How does a Mutual Fund Exchange work

how mutual funds operate and how is mutual fund different than stock and how to calculate mutual fund net asset value and how mutual funds are managed
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Published Date:17-07-2017
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MUTUAL FUNDS and ETFS A Guide for InvestorsHow Mutual Funds and ETFs Work How Mutual Funds Work A mutual fund is an SEC-registered open-end investment company that pools money from many investors and invests the money in stocks, bonds, short-term mon- ey-market instruments, other securities or assets, or some combination of these investments. The combined securities and assets the mutual fund owns are known as its portfolio, which is managed by an SEC-registered investment adviser. Each mutual fund share represents an investor’s proportionate ownership of the mutual fund’s portfolio and the income the portfolio generates. Investors in mutual funds buy their shares from, and sell/redeem their shares to, the mutual funds themselves. Mutual fund shares are typically purchased from the fund directly or through investment professionals like brokers. Mutual funds are required by law to price their shares each business day and they typically do so after the major U.S. exchanges close. This price—the per-share value of the mutual fund’s assets minus its liabilities—is called the NAV or net asset value. Mutual funds must sell and redeem their shares at the NAV that is calculated after the investor places a purchase or redemption order. This means that, when an investor places a purchase order for mutual fund shares during the day, the investor won’t know what the purchase price is until the next NAV is calculated. 4 MUTUAL FUNDS AND ETFSTypes of Investment Companies There are three basic types of investment com- panies: Open-end investment companies or open- end funds—which sell shares on a continuous basis, purchased from, and redeemed by, the fund (or through a broker for the fund); Closed-end investment companies or closed- end funds—which sell a fixed number of shares at one time (in an initial public offer - ing) that later trade on a secondary market; and Unit Investment Trusts (UITs)—which make a one-time public offering of only a specific, fixed number of redeemable securities called units and which will terminate and dissolve on a date that is specified at the time the UIT is created. Mutual funds are open-end funds. ETFs are generally structured as open-end funds, but can also be structured as UITs. ETFs operate pursu- ant to SEC exemptive orders. U.S. SECURITIES AND EXCHANGE COMMISSION 5How ETFs Work Like mutual funds, ETFs are SEC-registered investment companies that offer investors a way to pool their money in a fund that makes investments in stocks, bonds, other assets or some combination of these investments and, in return, to receive an interest in that investment pool. Unlike mutual funds, however, ETFs do not sell individ- ual shares directly to, or redeem their individual shares directly from, retail investors. Instead, ETF shares are traded throughout the day on national stock exchanges and at market prices that may or may not be the same as the NAV of the shares. ETF sponsors enter into contractual relationships with one or more Authorized Participants—financial insti - tutions which are typically large broker-dealers. Typically, only Authorized Participants purchase and redeem shares directly from the ETF. In addition, they can do so only in large blocks (e.g., 50,000 ETF shares) commonly called creation units, and they typically “pay” for the cre- ation units in an in-kind exchange with a group or basket of securities and other assets that generally mirrors the ETF’s portfolio. Once an Authorized Participant receives the block of ETF shares, the Authorized Participant may sell the ETF shares in the secondary market to investors. An ETF share is trading at a premium when its market price is higher than the value of its underlying holdings. An ETF share is trading at a discount when its market price is 6 MUTUAL FUNDS AND ETFSlower than the value of its underlying holdings. A history of the end-of-day premiums and discounts that an ETF experiences—i.e., its NAV per share compared to its clos- ing market price per share—can usually be found on the website of the ETF or its sponsor. Like a mutual fund, an ETF must calculate its NAV at least once every day. U.S. SECURITIES AND EXCHANGE COMMISSION 7A Word about Exchange-Traded Products (ETPs) ETFs are just one type of investment within a broader category of financial products called exchange-traded products (ETPs). ETPs constitute a diverse class of financial products that seek to provide investors with exposure to financial instruments, financial benchmarks, or investment strategies across a wide range of asset classes. ETP trading occurs on national securities exchang- es and other secondary markets, making ETPs widely available to market participants including individual investors. Other types of ETPs include exchange-traded commodity funds and exchange-traded notes (ETNs). Exchange-traded commodity funds are structured as trusts or partnerships that phys- ically hold a precious metal or that hold a port- folio of futures or other derivatives contracts on certain commodities or currencies. ETNs are secured debt obligations of financial institutions that trade on a securities exchange. ETN payment terms are linked to the performance of a refer- ence index or benchmark, representing the ETN’s investment objective. ETNs are complex, involve many risks for interested investors, and can result in the loss of the entire investment. This brochure discusses only ETFs that are registered as open-end investment