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An in-depth look at mutual funds, part 1

First introductory chapter: internal workings, the concept of NAV, growth vs. income funds, fees and taxes.

Other articles from this series

The world of investment funds is definitely huge. I tried to shed some light on the topic in one of my previous articles. In this episode I want to focus particularly on open-end mutual funds, a very common type of investment strategy. It's so well-known and established that when people talk about investment funds usually refer to open-end mutual funds.

How a mutual fund works

A mutual fund is a pool of stocks, bonds or commodities, aka securities mantained by a fund manager. The term mutual means that it's a sort of collective investment: you are combining your money alongside other investors who want to get into in a specific financial opportunity.

The fund managers raise money from the investors and invest it back in securities. They then do their best in studying the markets and buying/selling at the right time. Of course, in return for their support you have to pay a fee. The term open-end means that there are no restrictions in how many times you can invest in the fund.

Picture .1 below show the initial stage of an imaginary fund, boldly called Internal Pointers Mutual Fund. For example, the fund manager might collect $100 from the public, then buy 10 stocks where each is worth $10. Small numbers and only one type of security for simplicity's sake. Those stocks become something called units, or shares. They conceptually abstract away the underlying securities: you can think of them as tradable pieces of the mutual fund. Those $100 are the so-called Assets Under Management or AUM, namely the total securities' value.

Initial shares of a mutual fund
1. Initial stage of Internal Pointers Mutual Fund: 10 shares, 10 dollars each with 100 dollars of AUM.

NAV: Net Asset Value

The NAV (Net Asset Value) is one of the core concepts of a mutual fund: it's the value of a fund's securities minus its liabilities (i.e. debts or obligations). The NAV is typically calculated on a per-unit basis, which turns out to be the price at which you buy fund units, or in other words the fund's market value. Called NAV per unit (or also NAV per share), the formula is rather simple:

§NAV = "value of the securities" - "liabilities"§

§NAV_{unit} = {NAV} / "number of securities"§

In our example so far, let's pretend that Internal Pointers Mutual Fund owes $8 to its energy supplier:

§NAV_{unit} = {$100 - $8} / 10 = $9.2§

The NAV is computed at the end of each trading day, based on the closing market prices of the fund's securities. No, there's no place for day trading in mutual funds market.

Let's getting serious

One day you come along and decide to invest in Internal Pointers Mutual Fund: the NAV per unit is still fixed at $9.2 so you buy, say, 2 units for $18.4. The fund manager puts your money into the pool and issues new fund units for you, by buying more stocks from the market. Note: you don't actually own the stocks, but mutual fund units instead. Picture .2 below shows the process.

Adding more shares to the mutual fund
2. You buy more fund units: Internal Pointers Mutual Fund now contains 12 shares, 10 dollars each. AUM rises to $120.

As you may see the NAV per unit has adjusted: §{$120 - $8}/12~=$9.34§. Unlike stocks, where prices are moved by the supply and demand forces, fund prices are determined only by the number and the value of the underlying securities.

Also, fund units cannot be purchased from other investors on a market such as the New York Stock Exchange. You can buy units only from the fund itself, or through a broker for the fund.

How to make money from a mutual fund

At this point there are some ways you can make money from your mutual fund, as seen in the previous introduction. They can be summarized into income and growth classes. However you can also sell back your units to the fund, by making the so-called redemption.


The underlying securities yield something — the fund manager will pay out nearly all the incomes. Mutual fund yield is expressed as a percentage and is calculated as follows:

§"yield" = "security dividends" / "security price" * 100§

Say for example that Internal Pointers Mutual Fund's stocks pay $0.3 in dividends over the year and the stock value is still fixed at $10, so:

§{$0.3}/{$10} * 100 = 3%§

Let's compute now how much money would come from the yield. The math is quite common here: you own two units of Internal Pointer Mutual Fund, so your income is §$0.3 * 2 = $0.6§.


The underlying securities' value grows — here the fund manager can switch between two strategies:

  1. sell the securities (capital gain) — a capital gain occurs when the fund manager sells part of the securities for more than the purchase price. In Internal Pointers Mutual Fund the underlying stocks might rise to $14: if the manager sells part of them, say 3 stocks, the capital gain would be §$14*3 - $10*3 = $12§ (the new value minus the original value). When such thing happens, mutual funds are required by law to distribute almost all gains to their investors.

