Mutual Fund Structure & Expense Ratio

What a mutual fund is

• Open-end management companies, commonly called mutual funds, give investors access to professionally managed portfolios (also called pools or funds).
• The term open-end refers to the number of outstanding shares the fund maintains.

Each new purchase of mutual fund shares creates new shares. Each redemption (sale back to the fund) destroys shares.

Worked example — outstanding shares (verbatim)

For example, assume ABC Mutual Fund has 1,000,000 shares outstanding at the beginning of the day.

If an investor purchases one new share, outstanding shares increase to 1,000,001. If an investor redeems one share, outstanding shares decrease to 999,999.

Bottom line: purchases increase outstanding shares, and redemptions decrease outstanding shares.

Why this is unusual

• Most issuers offer a fixed number of shares or units to the public in the primary market. After that, the security trades among investors in the secondary market.
• The number of outstanding shares typically stays fixed unless the issuer:
  • sells more shares in an additional public offering (APO), or
  • buys back its securities in the open market.

Primary vs. secondary market

Shareholders

• Investors in mutual funds are called shareholders.
• This is similar to common stockholders: shareholders are owners and receive specific rights.
• In particular, shareholders have the right to receive dividends* and to vote on important issues (covered later in this unit).

*As with equity (common and preferred stock) securities, the Board of Directors approves dividend payments.

Investment objective

• Each mutual fund follows a specific investment strategy and goal, so you can see what the fund intends to do before you invest.
• Example: the Fidelity Corporate Bond Fund (ticker: FCBFX) invests in longer-term corporate debt securities.
• When you buy shares of a mutual fund, your money is invested according to that fund’s stated objectives. In this example, buying Fidelity Corporate Bond Fund shares means your money is invested in the corporate bonds held in the fund’s portfolio.

Mutual fund parties

Various parties must carry out specific roles for a mutual fund to operate as intended.

Fund sponsor (underwriter) — detail

• Establishing the fund includes gathering initial capital (money) and setting up the investment company’s structure.

🔑 Regulations require at least $100,000 of net worth to form an open-end investment company.

• Once the money is in place, the sponsor files the documents needed to create the fund (similar to forming a new business).
• After the fund is created, it must be registered with the Securities and Exchange Commission (SEC) before it can be offered to the public. For now, treat registration as filing paperwork with the SEC and making required disclosures to investors. Those disclosures appear in the prospectus (covered later in this unit).
• The sponsor also develops a marketing strategy, which might include:
  • adding the fund to an existing distribution network (for example, making the fund available on Charles Schwab’s platform), or
  • building a new network of funds (for example, creating a new business to compete with companies like Schwab).
• Companies like Charles Schwab, Fidelity, and Vanguard sponsor their own funds, but they also offer customers mutual funds from other sponsors. A Fidelity customer can invest in Fidelity funds and Schwab or Vanguard funds (or funds from hundreds of other sponsors).
• There’s typically a financial incentive for a firm to sell funds sponsored by other companies — the selling firm often earns a sales charge. For example, Fidelity charges its customers $75 to purchase shares of Vanguard mutual funds (as of 2025).

Board of Directors — detail

• Plays a similar role to the BOD of corporations with outstanding stock.
• 📌 Whether the sponsor appoints the BOD or the BOD appoints the sponsor is “not a critical test point.”
• After the BOD is in place, shareholders are responsible for approving the directors or voting in new members over time.

Fund manager — detail

• Fund managers invest shareholder assets according to the fund’s investment objective. They choose specific securities, but they must stay within the fund’s stated parameters. For example, a municipal bond fund manager would invest shareholder assets in municipal bonds.
• Many mutual funds manage hundreds of millions or billions of dollars; investing sums of that size is complex. Fund managers typically have significant finance experience and strong educational backgrounds. Larger funds often rely on teams of analysts (employed by the investment adviser).
• The industry is competitive, and fund managers may be replaced if performance is poor. A long-tenured fund manager often signals sustained success.

For example, Will Danoff has managed the Fidelity Contrafund for well over 30 years. His average return is over 12%, which exceeds the average annual return of the S&P 500 by greater than 2%. This is known as “beating the market,” and it’s difficult to do consistently over long periods. In fact, only 20% of fund managers like Will Danoff outperform the market over a five-year period.

Sidenote — The “market”

• The “market” typically refers to a benchmark index. An index is a basket of securities that represents a broad market (think of it as a curated list of securities).
• The S&P 500 includes 500 prominent US-based company stocks. While the calculation is more complex than this, the index is designed to track the overall price performance of those stocks. If most of the 500 stocks rise in price, the S&P 500 index rises (and vice versa).
• The S&P 500 is the benchmark index for many large-company stock portfolios and mutual funds that invest in those stocks. For example, the Fidelity Contrafund invests in stocks of large corporations and uses the S&P 500 as its benchmark index.
• Many other indices exist, covered later in this unit.

Shareholder benefits

• If your money is concentrated in one or a few investments, a sharp decline in a single security can significantly damage your overall account value.
• 🔑 As learned in a previous chapter, diversification reduces exposure to non-systematic risk.

Definitions

Sidenote — Marketing a fund as “diversified”

• Most investors want some level of diversification, so sponsors have an incentive to market funds as diversified.
• The Investment Company Act of 1940 requires investment companies to meet specific standards before describing their portfolios as diversified.

🔑 Specifically, at least 75% of assets must be invested so that the portfolio contains:

No more than 10% of the voting power of one issuer No more than 5% of the fund’s assets invested in one issuer’s securities

Expense ratio

• Fund sponsors and managers don’t operate mutual funds for free. Funds can charge a variety of fees, but investors often don’t see them directly.
• A fund’s operating costs are bundled into a single figure called the expense ratio.

🔑 If a fund has an expense ratio of 1%, its total annual operating expenses are equal to 1% of the fund’s assets.

Worked example (verbatim)

For example, a fund with $100 million in assets and a 1% expense ratio collects $1 million per year in operating expenses. To cover these costs, the fund keeps a portion of the returns it earns. For instance, the fund might liquidate a position for $5 million and retain $1 million to pay operating expenses.

Components of the expense ratio

• Mutual fund investors generally prefer lower expense ratios because expenses reduce shareholder returns.
• All else equal, a lower expense ratio means the fund is operating more efficiently and may be more attractive to investors.

Limitations

Key points

Mutual funds

• Legally classified as open-end management companies
• Investors are known as shareholders
• Manage and invest shareholder assets according to fund’s objective
• “Open-ended” (variable) amount of shares outstanding
• Purchases are considered primary market transactions
• Prospectus delivery required at sale
• $100k minimum capital to launch
• Provides diversification to investors

Fund sponsor (underwriter)

• Creates the fund’s structure
• Registers the fund with the SEC
• Develops marketing strategy

Investment adviser

• Responsible for fund investments
• Employs and appoints fund manager

Fund manager

• Investment adviser employee(s)
• Implements investment strategy

Diversification

• Investing in many different securities
• Reduces non-systematic risks

Diversified funds

• 75%+ invested with no more than:
  • 10% of an issuer’s voting power
  • 5% of its assets in one issuer

Expense ratio

• Represents total fund expenses
• Includes:
  • Management fees
  • Custodian fees
  • Legal fees
  • Administrative fees
• Efficient funds have low expense ratios

Management fee

• Cost of investment adviser’s services
• Typically is the largest part of the expense ratio

Custodian fee

• Paid to financial firm holding fund assets

Mutual fund transaction limitations

• Cannot be purchased on margin
• Cannot be sold short

Sources

Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.