Investing in mutual funds isn't difficult, but it isn't quite the same as investing in exchange-traded funds (ETFs) or stocks, either. Because of their unique structure, there are certain aspects of trading mutual funds that may not be intuitive for the first-time investor. Due to past abuses, many mutual funds impose limitations or fines on certain types of trading activity.
Before you begin investing in mutual funds, consider the following trading guidelines. A basic understanding of the ins and outs of mutual fund trading can help you navigate the process smoothly and get the most out of your investment.
Buying Mutual Fund Shares
Buying mutual funds shares is fairly simple. While mutual funds are not traded freely on the open market, like stocks and ETFs, they are easy to purchase directly from the fund or through an authorized broker, often through an online platform.
Before purchasing shares in a mutual fund, understand what type of fund you're investing in and the specific terms of investment. Many funds require a minimum contribution, often between $1,000 and $10,000. However, not all funds carry minimums.
Research the fund's holdings, its expense ratio, and the fund manager's track record. If it is an indexed fund, check its historical tracking error. Like any investment, you should know what you're getting into.
Mutual Fund Share Prices
You can only purchase mutual fund shares at the end of the day. Unlike exchange-traded securities, the value of mutual fund shares does not fluctuate throughout the day. Instead, the fund calculates the net value of all the assets in its portfolio, called the net asset value (NAV), when the market closes each day. The market closes at 4 p.m. Eastern Time, and mutual funds typically post their current NAVs by 6 p.m.
If you want to buy shares, your order will be fulfilled after the day's NAV has been calculated. If you want to invest $1,000, for example, you can place your order at any time, but you won't know how much you'll pay per share until the day's NAV is posted. If the day's NAV is $50, then your $1,000 investment will buy 20 shares.
Mutual funds typically allow investors to purchase fractional shares. If the NAV in the above example is $51, your $1,000 will buy 19.6 shares.
Look at the costs associated with your investment before you purchase it. Mutual funds carry annual expense ratios equal to a percentage of your investment, and there are a number of other fees a mutual fund may charge.
Some mutual funds charge load fees, which are essentially commission charges. These fees do not go to the fund; they compensate brokers who sell shares in the fund to investors. Not all mutual funds carry upfront load fees, however. Instead of a traditional load fee, some funds charge back-end load fees if you want to redeem your shares before a certain number of years have elapsed. This is sometimes called a contingent deferred sales charge (CDSC).
Mutual funds may also charge purchase fees (at the time of investment) or redemption fees (when you sell shares back to the fund), which go to defray costs incurred by the fund rather than to brokers in lieu of commission. Most funds also charge 12b-1 fees, which go towards marketing and advertising the fund. Many funds offer different classes of shares, called A, B or C shares, which offer different fee and expense structures.
Trade and Settlement Dates
When trading mutual funds, understand how and when your trades will be executed. The date when you place your order to purchase or sell shares is called the trade date. However, the financial transaction is not finalized, or settled, until a number of days have elapsed. The Securities and Exchange Commission (SEC) requires mutual fund transactions to settle within two days after the trade date.
If you place an order to buy shares on Friday, Jan. 2, for example, a fund with a two-day settlement period is required to settle your order by Tuesday, Jan. 6, since trades cannot be settled over the weekend.
Ex-Dividend and Report Dates
If you are investing in a mutual fund that pays dividends but you want to limit your tax liability, find out when shareholders are eligible for dividend payments. Any dividend distributions you receive increase your taxable income for the year, so if generating dividend income is not your primary goal, don't buy shares in a fund that is about to issue a dividend distribution.
The ex-dividend date is the last date when new shareholders can be eligible for an upcoming dividend. Because of the settlement period, the ex-dividend date is typically three days prior to the report date – the date when the fund reviews its list of shareholders who will receive the distribution.
If you want to receive an upcoming dividend payment, purchase shares prior to the ex-dividend date to ensure your name is listed as a shareholder on the date of record. If you want to avoid the tax impact of dividend distribution, delay your purchase until after the date of record.
Selling Mutual Fund Shares
Just like your original purchase, you redeem mutual fund shares directly through the fund itself or through an authorized broker. The amount that you receive is equal to the number of shares redeemed multiplied by the current NAV, minus any fees or charges due.
Depending on how long you have held your investment, you may be subject to a CDSC. If you want to sell your shares very soon after purchasing them, you may be subject to additional fees for early redemption.
Early Redemption Regulations
Mutual funds are built to be long-term investments. Unlike stocks and ETFs, short-term trading of mutual fund shares can seriously deteriorate the returns of remaining shareholders.
When you redeem your mutual fund shares, the fund often has to liquidate assets to cover the redemption, since mutual funds are not in the habit of keeping cash on hand. Any time a fund sells an asset at a profit, it triggers a capital gains distribution to all shareholders, thereby increasing their taxable incomes for the year and reducing the value of the fund's portfolio. This kind of frequent trading activity also causes a fund's administrative and operational costs to rise, increasing its expense ratio.
To discourage excessive trading and protect the interests of long-term investors, mutual funds keep a close eye on shareholders who sell shares within 30 days of purchase – called round-trip trading – or otherwise try to time the market to profit from short-term changes in a fund's NAV. Mutual funds may charge early redemption fees, or they may bar shareholders who employ this tactic frequently from making trades for a certain number of days.