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 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 a previous chapter that reviews negotiable vs. redeemable securities:
When an investor buys mutual fund shares, their money goes directly 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 liquidate securities to raise the cash needed for the payment.
For comparison, investors trading negotiable securities don’t transact directly with the issuer. If you purchase 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 value of the fund 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 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 outstanding shares to determine the NAV on a per-share basis.
The biggest factor affecting NAV is the current market value of the securities in the portfolio. At the end of every trading day, each mutual fund calculates the total market value of its securities 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 the three stocks increase 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 funds process transactions once per day, using the NAV calculated after the market closes.
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”).
Here’s the key timing point: mutual funds don’t calculate their daily NAV until after the market closes. Once the market closes, the fund determines the market value of all portfolio securities and factors in deposits and withdrawals. That information is used to calculate the new NAV. 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 after 4:00 pm ET, the order uses the next business day’s closing NAV. This can delay execution. For example, an order placed on a Friday night after the market closes executes when the NAV is calculated Monday evening.
Most investors place mutual fund orders in dollar amounts to avoid overspending. 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 in advance, but they do know they won’t spend more than $10,000. Mutual fund 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 purchased a Vanguard fund, they would likely pay a sales charge in addition to the NAV.
To compensate the selling group (other financial firms selling the mutual fund) for distributing shares, sales charges may be assessed on mutual fund transactions. The selling group purchases shares at NAV from the fund sponsor, then resells them with an added sales charge.
The most common sales charge is a front-end load, assessed when customers purchase shares. There are also back-end loads, charged when customers liquidate (sell) their shares.
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 purchase front-end loaded funds at the public offering price (POP). POP is the NAV plus any applicable sales charge. In equation form:
When a selling group member sells shares of a front-end loaded fund, the customer pays for:
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.
What does a purchase look like with and without a sales charge? First, here’s 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?
The calculation uses NAV because there is no sales charge.
Now compare that to a purchase with a sales charge, where we first calculate POP:
ABC mutual fund has a NAV of $25.50 and a 5% sales charge. What is the POP?
Now that we have POP, we can calculate how many shares the investor receives:
For the calculation above, you’ll use NAV or POP depending on whether there’s a sales charge. If there is no sales charge, use NAV. If there is a sales charge, use POP.
With NAV and the sales charge percentage, you can find the price per share the customer pays (POP). Because POP is higher than NAV, the customer buys fewer shares when a sales charge applies.
Generally, two types of exam questions require calculating POP. The formula depends on how the sales charge is presented:
If the sales charge is in percent (%)
If the sales charge is in dollars ($)
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 establish a bid/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 customer is still subject to taxes on the dividend or capital gain received.
When a fund makes a dividend or capital gains distribution, the value of the fund falls. NAV reflects the total value of the fund’s assets. If the fund pays out cash to investors, the fund holds less cash afterward, which reduces NAV. Many investors reinvest distributions, which results in additional shares. Dividend and interest distributions occur frequently, but capital gains are generally distributed once per year.
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 purchase a new fund within the same fund family. A fund family is a set 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 on the transaction.
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