Transactions
Buying and selling mutual funds shares is unlike trading stocks or bonds in the secondary market. If you recall, a security that trades in the secondary market is negotiable (most securities are transacted this way). Mutual funds do not trade between investors; they may only be bought from or sold to the fund issuer. Because of how their transactions work, mutual funds are known as redeemable securities. If you need a quick refresher, here’s a video you watched from the common stock chapter detailing the differences between negotiable and redeemable securities:
When an investor buys mutual fund shares, their money goes directly to the fund’s portfolio to be invested. When an investor sells their mutual fund shares, the fund must pay the value of the shares using cash in the fund. If the fund is short on cash, the fund manager must liquidate securities to make the payment.
For comparison, investors trading negotiable securities do not transact directly with the issuer. If you were to purchase shares of Microsoft stock in the secondary market, you would buy from another investor, not directly from Microsoft.
When a mutual fund transaction occurs, the foundation for the price per share is the net asset value (NAV). The NAV represents 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 maintain assets and liabilities, which is why NAV references 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. Net assets is divided by the number of outstanding shares to determine the NAV on a per share basis.
The most significant factor influencing the NAV is the current market value of the portfolio’s securities. At the end of every trading day, each mutual fund calculates the total market value of all its securities and releases its NAV to the public after market close.
To further demonstrate this, let’s look at the Putnam Growth Opportunities Fund; ticker: POGAX. As of March 2023, the fund’s top three investments were Apple, Microsoft, and Alphabet. To make it easy, 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).
Forward pricing
When an investor buys or sells a mutual fund, they are subject to forward pricing. Unlike stocks and bonds, which can be traded whenever the market is open, mutual funds only allow transactions to occur once daily 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 were to place a buy order for a mutual fund before 4:00 pm ET, you would receive that day’s NAV, also known as the fund’s “closing price.”
Remember, mutual funds don’t start calculating their daily NAVs until after the market closes. Once it closes, the fund calculates the market value of all of its securities, plus factors in deposits and withdrawals. This data is then used to calculate the fund’s new overall NAV. The term ‘forward pricing’ comes from this pricing structure. When a customer submits a transaction request, they do not know the NAV price they will be subject to. The NAV, which will be the basis for the customer’s transaction price, will be “forwardly” calculated (in the future).
If an investor’s purchase or sale is placed after 4:00 pm ET, it will revert to the next business day’s closing NAV. It could be a while for the transaction to occur, especially if the request is placed on a Friday night after the market closes. In this scenario, the transaction executes when the NAV is calculated Monday evening.
Most investors transact in dollar amounts to ensure they don’t overspend on their mutual funds. For example, a customer would typically submit an order to purchase $10,000 instead of a specific share amount. They may not know how many shares they’ll receive, but they won’t spend more than $10,000. In case you’re wondering, shares are transacted in fractions. Let’s demonstrate this concept:
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).
NAV vs. POP
Sometimes, mutual funds are sold at their NAV, especially if the mutual 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 cost.
To compensate the selling group (other financial firms selling the mutual fund) for distributing the shares, sales charges can be assessed on mutual fund transactions. The selling group purchases the shares at the NAV from the fund sponsor, then resells the shares with an added sales charge. The most common type of sales charge is a front-end load, which is assessed when customers purchase shares. There are also back-end loads, which are charged when customers liquidate (sell) their shares.
We’ll discuss the specifics of share classes in the next chapter. For the rest of this chapter, we’ll only discuss front-end loaded funds (known as 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, it looks like this:
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 amount is the public offering price. For example, if an investor purchased a fund share with a $20 NAV and a sales charge equal to $1, the POP (what they pay overall) is $21.
Any sales charge assessed is based on the POP, not the NAV. The maximum sales charge that can be assessed is 8.5% of the POP according to FINRA rules. What would a fund purchase look like with a sales charge? First, let’s refresh and remind ourselves what it looks like without a sales charge.
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 if there is no sales charge (no-load). The math changes slightly with a sales charge, as we first need to calculate the public offering price.
ABC mutual fund has a NAV of $25.50 and a 5% sales charge. What is the POP?
Now that we calculated POP, we can determine how many shares are obtained with simple division.
For the calculation above, you’ll either use NAV or POP dependent on the status of the sales charge. If there is no sales charge, NAV is used. If there is a sales charge, POP is used.
With the NAV and sales charge percentages, you can find the price per share the customer must pay (POP). As you can see, the customer buys fewer shares when a sales charge is involved.
Generally, two types of exam questions require calculating the POP. The formula used depends on how the sales charge is presented. Here’s the summary of both formulas:
If the sales charge is in percent (%)
If the sales charge is in dollars ($)
Calculating a sales charge is also a testable topic. If you were provided a fund’s NAV and POP, you could be asked for its sales charge percentage. Here’s how it can be calculated:
Let’s use the numbers we utilized before to demonstrate this formula.
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.” After a few years in finance, you’ll be well acquainted with bid/ask spreads. When firms trade securities with the public, they establish a bid/ask. The ask represents the firm’s “asking price” for a security, or what a customer must pay to buy it. This is why the POP is sometimes called the “ask.” The bid represents what the firm is “bidding” for a security, or the price an investor could sell their shares back to the firm. This is why the NAV is sometimes called the “bid.”
Added requirements
As previously discussed, the maximum allowable sales charge is 8.5% of POP. If a fund assesses the highest possible sales charge, it must offer a few extras to its investors.
First, customers must be allowed to reinvest their dividends and capital gains at the NAV (avoiding a new sales charge). Funds distribute dividends when securities in the portfolio pay income (like dividends from stock or interest from bonds) and capital gains when the fund liquidates a security at a profit. Although there will be no sales charge, the customer will still be subject to taxes due on the dividend or capital gain received.
When a fund makes a dividend or capital gains distribution, the value of the fund will fall. Remember, the NAV represents the total value of assets in the fund. If the fund releases a bunch of cash to investors, there will be less money in the fund (resulting in a declining NAV). Most investors reinvest their mutual fund income, providing them with more shares. Dividend and interest distributions occur frequently, but capital gains are generally only distributed once per year.
When a distribution of any kind is declared, the Board of Directors (BOD) is responsible for setting all important dates like the record date and payable date. They also set the ex-dividend date, which is different than how stock dividends work. If you recall, FINRA and the NYSE set stock ex-dates because they control settlement times. With mutual funds, the BOD sets their settlement times (usually one to three business days after the transaction), so they have control over the ex-date.
Another requirement for funds assessing sales charges is the conversion (exchange) privilege. No new sales charge is assessed if an investor sells their 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 transaction is taxable. If there’s a gain on the sale, the customer will likely owe taxes on the transaction.
Sign up for free to take 20 quiz questions on this topic