Mutual Funds and Investment Companies

Most retail investors own funds rather than individual stocks, so fund questions run through the products section. Two facts settle almost all of them: how the shares price, and what the investor pays.

Three ways to package a portfolio

An investment company pools money from many investors and invests it in securities. The Investment Company Act of 1940 sorts investment companies into three classes: face-amount certificate companies (nearly extinct), unit investment trusts, and management companies. Management companies split again into open-end and closed-end.

An open-end fund, better known as a mutual fund, issues new shares whenever an investor buys and redeems them whenever an investor sells. You buy from the fund and sell back to the fund.

A closed-end fund sells a fixed number of shares in one public offering, then stops issuing. Its shares trade on an exchange at a price set by supply and demand. That price can run above NAV (a premium) or below it (a discount). Closed-end funds may also borrow money and issue preferred stock; open-end funds may not.

A unit investment trust (UIT) buys a fixed portfolio, holds it, and ends on a set termination date. No adviser trades the portfolio and no board of directors oversees it. Its units are redeemable by the trust.

NAV and the price you pay

Net asset value (NAV) per share is the fund's total assets minus its liabilities, divided by the shares outstanding. An open-end fund computes NAV every business day, usually at 4:00 p.m. Eastern when the New York Stock Exchange closes.

Fund orders follow forward pricing: your order gets the next NAV the fund computes after it arrives. An order at 2:00 p.m. gets today's closing price; an order at 4:30 p.m. gets tomorrow's.

The public offering price (POP) is NAV plus any front-end sales charge. The charge is a percentage of the POP, not of NAV, so POP = NAV / (1 minus the sales charge). A fund with a $9.50 NAV and a 5% charge prices at $10.00.

An investor who redeems receives NAV, less any charge that applies at redemption. The fund must pay within seven days.

Loads and share classes

A load is the sales charge that pays the firm selling the fund. One portfolio is often sold in three classes that charge it differently.

• Class A shares carry a front-end load, taken from your money on the day you buy. Invest $10,000 with a 5% load and $9,500 buys shares. Class A has the lowest annual fees and qualifies for breakpoints.
• Class B shares carry no front-end load. They charge a contingent deferred sales charge (CDSC) on redemption. It shrinks each year and reaches zero after six or seven years. Annual fees run higher, and most fund families stopped selling them.
• Class C shares carry a level load. There is no front-end charge and a 1% CDSC inside the first year, but the high annual fee never steps down.

A large investment held for years belongs in Class A, where breakpoints cut the load and the annual fee stays low. A two or three year holding period suits Class C.

A no-load fund sells its shares with no sales charge at either end. It still charges annual operating expenses, and it may charge a 12b-1 fee of up to 0.25%.

FINRA caps a mutual fund's sales charges at 8.5% of the POP. A fund may charge the full 8.5% only if it meets three conditions, covered next.

Breakpoints, rights of accumulation, letters of intent

A breakpoint is an investment level at which the front-end load drops. A fund might charge 5.75% under $25,000, 5.00% from $25,000, and 4.50% from $50,000. An individual, a spouse, and dependent children can combine purchases to reach one. An investment club cannot.

Before you recommend an amount, check the next breakpoint. Selling a customer $24,000 when $25,000 would cut the load is a breakpoint sale, which FINRA Rule 2342 prohibits.

Rights of accumulation (ROA) let an investor count holdings already owned in the fund family toward the breakpoint on a new purchase. No promise is needed. An investor holding $40,000 who adds $10,000 reaches the $50,000 breakpoint.

A letter of intent (LOI) is a written commitment to invest a breakpoint amount within 13 months. The investor gets the lower charge from the first purchase. The fund holds shares in escrow and sells them to collect the difference if the investor falls short. An LOI can be backdated 90 days to cover an earlier purchase.

The exam swaps these two constantly. An LOI is a promise about future buying. ROA counts buying already done.

A fund may charge the full 8.5% load only when it offers all three: breakpoints, rights of accumulation, and dividend reinvestment at NAV.

Yearly fees and required disclosures

The expense ratio is the fund's yearly operating cost as a percentage of assets: the management fee, the 12b-1 fee, and administrative costs. Sales loads sit outside it.

A 12b-1 fee, named for the SEC rule that permits it, pays for distribution, marketing, and shareholder services out of fund assets each year. FINRA caps it at 0.75% for distribution plus 0.25% for service.

Every buyer of open-end fund shares gets a prospectus no later than the trade confirmation. A fund may send a summary prospectus instead when the full statutory prospectus is free online. The statement of additional information (SAI) holds the deeper detail and goes free on request. Funds also send shareholder reports yearly and at the half year.

A closed-end fund delivers a prospectus in its public offering. Later purchases on the exchange bring a commission and a confirmation, with no prospectus.

How this gets tested

• Structure: ask who redeems the shares. Open-end funds and UITs do; closed-end funds do not, which is why only closed-end prices drift to a premium or a discount.
• Pricing: the NAV formula, forward pricing, and the POP.
• Cost: given an amount and a holding period, which share class costs the investor less.
• Discounts: an LOI against ROA, and the breakpoint sale violation.