companies or unit investment trusts under the Investment Company Act of 1940. It does not address other types of ETPs, such as exchange-traded commodi- ty funds or ETNs. 8 MUTUAL FUNDS AND ETFSCommon Features of Mutual Funds and ETFs Some common features of mutual funds and ETFs are described below. Whether any particular feature is an advantage or disadvantage for you will depend on your unique circumstances—always be sure that the invest- ment you are considering has the features that are important to you. ■■ Professional Management. Most funds and ETFs are managed by investment advisers who are registered with the SEC. ■■ Diversification. Spreading investments across a wide range of companies or industry sectors can help lower risk if a company or sector fails. Many investors find it less expensive to achieve such diversification through ownership of certain mutual funds or certain ETFs than through ownership of individual stocks or bonds. ■■ Low Minimum Investment. Some mutual funds accommodate investors who don’t have a lot of money to invest by setting relatively low dollar amounts for the initial purchase, subsequent monthly purchases, or both. Similarly, ETF shares can often be purchased on the mar- ket for relatively low dollar amounts. U.S. SECURITIES AND EXCHANGE COMMISSION 9■■ Liquidity and Trading Convenience. Mutual fund investors can readily redeem their shares at the next calculated NAV—minus any fees and charges assessed on redemption—on any business day. Mutual funds must send investors payment for the shares within seven days, but many funds provide payment sooner. ETF investors can trade their shares on the market at any time the market is open at the market price—minus any fees and charges incurred at the time of sale. ETF and mutual fund shares traded through a broker are required to settle in three business days. ■■ Costs Despite Negative Returns. Investors in mutual funds must pay sales charges, annual fees, management fees and other expenses (discussed on pages 27-36), regardless of how the mutual fund performs. Investors may also have to pay taxes on any capital gains distribu- tion they receive. Investors in ETFs must pay brokerage commissions, annual fees, management fees and other expenses (discussed on pages 27-36), regardless of how the ETF performs. ETF investors may also have to pay tax- es on any capital gains distributions; however, because of the structure of certain ETFs that redeem proceeds in kind, taxes on ETF investments have historically been low- er than those for mutual fund investments. It is import- ant to note that the tax efficiency of ETFs is not relevant if an investor holds the mutual fund or ETF investment in a tax-advantaged account, such as an IRA or a 401(k). 10 MUTUAL FUNDS AND ETFS■■ Lack of Control. Investors in both mutual funds and ETFs cannot directly influence which securities are includ - ed in the funds’ portfolios. ■■ Potential Price Uncertainty. With an individual stock or an ETF, an investor can obtain real-time (or close to real-time) pricing information with relative ease by check- ing financial websites or by calling a broker. By contrast, with a mutual fund, the price at which an investor pur- chases or redeems shares will depend on the fund’s NAV, which the fund might not calculate until many hours after an order has been placed. U.S. SECURITIES AND EXCHANGE COMMISSION 11Factors to Consider Before Investing in Mutual Funds or ETFs: ■■ Determine your financial goals and risk tolerance . When it comes to investing in mutual funds and ETFs, investors have thousands of choices. Before you invest in any mutual fund or ETF, you must decide whether the investment strategy and risks are a good fit for you. You should also consider more generally whether the unique style of investing of the mutual fund’s or ETF’s sponsor is a good fit for you. The first step to successful investing is to figure out your current financial goals and risk toler - ance—either on your own or with the help of an invest- ment professional. ■■ Beware of risk. All investments carry some level of risk. An investor can lose some or all of the money he or she invests—the principal—because securities held by a fund go up and down in value. Dividend payments may also fluctuate as market conditions change. Mutual funds and ETFs have different risks and rewards. Generally, the higher the potential return, the higher the risk of loss. ■■ Consider the sponsor’s investing style. Before you in- vest, you may want to research the sponsor of the mutual fund or ETF you are considering. The sponsor’s website is often a good place to begin, and it is helpful to spend 12 MUTUAL FUNDS AND ETFSsome time browsing through the website to get a better understanding of the sponsor’s underlying philosophy on investing. Each sponsor has its own style of investing that will affect how it manages its mutual funds and ETFs. It is helpful to understand each sponsor’s style of investing, so you can better choose the right investment for you. ■■ Ask and check. Before you engage an investment professional or purchase shares of a mutual fund or ETF, make sure you research and verify relevant information to determine which option is best suited for you. • Investment professionals: Details on an investment professional’s background and qualifications are available on the SEC’s Investment Adviser Public Disclosure (IAPD) website ( or on the SEC’s website for individual investors, If you have any questions about check- ing the background of an investment professional, you can call the SEC’s toll-free investor assistance line at (800) 732-0330 for help. • Mutual funds and ETFs: You can research a mutual fund or ETF by reading its prospectus (discussed on pages 41-43) carefully