition, most funds meet the 1940 Act tests for diversification and:​ Limit holdings in a single security.​ Limit percentage ownership of the shares of a single company.​

Pass-Through Tax Status Fund Issues Shares Investors Pays out a proportionate share of its dividend and interest income and net capital gains to each shareholder. Pays taxes on distributions from the fund Earns interest and dividend income from investments May sell investments at a gain or loss Pays no taxes if it meets certain tests Page 31 criteria and tax issues on fund investors

1940 Act Diversification Standards 50% => mutual funds may not invest more than 5% of total assets in a single investment Other 50%=> mutual funds may not invest more than 25% in any one issue Limited ownership of voting securities. 50% => mutual funds may not own more than 10% of the voting securities of any one issuer

IRS Test To qualify for pass-through tax status, the IRS requires that funds:​ Limit holdings in a single security.*​ Limit percentage ownership of the shares of a single company.*​ Distribute almost all income and net realized capital gains annually.​ Earn most of their income from investing in securities and currencies.​ ​ *IRS test is slightly different from similar 1940 Act test

Mutual Fund: A Virtual Corporation Mutual funds generally don’t have employees.​ Instead, they hire other firms to provide needed services for a fee.​ The fund signs contracts with these service providers.​ Each fund has a board of directors which:​ Is elected by fund shareholders through a proxy vote.​ Negotiates contracts with service providers.​ Monitors potential conflicts of interest.​ Must have a majority of independent  or disinterested  directors.

Management Contract The most important contract is with the management company which:​ Creates the fund.​ Lends its brand name to the fund family or fund complex.​ Serves as investment adviser and is responsible for investment management of the fund’s portfolio.

The Gartenberg Standard A board’s review of the management contract is governed by the Gartenberg standard.  This legal standard suggests that directors consider:​ The nature and quality of services provided.​ The profitability of the fund to the adviser.​ Any fallout benefits to the adviser (i.e., indirect profits).​ The extent of economies of scale as the fund grows.​ Fees charged on comparable funds.​ The independence and conscientiousness of the directors.​ The Supreme Court recently reaffirmed the Gartenberg standard in the Jones v. Harris case. Page 36

Service Providers The fund also signs contracts with firms that provide: The links with investors The distributor sells fund shares to the public The transfer agent that keeps track of shareholder positions and provides customer service Portfolio administration The custodian holds the securities in the fund’s portfolio The fund accountant maintains the fund’s books and records and computes the NAV nightly Professional services Legal counsel Auditor

Service Provider Relationships Some of these services are provided by firms affiliated with the management company Others are provided by independent firms

Ethical Standards Managers of mutual funds are fiduciaries.​ ​ They must use their expertise to advance their clients’ interests and many not gain personally at their clients’ expense.​ They must present all material facts to their clients and disclose any conflicts of interests.​ ​ Managers of mutual funds are registered investment advisers.​ They must register with the SEC as required by the Investment Advisers Act of 1940.​ The SEC requires that they have a written code of ethics.

Components of a Registered Investment Adviser’s Code of Ethics (1)

Components of a Registered Investment Adviser’s Code of Ethics (2)