Most of our client assets are shares of open-end mutual funds.  When you think of a mutual fund, chances are you are thinking of the open-end variety.  The U.S. has thousands of funds in operation, holding hundreds of billions of dollars of assets.  There is such an animal as a closed-end fund, but those are relatively tiny and rarely used by most investors. I will confine this to the open-end variety.

A mutual fund is not an investment itself: it is a mechanism by which investors share common interest in a pool of other assets. In most cases those assets are stocks or bonds. Some mutual funds hold combinations of stocks and bonds, some hold other assets like commodities (precious metals, oil, etc) but the bulk hold stocks or bonds, which is how we use them to invest client assets and build portfolios.

The largest mutual fund in operation today is Vanguard’s 500 Index fund which mimics the movement of the S&P 500 index. It holds $157 billion in assets. Owning a share of this fund gives an investor exposure to 500 of the largest public companies in the US, and thus diversified exposure to the bulk of the stock market.  It’s this diversification at a rock-bottom cost that makes mutual funds such a powerful tool.

U.S. law requires the operator of a mutual fund to determine the net asset value (abbreviated “NAV”) of the fund once per day. This price coincides with the value of all of the assets of the fund at market close (4pm Eastern time) divided by the number of shares outstanding. The law requires the fund to permit customers to redeem their shares or buy new shares at that price.  The NAV for the Vanguard 500 fund (mentioned above) was 200.80 on Friday, so every person who bought shares that day paid $200.80 per share.  Conversely, everyone who sold shares that day received $200.80 per share.

It’s important to note that the underlying index on Friday ranged from a high of 2187.94 to a low of of 2160.39, but the only number that matters is the closing value.  This is one of the ways mutual funds discourage rapid trading: it is impossible to exploit intra-day differences in pricing.

In future installments, I will discuss the management and cost structure of mutual funds and how this works either for or against individual investors. I will also show the similarities and differences between open-end funds and alternatives such as exchange-traded funds (ETFs).