    Another thing that might happen: the NAV per unit adjusts a bit, because the number of securities has changed as well. Internal Pointers Mutual Fund initially owned 12 stocks, so the NAV summed up to:

    §NAV_{unit} = {12 * $14 - $8} / 12 = $13.34§

    (12 securities $14 each, $8 liabilities). Without those 3 stocks just sold, it becomes:

    §NAV_{unit} = {9 * $14 - $8} / 9 = $13.12§

    (9 securities $14 each, $8 liabilities). Lesson learned: if the NAV decreases a bit doesn't always mean that your fund is going bad.

  2. keep the securities — the fund's NAV grows as seen in the previous example where it rose to $13.34. There are no dividends to yield, but the overall fund's value increases.

Whenever the fund yields something, be it from the underlying stocks or from a sell of securities, you can choose between the accumulation or income version of a mutual fund, otherwise known as acc or inc. Buying the accumulation model would mean that the incomes would be reinvested back into the fund, while buying the income model would pay out to you in cash directly in your bank account.


Redempion occurs when you sell back the fund units. You can redeem part of your bag of units or the whole collection by selling them at the current NAV.

Taxes, fees and other nuisances

The real world a mutual fund brings up two main categories of expenses: expense ratio, or the cost of owning a fund, and sales loads, or the money you have to pay when you actually buy/sell fund units. They are a fundamental aspect to take into consideration when you are forecasting all the possible incomes/losses from your investments.

Expense ratio

The expense ratio is an annual fee that the fund managers charge the investor. More to the point, there are three main types of expenses:

  • management fees — the fund manager's salary;

  • administrative costs — the cost of running an organization;

  • 12b-1 distribution fee — marketing, advertising, and distribution services. The bizarre name comes from the section of the Investment Company Act of 1940 that makes them legal.

12b1-1 fees might seem almost insulting. Actually back in the early days of the mutual fund business, the 12b-1 fee was thought as a boost for the fund's assets as management could lower expenses because of economies of scale. This has yet to be proved.

In general, the expense ratio is expressed as a percentage and it's calculated as follows:

§"expense ratio" = "total fund expenses per year" / "averaged AUM"§

Note that averaged AUM: it is the total value of all the securities in the portfolio, less any liabilities, averaged over a period of time (usually one year). So for example Internal Pointers Mutual Fund might face $3 of annual expenses over an average AUM of $180, which turns out to be:

§"expense ratio" = {$3} / {$180} ~= 0.017 = %1.7§

Those expenses are buried into the NAV, so what you actually see in charts and official papers is the net NAV, made after the fees. You pay the fees just by holding fund units: nobody would suck that %1.7 from your account at the end of the year!

Sales loads

Sales loads occur whenever you buy or sell fund units. Funds that apply sales loads are called load funds. They usually come into play when you purchase fund units from your advisor, broker or any other middleman. There are two types of sales loads:

  • front-end sales loads — fees you have to pay at the time of the investment. For example, if you invest $1000 in Internal Pointers Mutual funds with a 3% front-end sales loads, $30 would be taken out from your account, so that you would end up with a $970 investment. Those money pays the broker and other intermediate layers.

  • back-end sales loads — fees you have to pay when you quit, i.e. when you redeem you units. Usually the fee amounts to a percentage of the value of the units you want to sold. That percentage decreases year after year until it eventually drops to zero. That way you are discouraged from buying and selling units at a very fast pace. For this very reason back-end loads are also known as redempion fees.

Do sales loads seem unreasonable to you? No-loads mutual funds are funds in which units are sold directly by the investment company without further fees.

The real-world complexity

Our fictional Internal Pointers Mutual Fund was obviously over-simplified. In the real world mutual funds hold hundreds of thousands of securities, often mixed between stocks, bonds, currencies and commodities and their exact composition is not completely undisclosed: the securities' picking is their secret recipe after all.

Moreover, operating and mantaining mutual funds include annual operating costs and sales charges, dividends might be non-periodic, liabilities change over the time: lots of aspects that complicate the math. I will evaluate such components more in detail in the second part of the article.


Khan Academy - Open-Ended Mutual Fund (video)
Investopedia - Assets Under Management - AUM (link)
InvestingAnswers - Net Asset Value (link)
Investopedia - How A Mutual Fund Works (link)
American Funds - Capital Gain Distribution FAQs (link)
Morningstar - Share Classes: Accumulation vs. Income (link) - Mutual Funds (link)
The Motley Fool - Expense Ratios (link)
Morningstar - Expense Ratio (link)
The Street - Are a Fund's Expenses Deducted Daily From Assets? (link)
About Money - Are No-load Mutual Funds Free? (link)

next article
An in-depth look at mutual funds, part 2