Mutual Funds Explained

Mutual Funds explained… In the next few posts in this topic, we’re going to explain how mutual funds work, what they are, and the different types that exist as well as showing you the similarities and differences between mutual funds and ETFs.

The most common funds which people own today are mutual funds.  Although they are commonly owned, they are not commonly understood.  Today, we’ll look at the first of the two main types of mutual funds:

Open End Mutual Funds

Most mutual funds are Open End funds.  These are so common that you will rarely see them referred to as open ended.  It is usually assumed.  This type of mutual fund always sells at Net Asset Value and can only be bought or sold at the end of each business day.

At the end of each day, the management team computes the day’s ending value of every asset in the portfolio and adds them all together to determine the present Net Asset Value of the fund.  Then all the orders which came in to purchase the fund over the last 24 hours are credited new shares at this price.  All shares which were sold during this period are redeemed at this price and the cash credited to the shareholder.

This methodology has advantages and disadvantages.  The advantage is that the price the fund is trading at is always a very recent fair market value.  Because new shares are issued each day to new buyers and old shares are disposed of for sellers, there is never a supply or demand squeeze which would cause the share price to move up or down further than the NAV.  The number of shares fluctuates to accommodate demand instead of the price of the fund fluctuating to accommodate demand as we will see with closed end funds.

There are a couple disadvantages to this style of fund. Because the fund can only be liquidated at the end of the day, the owners are unable to sell in the middle of a business day if the market environment begins to move against them.  This is not typically very important, but sometimes people are shocked and disappointed to find out that they put in an order to sell their mutual fund after the cut off time only to watch the market plummet the following day and receive the value of the close of the following day’s business.

Shares can only be bought or sold at the end of each day, so unless you are placing your order right before the cut off, the shares could move substantially after you place your order and you will receive the price that it ends up at.  Again, in the grand scheme of things, this isn’t overly important, but something we want to make sure you’re aware of.

A disadvantage that is more substantial (although much less quantifiable) is the fact that the human nature of your fellow investors will hurt your manager’s performance.  This is because the masses of investors will tend to pull money out of the market when it is bottoming and pile into the market when it is topping.

Because an open end fund accepts all cash that comes in to buy new shares, the manager has a dilemma.  When the price of things is low and he wants to be buying more great values, your fellow investors will be redeeming shares.  All open end fund managers must keep cash on hand to deal with these redemptions.  This fact alone reduces performance if the manager would otherwise prefer to be fully invested (although many of the greatest investors always keep a substantial cash position so that they are ready to take advantage of the next incredible deal that might come along.)

But a falling market will often cause mutual fund managers to have to sell shares of stocks or bonds that they love because they have to redeem the shares that the owner is selling and they have run out of cash to do so.  So while the bargains are greatest, they have to sell.

On the flip side, when the market has put a high price on everything, money will often flow into a mutual fund manager’s coffers.  He will then have to decide where to put this money so that it is not sitting idly by depressing the performance of the fund.  Thus he has an incentive to buy things that might be overpriced.  Because of this phenomenon, you’ll occasionally hear of very successful managers closing their fund to new investors because there comes a point at which new money will simply mean the manager has to invest in securities he feels are les advantageous and he doesn’t want to bog down the performance of the whole fund in order to accommodate new investors who are chasing his past performance.

This is Part 3 in a series on professional money management and funds.  You can find the prior posts by following these links: Pt 1 & Pt 2. We also recently began a series on asset allocation which in many ways relates to some of the purpose in funds, so you might want to check out the following posts:  Pt 1Pt 2, and Pt 3.

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