Buying and selling mutual fund shares is different from trading stocks or bonds in the secondary market. A security that trades in the secondary market is negotiable, meaning investors trade it with each other (this is how most securities trade). Mutual funds don’t trade between investors. Instead, shares are bought from and 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 a previous chapter that reviews negotiable vs. redeemable securities:
When an investor buys mutual fund shares, their money goes into the fund’s portfolio to be invested. When an investor sells (redeems) mutual fund shares, the fund must pay the value of those shares using cash held by the fund. If the fund doesn’t have enough cash, the fund manager must sell portfolio securities to raise cash for the payment.
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 assets and liabilities, which is why NAV is based on net assets. Liabilities include required payouts (redemptions) to investors, management fees, and administrative costs. The fund subtracts liabilities from portfolio assets (securities and cash held in the fund) to determine net assets. Then it divides net assets by the number of outstanding shares to determine the NAV on a per-share basis.
The biggest driver of NAV is the current market value of the portfolio’s securities. At the end of each trading day, every mutual fund totals the market value of its holdings and calculates its NAV. The fund then releases the NAV to the public after the market closes.
To see why market value 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 the three stocks rise in value, the fund’s NAV rises (and vice versa).
When an investor buys or sells a mutual fund, they are subject to forward pricing. Unlike stocks and bonds (which can trade throughout the market day), mutual fund transactions are priced once per day, using the NAV calculated after the market closes.
Mutual funds don’t calculate the day’s NAV until after the market closes. After the close, 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 request after 4:00 pm ET, the order receives the next business day’s closing NAV. That can create a delay. For example, an order placed Friday night (after the close) executes using the NAV 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 purchase $10,000 rather than a specific number of shares. They won’t know the exact share amount until the NAV is calculated, but they do know they won’t spend more than $10,000.
Shares can be purchased in fractions. For example:
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 buys a Vanguard fund, they will likely pay a sales charge in addition to NAV.
To compensate the selling group (other financial firms that distribute the mutual fund), sales charges may be assessed on mutual fund transactions. The selling group buys shares from the fund 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:
The total is the public offering price. 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. Under FINRA rules, the maximum sales charge is 8.5% of the POP.
To see how a sales charge affects a purchase, first recall the no-load example:
An investor purchases $10,000 of no-load ABC mutual fund shares at a NAV of $25.50. How many shares did they purchase?
Our calculations are the same as long as there is no sales charge (no-load). With a sales charge, you first calculate the POP.
ABC mutual fund has a NAV of $25.50 and a 5% sales charge. What is the POP?
Now that we have POP, we can determine how many shares are purchased.
For the calculation above, you’ll use NAV or POP depending on whether a sales charge applies. If there is no sales charge, use NAV. If there is a sales charge, use POP.
With the NAV and sales charge percentage, you can find the price per share the customer pays (POP). Because POP is higher than NAV, the customer buys fewer shares when a sales charge is involved.
Generally, two types of exam questions require calculating POP. The formula you use depends on how the sales charge is presented:
If the sales charge is in percent (%)
If the sales charge is in dollars ($)
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 the POP is called the “ask” and the NAV is called the “bid.” Firms that trade securities with the public quote a bid and an ask:
That’s why POP is sometimes called the ask, and NAV 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 (avoiding a new sales charge). Funds distribute:
Even though there’s no sales charge on reinvestment, the investor 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. If the fund pays out cash, the fund holds less money, so NAV declines. Many investors reinvest distributions, which results in additional shares. Dividend and interest distributions can occur frequently, but capital gains are generally distributed once per year.
Another requirement for funds that assess sales charges is the conversion (exchange) privilege. No new sales charge is assessed if an investor sells their 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 all part of the Vanguard fund family). Like reinvesting dividends and capital gains, the exchange is taxable. If there’s a gain on the sale, the customer will likely owe taxes.
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