Buying Mutual Funds Is Different Than Buying Stocks
Process Is Simple and You Deal Directly with the Fund
Investors used to buy individual stocks may find investing in mutual funds a little confusing. In most cases, mutual funds are marketed and sold differently than individual stocks.
To understand the process better, let's start with how mutual funds are priced.
Individual stocks are re-priced constantly during trading hours based on supply and demand influences. When you buy a stock, you are becoming a partial owner of the company.
When you buy into a mutual fund you are buying a partial interest in a collection of assets (usually stocks, bonds, and derivatives.
Mutual funds are priced differently than stocks. Most mutual funds issue as many shares as people want to buy, whereas a finite number of shares of a stock are available.
These funds are known as open-end mutual funds. For example, if a fund has issued 2 million shares and has $30 million in assets, each share is priced at $15 per share. For every additional $15 invested, the fund's assets increase by that amount and the share price remains at $15 because the fund issues new shares at the current price ($15). That price is what is quoted in the newspaper and online and is known as the net asset value.
Net asset value is the daily value of a mutual fund that includes all the assets minus the fund's liabilities converted to a per-share price. This is the price you buy and sell mutual fund shares at if you deal directly with the company.
The calculation of the net asset value is more complicated than this simple example because the fund is not just selling shares - it is buying and selling stocks and/or bonds, making and selling other investments and redeeming shares of investors who want to sell.
In addition, the market value of the fund's holdings changes every day and must be recalculated when the stock market closes and all the fund's holdings have a closing value. Here is a simple formula that illustrates the calculation of the net asset value:
Beginning value of funds assets
Any new investments
Dividends, interest, capital gains [plus]
Any gain in price or value of fund assets
Any decrease in price or value of fund assets
Any shares redeemed to investors (assets sold or cash diminished)
Dividends, interest or capital gains paid to shareholders
New Net Asset Value
If you want to buy or sell shares of the fund during the day, this is the price you will pay or receive. The fund calculates it every day after the markets close.
Another type of mutual fund called a closed-end fund works differently. A closed-end mutual fund issues a fixed number of shares. These shares are traded on the stock exchanges like the common stock of companies. Because closed-end funds trade on the open market, their share price is determined by supply and demand.
Although closed-end mutual funds have a NAV, they may trade above or below this price based on whether investors are confident in the fund's future or not. There are much more open-end funds than closed-end funds.
You'll know you are buying a closed-end fund because it must be bought through a stockbroker and you can watch the price change during the day. Unlike an open-end mutual fund, you can only buy or sell closed-end fund when the markets are open.
Buying and Selling Mutual Funds
One of the advantages of investing in mutual funds is their liquidity, meaning you can sell your shares or buy more with ease. Most funds make investing easy, with a minimum of paperwork and multiple options for payment.
Mutual fund shares are bought from the mutual fund and sold back to the fund. Except in those circumstances where a broker or sales agent is involved, you almost always deal directly with the fund.
Mutual funds are not bothered with transacting fractional shares. Unlike common stock, you buy mutual funds in dollar amounts and the fund converts your investment into the correct number of shares based on the NAV at the time of your investment, even if that results in an uneven number of shares.
Most of the larger fund companies maintain extensive Internet sites and customer service phone banks to answer questions and process purchases and redemptions.