How Mutual Fund Trading Works

How Mutual Fund Trading Works

How Mutual Fund Trading Works

Many investors have neither the time, the inclination or the available funds to hand-pick and manage a portfolio of hundreds of investments. For those types of investors, a mutual fund can be a good investment solution. For day traders or those who rapidly move in-and-out of investments, a mutual fund isn’t the answer. Mutual funds have limited liquidity, which means investors can only buy and sell funds at certain times. Thus, they are inherently different than stocks, regarding how they work, how they are priced and what type of investor they are designed for.

What Is a Mutual Fund?

A mutual fund is an investment that pools money from many investors. These collective funds are pooled together and invested as a single entity by professional money managers. Unlike stocks, which are individual investments, a mutual fund can hold hundreds of different securities at one time.

There are thousands of mutual funds available for purchase by private investors. Some charge upfront fees, known as loads, while others are “no-load” and only charge ongoing management expenses.

Fund managers buy and sell securities based on the stated objectives of a mutual fund. You can find a mutual fund to cater to nearly any conceivable investment philosophy. Some funds are high-risk, high-reward, while others are conservative. Some only invest in large U.S. stocks, while others invest in companies based in emerging markets like Indonesia or the Philippines. Some funds invest in U.S. Treasuries, while others invest in low-rated bonds from companies in financial distress. The point is that with some research, you’re likely to find many funds that can match both your investment objective and your risk tolerance.

Mutual Fund Pricing

Traditional mutual funds don’t trade on a stock exchange. Rather, investors must buy or sell shares directly from the fund companies themselves. As a result, funds are only priced once per day, after the markets close. No matter what time of day you enter your order, you’ll get the same closing price as every other buy or sell order entered that day for that particular mutual fund.

Part of the reason for this pricing structure is that mutual funds are collective investments. Although you can easily tell the price of a stock at any moment of the day, mutual funds have lots of moving parts. Each security within a mutual fund has its daily closing price. To get the price of a mutual fund as a whole, the total value of all of these investments are tallied up every day and divided by the number of outstanding mutual fund shares after the market closes. This calculation provides a number known as a net asset value or NAV. Net asset value per share is reported every day at about 6 p.m. ET, and it represents the price at which all mutual fund orders are executed for that day.

Mutual Fund Gains and Losses

Although the movement of a fund’s NAV is one way to measure profits and losses, that is not the only return component of a mutual fund. After all, when you invest in individual stocks and bonds, you also earn dividends and interest. What does a mutual fund do with those types of distributions?

Technically, a mutual fund is known as a Regulated Investment Company. To keep its status as a RIC and to avoid corporate taxation on all the dividends and interest it receives, a mutual fund, by law, must distribute at least 90 percent of those earnings. Practically speaking, most mutual funds distribute all of those earnings to shareholders.

In addition to dividends and interest received, funds also pay out capital gains distributions to shareholders, often in December. Capital gains distributions reflect the realized profits that funds receive throughout the year based on the sales of profitable positions. All fund distributions to shareholders are taxed based on the investor’s tax rate, not the tax rate of the mutual fund.

When mutual funds report their performance figures, they factor in both the change in the fund’s NAV and the total amount of dividends or interest received.

Day Trading Funds

A day trader is a market participant who is looking for a quick profit on an investment. A day trader buys and sells the same security within minutes or hours and never holds a position overnight. Day trading and mutual fund investing are not compatible. For starters, mutual funds are intended to be long-term investments. Some funds impose short-term trading fees to prevent a mutual fund round trip or the rapid buying and selling of a fund. On a practical level, trading mutual funds are impossible, as funds are only priced once per day. A day trader who puts in an order to buy at 10 a.m., 11 a.m. and 12 p.m. will not see those orders executed until after the market closes, and they will all execute at the same price.

Even if a day trader could buy and sell mutual fund shares within a single day, funds are still not an optimal day trading vehicle. Mutual funds are typically much less volatile than individual stocks because they are diversified. As some investments within the fund go up in value, others likely go down in value. Spread out over hundreds of investments, mutual funds' collective effect is to dampen the volatility of the individual securities. A day trader, on the other hand, seeks out volatile securities to profit as much as possible from rapid, large price movements. Those can be hard to come by in your typical, garden-variety mutual fund.

Can You Buy and Sell Mutual Funds Like Stocks?

Although traditional mutual funds are not an avenue for day traders, a newer version of funds known as exchange-traded funds might be. An exchange-traded fund, or ETF, is a type of mutual fund that trades on an exchange, like a stock. Investors can buy or sell shares of an ETF at any time that the market is open. Thus, a day trader can jump in and out of an ETF just like they could with an individual stock.

Exchange-traded funds are different than traditional mutual funds in a few ways, however. For starters, many ETFs employ passive investing strategies and merely try to replicate the performance of an underlying index. For example, the largest publicly traded ETF, symbol SPY, tries to replicate the performance of the S&P 500 index. For some investors, this is a plus; others prefer the active management style of a traditional mutual fund, with a professional money manager picking and choosing individual securities with the best opportunity for appreciation.

Cost is another difference. Although some mutual funds still charge an upfront fee to purchase shares, others are no-load, charging no commission to buy or sell shares. Exchange-traded fund transactions typically incur a commission charge from a brokerage firm.

Another difference is in pricing. Mutual funds are always priced at the true net asset value of the underlying securities. Exchange-traded funds, on the other hand, trade at whatever price the market will bear. Demand for a certain ETF can push that fund's market price above the value of the underlying securities in its portfolio.

Even with the added flexibility and liquidity that ETFs offer, brokerage firms including Fidelity generally discourage day trading funds for most investors.

The Bottom Line

Traditional mutual funds are diversified, long-term investments. They are priced once per day and are not intended to be bought and sold numerous times. Those looking for a more actively traded investment may prefer exchange-traded funds, which can be bought and sold at any time throughout a trading day. However, this type of trading may incur additional trading costs and taxes. Investment houses such as Fidelity generally don't recommend day trading for most investors.

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About the Author

John Csiszar served as a financial adviser for over 18 years, both for a global wirehouse and at his own investment advisory firm, earning a Certified Financial Planner designation along the way. He now works as a writing and editing contractor for private clients, with thousands of online articles to his credit, along with five educational books written for young adults.