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 (most securities trade this way). Mutual funds don’t trade between investors. You can only buy shares from the fund issuer and sell shares back to the fund issuer.
Because of this structure, mutual funds are called redeemable securities. If you want a quick refresher, here’s the video from the common stock chapter that compares negotiable and 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 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 on hand, the fund manager must sell (liquidate) portfolio securities to raise the 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 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 totals the market value of its holdings and publishes its NAV 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 if they fall, the NAV falls).
Mutual funds use forward pricing. Unlike stocks and bonds (which trade throughout the market day), mutual fund transactions are priced 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 stock market close. 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 idea: mutual funds don’t calculate the day’s NAV until after the market closes. Once the market closes, the fund:
This is why it’s called forward pricing: when you submit the order, you don’t yet know the NAV that will be used. The NAV is calculated later.
If you place a purchase or sale after 4:00 pm ET, the order is priced at the next business day’s closing NAV. This can delay execution. For example, an order placed Friday night after the market closes 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 (not 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.
Mutual fund shares can be purchased in fractions. Let’s work through an 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 you buy directly from the sponsor. For example, Vanguard customers buy Vanguard funds at NAV. However, if a Fidelity customer buys a Vanguard fund, they’ll 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 added to mutual fund transactions. The selling group buys shares from the sponsor at NAV and then resells them with an added sales charge.
The most common sales charge is a front-end load, charged when customers buy shares. There are also back-end loads, charged when customers sell (liquidate) shares.
We’ll cover share classes in the next chapter. For the rest of this chapter, the focus is 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 is based on the POP, not the NAV. FINRA limits the maximum sales charge to 8.5% of 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’s no sales charge. With a sales charge, you first calculate POP.
ABC mutual fund has a NAV of $25.50 and a 5% sales charge. What is the POP?
Now that we have POP, we can determine how many shares the investor receives.
For the calculation above, you’ll use NAV or POP depending on whether there’s a sales charge. If there is no sales charge, use NAV. If there is a sales charge, use POP.
With NAV and the sales charge percentage, you can find the price per share the customer pays (POP). Because POP is higher than NAV, the customer buys fewer shares when a sales charge applies.
Generally, two types of exam questions require calculating POP. The formula depends on how the sales charge is presented:
If the sales charge is in percent (%)
If the sales charge is in dollars ($)
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:
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 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 (so they avoid paying 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 the fund’s assets. If the fund pays out cash, the fund holds less cash afterward, so NAV declines. Many investors reinvest distributions, which increases their share count. 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 key dates such as the record date and payable date. The BOD also sets the ex-dividend date, which differs from stock dividends. For stocks, FINRA and the NYSE set ex-dates because they control settlement times. For mutual funds, the BOD sets settlement times (usually one to three business days after the transaction), so it also controls the ex-date.
Another requirement for funds that assess 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, an exchange is taxable. If the investor has a gain on the sale, they’ll likely owe taxes.
Sign up for free to take 12 quiz questions on this topic