Buying and selling mutual fund shares works differently than trading stocks or bonds in the secondary market. A security that trades in the secondary market is negotiable, meaning investors buy and sell it with each other (this is how most securities trade). Mutual funds don’t trade between investors. Instead, shares can only be bought from or sold back to the fund issuer. Because of this structure, mutual funds are redeemable securities.
If you want a quick refresher, here’s a video from the common stock chapter that reviews negotiable vs. redeemable securities:
When an investor buys mutual fund shares, their money goes directly into the fund to be invested in the portfolio. When an investor sells (redeems) mutual fund shares, the fund must pay the investor using cash held by the fund. If the fund doesn’t have enough cash on hand, the fund manager may need to sell portfolio securities to raise cash.
For comparison, investors trading negotiable securities don’t transact with the issuer. If you buy shares of Microsoft stock in the secondary market, you buy from another investor - not directly from Microsoft.
When a mutual fund transaction occurs, the starting point for the price per share is the net asset value (NAV). The NAV is the fund’s value on a per-share basis.
For example:
ABC mutual fund has $100 million of net assets in securities and 1 million shares outstanding.
With this information, we can calculate the NAV.
Funds have both assets and liabilities, which is why NAV is based on net assets. Liabilities include items like required payouts (redemptions) to investors, management fees, and administrative costs. To find net assets, the fund subtracts liabilities from portfolio assets (securities and cash held in the fund). Then it divides net assets by the number of shares outstanding to get the NAV per share.
The biggest driver of NAV is the current market value of the securities in the portfolio. At the end of each trading day, every mutual fund calculates the total market value of its holdings and releases its NAV to the public after the market closes.
To see why this matters, consider the Putnam Growth Opportunities Fund; ticker: POGAX. As of March 2023, the fund’s top three investments were Apple, Microsoft, and Alphabet. To keep it simple, assume these are the only three investments in the fund. If those three stocks rise in value, the fund’s NAV rises (and vice versa).
When an investor buys or sells a mutual fund, the transaction uses forward pricing. Unlike stocks and bonds (which trade throughout the market day), mutual funds process transactions once per day, using the NAV calculated at the market close.
The cut-off time for mutual fund purchases and sales is 4:00 pm ET, the closing time for the stock markets. If you place a buy order before 4:00 pm ET, you receive that day’s NAV (often called the fund’s “closing price”).
Mutual funds don’t calculate the day’s NAV until after the market closes. After 4:00 pm ET, the fund:
This is why it’s called forward pricing: when you submit the order, you don’t yet know the NAV that will apply. The NAV used for your transaction will be calculated later.
If an investor places a purchase or sale order after 4:00 pm ET, the order receives the next business day’s closing NAV. This can delay execution. For example, an order placed Friday night after the market closes won’t execute until the NAV is calculated Monday evening.
Most investors place mutual fund orders in dollar amounts so they don’t overspend. For example, a customer typically submits an order to invest $10,000 rather than requesting a specific number of shares. They may not know the exact share amount they’ll receive, but they know they won’t invest more than $10,000.
Mutual fund shares can be purchased in fractions. Here’s what that looks like:
An investor purchases $10,000 of ABC mutual fund shares at a NAV of $25.50. How many shares did they purchase?
As you can see, mutual fund shares can be purchased in fractional form in thousandths (up to 3 decimal places).
Sometimes mutual funds are sold at NAV, especially when the fund is purchased directly from the sponsor. For example, Vanguard customers buy Vanguard funds at NAV. However, if a Fidelity customer purchases a Vanguard fund, they would likely pay a sales charge in addition to NAV.
To compensate the selling group (other financial firms distributing the mutual fund), sales charges may be assessed on mutual fund transactions. The selling group buys shares from the sponsor at NAV and then resells them with an added sales charge.
We’ll cover share classes in the next chapter. For the rest of this chapter, the focus is on front-end loaded funds (Class A shares).
Investors buy front-end loaded funds at the public offering price (POP). POP is the NAV plus any applicable sales charge.
When a selling group member sells shares of a front-end loaded fund, the customer pays:
That total is the POP. For example, if a fund share has a $20 NAV and a $1 sales charge, the POP is $21.
Any sales charge assessed is based on the POP, not the NAV. FINRA rules cap the maximum sales charge at 8.5% of POP.
To see how a sales charge affects a purchase, it helps to compare a no-load purchase to a loaded purchase.
An investor purchases $10,000 of no-load ABC mutual fund shares at a NAV of $25.50. How many shares did they purchase?
The calculation is straightforward because there’s no sales charge.
With a front-end load, you first calculate POP.
ABC mutual fund has a NAV of $25.50 and a 5% sales charge. What is the POP?
Now use POP to find how many shares the investor receives.
For the calculation above, you’ll use NAV or POP depending on whether there’s a sales charge. If there is no sales charge, use NAV. If there is a sales charge, use POP.
With NAV and the sales charge percentage, you can find the price per share the customer pays (POP). Because POP is higher than NAV, the customer buys fewer shares when a sales charge applies.
Generally, two types of exam questions require calculating POP. The formula you use depends on how the sales charge is presented:
If the sales charge is in percent (%)
If the sales charge is in dollars ($)
Calculating a sales charge is also testable. If you’re given a fund’s NAV and POP, you may be asked to find the sales charge percentage:
Let’s use the same numbers as before.
ABC mutual fund has a NAV of $25.50 and a POP of $26.84. What is the sales charge?
Can you confirm a 5% sales charge using the percent formula above?
Sure enough, it works!
Sometimes POP is called the “ask” and NAV is called the “bid.” Firms that trade securities with the public quote a bid and an ask:
That’s why POP (what you pay to buy a loaded fund) is sometimes called the ask, and NAV (what you receive when redeeming) is sometimes called the bid.
As discussed earlier, the maximum allowable sales charge is 8.5% of POP. If a fund charges the maximum, it must provide a few additional features.
First, customers must be allowed to reinvest dividends and capital gains at NAV (so they avoid paying a new sales charge). Funds distribute:
Even though there’s no sales charge on reinvestment, the customer is still subject to taxes on the dividend or capital gain received.
When a fund makes a dividend or capital gains distribution, the fund’s value falls. NAV reflects the total value of assets in the fund. When the fund pays out cash, there’s less money in the fund, so NAV declines. Many investors reinvest distributions, which gives them additional shares. Dividend and interest distributions can occur frequently, while capital gains are generally distributed once per year.
When a distribution is declared, the Board of Directors (BOD) sets these dates:
The record date is the date an investor must be a settled owner to receive the distribution. Most mutual funds use one- or three-business-day settlement (T+1 or T+3). For example, assume the record date is Friday for a mutual fund with T+3 settlement. An investor must purchase by Tuesday for the trade to settle by Friday and qualify for the dividend. In that case, Wednesday is the ex-dividend date - the first day the fund can be purchased without receiving the dividend (because a Wednesday purchase wouldn’t settle until the following Monday). The payable date is when the dividend is actually paid, usually a few weeks after the record date.
Another requirement for funds assessing sales charges is the conversion (exchange) privilege. No new sales charge is assessed if an investor sells shares and uses the proceeds to buy another fund within the same fund family. A fund family is a group of funds from the same sponsor (for example, Vanguard funds are part of the Vanguard fund family). Like reinvesting dividends and capital gains, the exchange is taxable. If the sale creates a gain, the customer will likely owe taxes.
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