Smart Investor

Mutual Fund Mechanics

The mutual fund industry is vast and complex, managing over $12.5 trillion spread across more than 7,500 mutual funds. While most investors probably hold a large percentage of their investments in mutual funds, how many truly understand the inner workings of mutual funds and how they are structured? With our guide, you will quickly learn the basics of how the mutual fund industry operates.

The entire premise of the mutual fund industry is that average, individual investors can pool their assets to invest as one entity in an effort to reduce risk and maximize return. If one million people invest $10,000 each in the same mutual fund, the fund now has pooled together $10 billion to invest, which allows the fund to be much more diversified and invested in more securities than any investor would have been on an individual basis.

One of the major distinctions between the mutual fund industry and the stock market is that stocks are traded on public exchanges, often with dedicated market makers, who buy and sell shares to maintain liquidity in the system. A stock trade needs three parties: the buyer, the seller, and the exchange. Most mutual fund transactions, however, are private, requiring only the buyer/seller and the mutual fund company, i.e., an investor can open an account directly with the mutual fund company and purchase shares in a mutual fund without any assistance.

Mutual funds are able to operate in this manner because they are constantly creating and eliminating shares of the mutual fund. Unlike the common stock of a public company, which has a fixed number of shares outstanding, the number of mutual fund shares is a flexible, always changing number. When you buy stock, it means someone else is selling it, and the same shares just trade hands. However, when you invest in a mutual fund, the fund issues completely new shares based on the current value of the portfolio and issues the shares only to you.

When you are ready to sell, you turn your shares back in to the mutual fund company, which decreases the number of shares outstanding as the fund company “de-issues” them. The mutual fund industry also calls this process of selling your shares “redeeming”—since you are technically not selling your shares to a buyer but simply redeeming your shares at their face value, the term redeem is much more accurate.

As you can see, the mechanics of mutual fund investing differ significantly from stock trading. By understanding these important, yet subtle differences, you will have a much better understanding of what happens when you buy or redeem shares in a mutual fund.

 

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