5.2 Mutual Funds (Open-End Funds)

Net Asset Value (NAV)

A mutual fund is an open-end management company whose shares are bought from and redeemed by the fund itself at Net Asset Value (NAV). The fund must compute NAV at least once every business day, customarily at the 4:00 PM ET market close.

NAV Formula

$\text{NAV per share} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Shares Outstanding}}$

Worked example: A fund holds $500,000,000 in assets, owes $5,000,000 in liabilities, and has 25,000,000 shares outstanding.

• Net assets = $500,000,000 − $5,000,000 = $495,000,000
• NAV = $495,000,000 ÷ 25,000,000 = $19.80 per share

Subtract liabilities first, then divide. A frequent exam distractor divides total assets by shares before removing liabilities.

Forward Pricing (Rule 22c-1)

Under forward pricing, an order to buy or redeem executes at the next NAV computed after the fund receives the order. Orders received before the 4:00 PM ET cutoff get that day's closing NAV; orders received later get the next business day's NAV. This prevents the abusive practice of trading on already-known (stale) prices.

Investment Objectives and Suitability

The prospectus states the fund's objective, which must drive the representative's suitability recommendation.

• Growth funds — seek capital appreciation through growth equities; minimal dividends; higher volatility; suit younger, risk-tolerant investors with long horizons.
• Aggressive growth funds — emphasize small-cap or emerging companies; highest volatility.
• Income funds — buy dividend-paying stocks or bonds for current cash flow; suit retirees.
• Balanced funds — blend equities and fixed income to smooth volatility while providing both growth and income.
• Index funds — passively replicate a benchmark (e.g., S&P 500); low turnover; low expense ratios.
• Money market funds — invest in short-term, high-quality debt; strive to keep a stable $1.00 NAV; very low risk and yield; high liquidity. They are securities — not FDIC-insured.
• Sector / specialty funds — concentrate in one industry; high concentration risk.
• Municipal bond funds — generate federally tax-exempt interest (covered in 5.5).

The 75-5-10 Diversification Rule

To advertise itself as a diversified company under the Act of 1940, a fund must satisfy the 75-5-10 rule as applied to 75% of its total assets:

The remaining 25% of assets is unrestricted and may be concentrated. A fund that fails this test is a non-diversified company and must disclose that status.

Restrictions on Mutual Funds

The Act of 1940 also limits leverage and certain practices:

• A fund must maintain 300% asset coverage on any senior security (it may borrow no more than one-third of its assets, effectively a 33% limit).
• A fund needs $100,000 minimum capital to begin a public offering.
• A fund may not purchase securities on margin, sell short, or participate in a joint trading account.

Reading the Question on Objectives

The exam frequently presents a customer profile and asks which fund objective fits. Match the investor's time horizon, risk tolerance, and income need to the objective. A 28-year-old saving for retirement in 35 years tolerates volatility and wants compounding, so a growth or index equity fund fits; an income need would only dilute the goal. A 70-year-old retiree living off the portfolio needs stability and cash flow, so an income or balanced fund fits, and an aggressive growth fund would be unsuitable. A customer parking emergency cash needs liquidity and principal stability, so a money market fund fits.

When a question stresses 'preservation of capital,' steer toward money market or short-term bond funds; when it stresses 'maximum capital appreciation,' steer toward growth or aggressive growth.

Combination and Specialized Objectives

Some objectives blend or narrow the categories above, and the exam expects you to recognize the trade-offs. A growth and income fund pursues both appreciation and dividends, sitting between pure growth and pure income on the risk spectrum. A bond (fixed-income) fund generates interest income and carries interest-rate and credit risk rather than equity risk. A specialized or sector fund concentrates in one industry — technology or healthcare, for example — and therefore sacrifices diversification for the chance at outsized returns, which raises concentration risk.

An international or global fund adds currency and political risk; the exam distinguishes 'international' (foreign only) from 'global' (foreign plus domestic). Each narrower objective trades breadth of diversification for a more specific exposure, and the suitability answer follows from that trade-off.

Why the Diversification Test Matters

The 75-5-10 test is not merely a labeling rule; it protects retail investors from hidden concentration. A fund marketed as 'diversified' that quietly held 30% of its assets in a single issuer would expose shareholders to single-name blowup risk they did not expect. By capping any one issuer at 5% within the diversified portion and barring ownership of more than 10% of an issuer's voting stock, the Act of 1940 keeps a 'diversified' label honest and prevents a fund from using shareholder money to seize control of a portfolio company.

Exam Trap: The 5% and 10% limits apply only inside the 75% diversified slice. A fund can still call itself diversified while concentrating the remaining 25%. Do not apply 5-and-10 to the whole portfolio.