Explain mutual funds and how they differ from other pooled investment vehicles
The idea
A mutual fund pools investors' money into a professionally managed portfolio. An open-end fund issues and redeems shares at net asset value, which is assets minus liabilities divided by shares outstanding, calculated at the end of each day. A closed-end fund issues a fixed number of shares that then trade on an exchange, so its price can sit at a premium or discount to NAV. Exchange-traded funds also trade on an exchange throughout the day, but authorised participants can create and redeem shares, usually in kind, which keeps price close to NAV and tends to make ETFs tax-efficient. A separately managed account gives the investor direct ownership of the securities, allowing customisation and tax management, at the cost of higher minimums. Hedge funds and private equity funds are also pooled but are generally limited to qualified investors, less regulated, less liquid and charge performance fees.
Formulas
Net asset value per share
NAV per share = (assets − liabilities) ÷ shares outstanding
- assets
- the market value of everything the fund holds
- liabilities
- what the fund owes, such as fees and borrowing
- shares outstanding
- the number of shares or units in issue
An open-end fund deals at this value. A closed-end fund or exchange-traded fund trades at a market price that can sit above it (a premium) or below it (a discount).
A practice question
Investors in an open-end mutual fund buy and redeem shares:
- from the fund itself, at net asset value - correct
- from other investors on an exchange, at market priceWhy not: That describes a closed-end fund or an ETF. Open-end shares are bought from and redeemed by the fund.
- from the fund, at a price negotiated with the managerWhy not: Open-end prices are set by net asset value, not by negotiation.
An open-end fund creates new shares when investors buy and cancels them when they redeem, always at the day's NAV.
A harder one
What mainly keeps an ETF's market price close to its net asset value?
- A rule that fixes the ETF price at NAVWhy not: No rule fixes the price. It stays close to NAV because arbitrage keeps it there.
- Daily buy-backs by the fund managerWhy not: The fund does not buy back shares each day. Authorised participants create and redeem them.
- Creation and redemption by authorised participants - correct
If the ETF trades above NAV, authorised participants deliver the underlying securities for new shares and sell them; below NAV, they redeem. This arbitrage limits the gap.
The hardest tier
A high-net-worth investor wants to harvest tax losses on individual holdings and exclude certain companies. Which vehicle best fits?
- An open-end mutual fundWhy not: Fund shareholders own units of a pool, so they cannot direct tax lots or exclusions.
- A separately managed account - correct
- A closed-end fundWhy not: Also a pooled vehicle; investors own fund shares, not the underlying securities.
In a separately managed account the investor owns the securities directly, so the portfolio can be customised and tax lots managed for that investor alone.
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