to learn about its investment strategy and the potential risks. You can find the prospectus on the mutual fund’s or ETF’s website or U.S. SECURITIES AND EXCHANGE COMMISSION 13on the SEC’s EDGAR database ( edgar/searchedgar/mutualsearch.html) and down- load the documents for free. A Word about Derivatives Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security, or index. Even small market movements can dramat- ically affect their value, sometimes in unpredict - able ways. There are many types of derivatives with many different uses. A mutual fund’s or ETF’s prospectus will disclose whether and how it may use derivatives. An investor may also want to call a fund and ask how it uses these instruments. Different Types of Mutual Funds And ETFs Mutual funds and ETFs fall into several main categories. Some are bond funds (also called fixed income funds), and some are stock funds (also called equity funds). There are also funds that invest in a combination of these categories, such as balanced funds and target date funds, and newer types of funds such as alternative funds, smart-beta funds and esoteric ETFs. In addition, there are money market funds, which are a specific type of mutual fund. 14 MUTUAL FUNDS AND ETFS■■ Bond Funds Bond funds invest primarily in bonds or other types of debt securities. They generally have higher risks than money market funds (discussed on pages 20-21), largely because they typically pursue strategies aimed at produc- ing higher yields. Unlike money market funds, the SEC’s rules do not restrict bond funds to high-quality or short- term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards. Some of the risks associated with bond funds include: • Credit Risk—the possibility that companies or other issuers whose bonds are owned by the fund may fail to pay their debts (including the debt owed to holders of their bonds). Credit risk is less of a factor for bond funds that invest in insured bonds or U.S. Treasury Bonds. By contrast, those that invest in the bonds of companies with poor credit ratings generally will be subject to higher risk; • Interest Rate Risk—the risk that the market value of the bonds will go down when interest rates go up. Because of this, an investor can lose money in any bond fund, including those that invest only in insured bonds or U.S. Treasury Bonds. Funds that invest in longer-term bonds tend to have higher interest rate risk; and, U.S. SECURITIES AND EXCHANGE COMMISSION 15• Prepayment Risk—the chance that a bond will be paid off early. For example, if interest rates fall, a bond issuer may decide to pay off (or retire) its debt and issue new bonds that pay a lower rate. When this happens, the fund may not be able to reinvest the proceeds in an investment with as high a return or yield. ■■ Stock Funds Stock funds invest primarily in stocks, which are also known as equities. Although a stock fund’s value can rise and fall quickly (and dramatically) over the short term, historically, stocks have performed better over the long term than other types of investments—including corpo- rate bonds, government bonds, and treasury securities. Stock funds can be subject to various investment risks, including Market Risk, which poses the greatest potential danger for investors in stock funds. Stock prices can fluctuate for a broad range of reasons—such as the overall strength of the economy or demand for particular products or services. ■■ Balanced Funds Balanced funds invest in stocks and bonds and some- times money market instruments in an attempt to reduce risk but still provide capital appreciation and income. They are also known as asset allocation funds and typ- ically hold a relatively fixed allocation of the categories of portfolio instruments. But the allocation will differ 16 MUTUAL FUNDS AND ETFSfrom balanced fund to balanced fund. These funds are designed to reduce risk by diversifying among investment categories, but they still share the same risks that are associated with the underlying types of instruments. ■■ Target Date Funds Also called target date retirement funds or lifecycle funds, these funds also invest in stocks, bonds, and other investments. Target date funds are designed to be long-term investments for individuals with particular retirement dates in mind. The name of the fund often refers to its target retirement date or target date. For example, there are funds with names such as “Portfolio 2050,” “Retirement Fund 2050,” or “Target 2050” that are designed for individuals who intend to retire in or near the year 2050. Most target date funds are designed so that the fund’s allocation of investments will auto- matically change over time in a way that is intended to become more conservative as the target date approaches. That means that funds typically shift over time from a mix with a lot of stock investments in the beginning to a mix weighted more toward bonds. Even if they share the same target date, target date funds may have very different investment strategies and risks and the timing of their allocation changes may be different. They also may have different investment results and may charge different fees. Often a target date fund invests in other funds, and fees may be charged by both the target date fund and the other funds. In addition, U.S. SECURITIES AND EXCHANGE COMMISSION 17target date funds do not guarantee that an investor will have sufficient retirement income at the target date, and investors can lose money. Target date funds are gen- erally associated with the same risks as the underlying investments. ■■ Alternative Funds Alternative funds are funds that invest in alternative investments such as non-traditional asset classes (e.g., global real estate or currencies) and illiquid assets (e.g., private debt) and/or employ non-traditional trading strategies (e.g., selling short). They are sometimes called “hedge funds for the masses” because they are a way to get hedge fund-like exposure in a registered fund. These funds generally seek to produce positive returns that are not closely correlated to traditional investments or benchmarks. Many investors may see alternative funds as a way to diversify their portfolios while retaining liquidity. The risks associated with these investments vary depend- ing on the assets and trading strategies employed. These funds can employ complicated investment strategies, and their fees and expenses are commonly higher than traditionally managed funds. In addition, these types of funds generally have limited performance histories, and it is unclear how they will perform in periods of mar- ket stress. 