ETFs Made Easy: What Is A Fund?

Examining the basic structure that allows lots of investors to pool their money together and invest.

In this series, we answer the questions investors are afraid to ask. You can submit your questions to me at [email protected]. All correspondence will remain anonymous.

Let’s start right at the beginning. We talk about “funds” as if everyone knows what we mean. Mutual funds. Exchange-traded funds. Hedge funds. Private equity funds. What do they all mean?

Imagine you have $1,000 to invest. You think you’ve got some good ideas on what stocks to buy. So you open a brokerage account with one of the big-name brokerages—Charles Schwab, Etrade, TD Ameritrade, etc.—and you buy a bunch of stocks.

Congratulations—in many ways, you’re running a “fund.” You have a bunch of different stocks (or bonds or commodities or other items) held together in a single portfolio.

How A Fund Works

We don’t usually call our brokerage account a fund though. For that, we need a second person.

Let’s say that you have $1,000 to invest, but this time, you think I’m pretty good at managing money. Rather than buy stocks in your own brokerage account, you’d rather just give your thousand bucks to me and let me invest it alongside my own money.

Now, we could operate on a handshake and you could just trust me to keep track of everything fairly. But in the modern world, who trusts anyone? To keep everything on the straight and narrow, we’ll form a little organization called a trust or a company.

We will both put $1,000 into the organization, and we’ll agree that I’ll invest all the money. To keep track of things, we’ll give you one share of the organization and we’ll give one share to me. The shares represent each investor’s “share” of the total investment, so if you invested $2,000 and I invested $1,000, you would get 2 shares to my 1, and so on.

We just made a “mutual fund.” If the stocks we buy go up, we share in that … mutually. If the stocks go down, we both lose money.

Funds Follow Rules

Any investment vehicle that calls itself a fund operates essentially just like that.

Investors contribute their money in exchange for a fair share of the total portfolio value. Someone is put in charge of running the portfolio. Typically, they’re required to follow a set of rules.

Those rules could be “buy all the stocks in the S&P 500”—that’s what an index fund does. Or the rules could be “invest in anything you want”—an actively managed go-anywhere fund. And then, as mentioned, everyone benefits (or suffers) equally as the fund’s value goes up or down.

The Investment Company Act Of 1940

The funds most investors are used to thinking about in the investment world today (including ETFs) are governed by a set of rules called the Investment Company Act of 1940. These rules help create a safe and fair landscape for investors in funds.

The rules require funds to have independent boards that oversee their operations, and dictate certain commonly accepted ways funds must communicate with shareholders (including publishing prospectuses and periodic reports). Most importantly, the rules require funds to allow investors to get their money in and out each day at fair value base, to ensure everyone gets a fair deal.

The terms “mutual fund” or “exchange-traded fund” can sound intimidating, bin the end, the concept is simple. It’s a structure that allows lots of investors to pool their money together and invest. The rest is just details.