Mutual Funds 101
Mutual funds are one of the most popular investment vehicles in America, with trillions of dollars invested. They allow investors to pool their money and access professional management and diversification. Understanding how mutual funds work is essential for the SIE exam.
What Is a Mutual Fund?
A mutual fund is a pooled investment vehicle that collects money from many investors to invest in a diversified portfolio of securities. The fund is managed by professional investment advisers.
Key Characteristics
- Pooled investment: Many investors share ownership
- Professional management: Investment advisers make buy/sell decisions
- Diversification: Fund holds many different securities
- Regulated: Subject to Investment Company Act of 1940
Types of Investment Companies
The Investment Company Act of 1940 defines three types of investment companies:
| Type | Description |
|---|---|
| Face-amount certificate companies | Issue debt certificates at a discount (rare today) |
| Unit investment trusts (UITs) | Fixed portfolio, no active management |
| Management companies | Actively or passively managed portfolios |
Management companies are further divided into open-end and closed-end funds.
Open-End Funds (Mutual Funds)
When people say "mutual fund," they typically mean open-end funds.
Key Features
| Feature | Description |
|---|---|
| Shares | Unlimited—new shares created for each investment |
| Pricing | Net Asset Value (NAV) calculated daily at 4 PM ET |
| Redemption | Fund must redeem shares at NAV |
| Trading | Bought from/sold to the fund company, not on exchanges |
How Open-End Funds Work
- Investor sends money to the fund
- Fund issues new shares to the investor
- When investor sells, fund redeems (buys back) shares
- All transactions occur at end-of-day NAV
Key Point: Open-end fund shares are always bought and sold at NAV. There is no secondary market—shares do not trade on exchanges.
Closed-End Funds
Closed-end funds issue a fixed number of shares through an IPO, then trade on exchanges like stocks.
Key Features
| Feature | Description |
|---|---|
| Shares | Fixed number issued at IPO |
| Pricing | Market price (may differ from NAV) |
| Redemption | Fund does NOT redeem shares |
| Trading | Bought and sold on exchanges |
Premium and Discount
Closed-end funds can trade at prices different from NAV:
- Premium: Market price > NAV (investors pay more than assets are worth)
- Discount: Market price < NAV (investors pay less than assets are worth)
Exam Tip: Closed-end funds are the only pooled investments that can trade at a discount to NAV.
Open-End vs. Closed-End Comparison
| Factor | Open-End (Mutual Funds) | Closed-End |
|---|---|---|
| Shares outstanding | Unlimited (changes daily) | Fixed |
| Share price | NAV | Market price |
| Premium/Discount | No—always at NAV | Yes—can trade above or below NAV |
| Redemption | Required by fund | Not required |
| Trading venue | Fund company | Stock exchange |
| When priced | Once daily (4 PM ET) | Continuously |
Net Asset Value (NAV)
Net Asset Value (NAV) is the per-share value of a mutual fund's assets.
NAV = (Total Assets - Total Liabilities) ÷ Shares Outstanding
What Affects NAV?
| Event | Effect on NAV |
|---|---|
| Market gains | NAV increases |
| Market losses | NAV decreases |
| Dividend distribution | NAV decreases |
| New investor purchases | No change (shares increase proportionally) |
NAV is calculated at the end of each trading day (4 PM ET). All buy and sell orders received during the day execute at that day's closing NAV.
Diversification Requirements (75-5-10 Rule)
To call itself "diversified," a mutual fund must meet the 75-5-10 test:
| Requirement | Meaning |
|---|---|
| 75% | At least 75% of assets in securities of other issuers |
| 5% | No more than 5% of assets in any one company |
| 10% | Cannot own more than 10% of any company's voting stock |
Funds not meeting these requirements are "non-diversified."
Prospectus Requirements
Before investing in a mutual fund, investors must receive a prospectus containing:
- Investment objectives and strategies
- Risks
- Fees and expenses
- Past performance
- Fund management information
- How to buy and sell shares
Legal Requirement: A prospectus must be delivered to investors at or before the sale of mutual fund shares.
Benefits of Mutual Funds
| Benefit | Description |
|---|---|
| Diversification | Reduces single-security risk |
| Professional management | Experienced managers make decisions |
| Liquidity | Can redeem shares any business day |
| Convenience | Easy to invest small amounts |
| Regulatory oversight | SEC registration protects investors |
Key Takeaways
- Mutual funds (open-end) issue unlimited shares at NAV
- Closed-end funds have fixed shares trading on exchanges
- NAV = (Assets - Liabilities) ÷ Shares Outstanding
- Only closed-end funds can trade at premium or discount to NAV
- The 75-5-10 rule defines diversified funds
- Prospectus delivery is required before or at sale
An investor wants to purchase shares of an open-end mutual fund. At what price will the investor buy?
Which type of fund can trade at a discount to its net asset value?
Under the 75-5-10 diversification rule, a diversified mutual fund may invest no more than what percentage of its assets in any single company?
2.14 Mutual Fund Fees
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