18 MUTUAL FUNDS AND ETFS■■ Smart-Beta Funds These funds are index funds (discussed below) with a twist. They compose their index by ranking stock using preset factors relating to risk and return, such as growth or value, and not simply by market capitalization as most traditional index funds do. They aim to achieve better returns than traditional index funds, but at a lower cost than active funds. These funds can be more complicated and have higher expenses than traditional index funds, and the factors are sometimes based on hypothetical, backward-looking returns. In addition, these types of funds generally have limited performance histories, and it is unclear how they will perform in periods of mar- ket stress. ■■ Esoteric ETFs Esoteric or exotic funds are ETFs that focus on niche investments or narrowly focused strategies. They may be complicated investments and may have higher expenses. In addition, these ETFs are often thinly traded, which means they can be harder to sell and may have larger bid-ask spreads (discussed on page 32) than ETFs that aren’t as thinly traded. U.S. SECURITIES AND EXCHANGE COMMISSION 19A Word about Hedge Funds Hedge fund is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticat- ed, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numer- ous regulations that apply to mutual funds for the protection of investors—including regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against con- flicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more. ■■ Money Market Funds Money market funds are a type of mutual fund that has relatively low risks compared to other mutual funds and ETFs (and most other investments). By law, they can invest in only certain high-quality, short-term investments issued by the U.S. Government, U.S. corporations, and state and local governments. Government and retail money market funds try to keep their NAV at a stable 1.00 per share, but the NAV may fall below 1.00 if the fund’s investments perform poorly. Investor losses have been rare, but they are possible. • A Government Money Market Fund is a money market fund that invests 99.5% or more of its total assets in cash, government securities and/or repurchase 20 MUTUAL FUNDS AND ETFSagreements that are collateralized solely by govern- ment securities or cash. • A Retail Money Market Fund is a money market fund that has policies and procedures reasonably de- signed to limit all beneficial owners of the money market fund to natural persons. Other money market funds, however, have a floating NAV like other mutual funds that fluctuates along with changes in the market-based value of their portfolio securities. All money market funds pay dividends that gener- ally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds. A risk commonly associ- ated with money market funds is Inflation Risk , which is the risk that inflation will outpace and erode investment returns over time. Different Types of Investment Strategies ■■ Index-based Funds Index-based mutual funds and ETFs seek to track an underlying securities index and achieve returns that closely correspond to the returns of that index with low fees. They generally invest primarily in the compo- nent securities of the index and typically have lower management fees than actively managed funds. Some index funds may also use derivatives (such as options U.S. SECURITIES AND EXCHANGE COMMISSION 21or futures) to help achieve their investment objective. Index-based funds with seemingly similar benchmarks can actually be quite different and can deliver very dif - ferent returns. For example, some index funds invest in all of the companies included in an index; other index funds invest in a representative sample of the companies included in an index. Because an index fund tracks the securities on a particular index, it may have less flexibility than a non-index fund to react to price declines in the securities contained in the index. Also because market indexes themselves have no expenses, even a passively managed index fund can underperform its index due to fees and taxes. ■■ Actively Managed Funds The adviser of an actively managed mutual fund or ETF may buy or sell components in the portfolio on a daily basis without regard to conformity with an index, provided that the trades are consistent with the overall investment objective of the fund. Unlike similar mutual funds, actively managed ETFs are required to publish their holdings daily. Because there is no underlying index that can serve as a point of reference for investors and other market participants as to the ETF’s holdings, dis- closing the specific fund holdings ensures that market participants have sufficient information to engage in activity, called arbitrage, that works to keep the market price of ETF shares closely linked to the ETF’s under- lying value. 22 MUTUAL FUNDS AND ETFS

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