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 trade it with each other (this is how most securities trade). Mutual funds don’t trade between investors; they can only be bought from or sold back to the fund issuer. Because of this structure, mutual funds are redeemable securities.
If you need 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’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 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 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 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 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 things simple, assume these are the only three investments in the fund. If those 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 trade throughout the market day), mutual funds process transactions only once per day, 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. Once the market closes, the fund:
This is why it’s called forward pricing: when a customer submits a transaction request, they don’t yet know the NAV that will apply. The NAV used for the transaction will be calculated later (after the close).
If an investor places a purchase or sale after 4:00 pm ET, the transaction uses the next business day’s closing NAV. This can create a delay. For example, if the request is placed on a Friday night after the market closes, the transaction executes when the NAV is calculated Monday evening.
Most investors place mutual fund orders in dollar amounts to control how much they spend. For example, a customer typically submits an order to purchase $10,000 rather than a specific number of shares. They may not know the exact share amount in advance, but they know they won’t spend more than $10,000.
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 their NAV, especially when the fund is bought directly from the sponsor. For example, Vanguard customers buy Vanguard funds at the 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 the NAV from the fund sponsor, then resells them with an added sales charge.
We’ll cover the specifics of share classes in the next chapter. For the rest of this chapter, we’ll focus on front-end loaded funds (Class A shares).
Investors purchase front-end loaded funds at the public offering price (POP). The 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, they charge for the value of the shares (NAV) plus the amount they’re compensated (the sales charge). The total is the public offering price. For example, if an investor buys a fund share with a $20 NAV and a $1 sales charge, the POP (the total price paid) 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 the POP.
What does a purchase look like with a sales charge? First, here’s the no-load version:
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 before because there is no sales charge. With a sales charge, you first calculate the POP.
ABC mutual fund has a NAV of $25.50 and a 5% sales charge. What is the POP?
Now that we have the POP, we can determine how many shares are purchased.
For the calculation above, you’ll use NAV or POP depending on whether there’s a sales charge. If there is no sales charge, use NAV. If there is a sales charge, use POP.
With the NAV and sales charge percentage, you can find the price per share the customer must pay (POP). Notice that the customer buys fewer shares when a sales charge is included.
Generally, two types of exam questions require calculating the POP. The formula you use depends on how the sales charge is presented:
If the sales charge is in percent (%)
If the sales charge is in dollars ($)
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 the POP is sometimes called the ask, and the 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 the 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 value of the fund falls. Since NAV reflects the total value of assets in the fund, paying out cash reduces the assets held by the fund (which lowers NAV). Many investors reinvest distributions, which increases their share count. Dividend and interest distributions occur frequently, but 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. They also set the ex-dividend date, which works differently than stock dividends. For stocks, FINRA and the NYSE set ex-dates because they control settlement times. With mutual funds, the BOD sets settlement times (usually one to three business days after the transaction), so the fund 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 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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