2.13 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:

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

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

1. Investor sends money to the fund

2. Fund issues new shares to the investor

3. When investor sells, fund redeems (buys back) shares

4. All transactions occur at end-of-day NAV

Key Point: Open-end fund shares are bought from the fund at the next calculated NAV plus any sales charge, and redeemed at the next calculated NAV minus any fees. 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

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 greater than NAV (investors pay more than assets are worth)

- Discount: Market price less than NAV (investors pay less than assets are worth)

Exam Tip: Closed-end funds and ETFs trade on exchanges at market prices that can be above or below NAV. Open-end mutual funds never trade at a premium or discount.

Open-End vs. Closed-End Comparison

Shares outstanding: Open-End - Unlimited (changes daily); Closed-End - Fixed

Share price: Open-End - NAV; Closed-End - Market price

Premium/Discount: Open-End - No, always at NAV; Closed-End - Yes, can trade above or below NAV

Redemption: Open-End - Required by fund; Closed-End - Not required

Trading venue: Open-End - Fund company; Closed-End - Stock exchange

When priced: Open-End - Once daily (4 PM ET); Closed-End - Continuously

Net Asset Value (NAV)

Net Asset Value (NAV) is the per-share value of a mutual fund's assets.

NAV = (Total Assets minus Total Liabilities) divided by Shares Outstanding

What Affects 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:

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

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

- Closed-end funds (and ETFs) can trade at a premium or discount to NAV; open-end funds cannot

- The 75-5-10 rule defines diversified funds

- Prospectus delivery is required before or at sale