With apologies to Mark Twain for paraphrasing, we all know about mutual funds, but do we really understand them? This is the first in a series of articles that I hope will help you understand all about these not-so-mystical creatures. Think of it as Mutual Funds 101.
Basically, mutual funds are a way for us to combine our dollars so that all of us can easily participate in the bounty (and the risks) of the markets. They come in two broad categories, open-end funds and closed-end funds, but each of these have a variety of flavors that we will sample over subsequent articles.
So what’s the difference? An open-end fund is the type most of us know. With open-end funds, investors are able to purchase shares or redeem shares on a daily basis. There is typically no limit to the number of shares that can be sold.
The fund is evaluated at the end of each trading day by its net asset value (NAV). NAV is calculated once a day by evaluating the market value of each security held in the portfolio at the end of the day and adding in net inflows (amount of cash invested that day less the amount of redemptions).
This is an important number because the daily price of the fund is therefore the NAV divided by the number of shares owned by the shareholders (you and me). So if the fund is worth $50,000,000 and there are 1,000,000 shares, then the price of the fund is $50. So for new investors, each share will cost $50. Current investors can redeem shares and receive $50 per share.
The NAV and the price can (and will) go up or down each day. Sometimes they go up and down so fast that it makes us seasick, but you only profit if you sell when the price is higher than what you paid for it (duh!) and in that way it’s like any other investment. You’ve got to buy low and sell high.
A closed-end fund operates just like an open-end fund with one big exception. The closed-end fund is offered on a one-time basis and sells only a limited number of shares. It then trades on a stock exchange just like any stock.
NAV is calculated exactly the same way, but price is determined by supply and demand, so some popular closed-end funds sell at a premium (higher) price than the NAV and others sell at a discount (lower) price than the NAV. There are various reasons behind this phenomenon which we’ll discuss in future articles, but for now keep in mind the difference between these two types.
So why invest in mutual funds and when should you choose open-end versus closed? Well that’s a tale for another time. Stay tuned.
Michael Terry is a financial planner who specializes in objective and independent advice.