How it works
Money paid in buys units; the manager invests it. Each unit is an equal share of everything the fund holds. The fund is “open-ended”: when money comes in, new units are made, and when an investor leaves, their units are cancelled and they are paid from the pool.
A unit’s price is the net asset value: everything the fund owns, less anything it owes, divided by the number of units. It is worked out once each dealing day, after the markets the fund invests in have closed, using closing prices.
An order placed during the day is not dealt at once. It waits, with everyone else’s, until that day’s price is struck, and all of them deal at that one price. An investor therefore does not know the exact price when placing the order. An order that arrives after the day’s cut-off time gets the next day’s price.
Some funds try to match an index; others, called actively managed, pay a manager to choose holdings in the hope of beating one. The fund’s documents state what it may hold, what it charges and how often it deals.
What it costs
- The ongoing charge, taken from the fund each year as a percentage of its assets. It is deducted inside the fund, so it never appears as a bill.
- An entry or exit charge, in some funds, taken from money going in or coming out.
- A performance fee, in some funds, taken when the fund beats a stated target.
- The fund’s own dealing costs when the manager buys and sells holdings, which reduce its return and are reported separately from the ongoing charge.
- A platform or adviser charge, where the fund is held through one.
The risks
- The fund’s price falls when its holdings fall. Pooling spreads the risk across many holdings; it does not remove it.
- A manager’s choices can do worse than the market the fund is measured against, for years.
- A fund that holds things that are slow to sell, such as property, may suspend dealing when many investors want to leave at once, and the money is then out of reach until it reopens.
- The price at which an order deals is not known when the order is placed.
- Currency risk, when the holdings are priced in other currencies.
Where people go wrong
- Choosing a fund on its recent results. A good past period says little about the next one.
- Treating a 1% or 2% yearly charge as small. Taken every year from the whole amount, it compounds like growth in reverse.
- Reading the fund’s name instead of its holdings and rules.
- Owning many funds that hold much the same things.
- Expecting to get out instantly at a known price. A fund deals once a day, and can stop dealing.
Questions people ask
- What does net asset value mean?
- It is the value of everything a fund owns, less anything it owes. Divided by the number of units in issue, it gives the price of one unit. It is calculated once each dealing day.
- Why can’t a mutual fund be bought at the price shown right now?
- The price shown is the last one struck, usually yesterday’s. A new order deals at the next price to be calculated, after the markets close, so that nobody can deal at a price that is already out of date. This is called forward pricing.
- Is a mutual fund safer than buying shares directly?
- It is usually more spread out, so the failure of one company does less damage. It still rises and falls with the markets it holds, and its charges are taken whatever the result.
The words on this page
A general explanation for study, with invented examples. Costs, taxes and rules differ by country, market and product, and the documents of the thing itself are what count. Educational information, not investment advice or a recommendation to trade.