Open-Ended Mutual Funds Mutual fund basic
Open-Ended Mutual Funds
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- Let's say Pete over here thinks that he's a pretty good investor,
- so what he does is, or he has an idea, and says
- "Well look, I'm gonna create a corporation,
- and I'm gonna get a bunch of people to contribute money to that corporation
- and then I'll manage that money, and maybe I'll take a little fee for myself
- so that I can, um, maybe hire some analysts
- or get some computers, or get some office space."
- So what he does is he sets up a corporation
- Let's say he sets up a corporation right over here
- And let's say the way he first sets up the corporation
- let's say it just has 4 shares. And I making the number really small
- just to make the drawing and the map easy.
- This wouldn't be realistic, normally it would be something in the 100s or 1,000s of shares
- or maybe even more than that, but let's say it has 4 shares
- and let's say all of the 4 shares are owned by Pete initially
- just to simplify the explanation.
- And he puts in $400 into this corporation,
- so another way to think about it, in exchange putting $400 into this corporation
- he gets 4 shares, or each share is worth $100
- Each of these shares right over here.
- And so what he does, is he registers this corporation
- I'm talking about a US specific case, but there's similar types of organizations
- in other countries. He registers this organization right over here
- with the US SEC (Securities and Exchange Commission)
- And he also registers himself with the SEC, or even better
- he registers a management company that he runs with the SEC
- so let's call it "Pete, Inc." is a corporation he starts off
- that he also registers with the SEC.
- And when he registers with the SEC he tells them that look,
- "This company right over here, we're going to issue more shares
- for more people to contribute money, and I'm going to manage this money right over here
- and I'm just going to take a percentage of the total
- assets under management. Sometimes you'll see AUM used
- that just means Assets Under Management. That will go to Pete, Inc. every year
- for figuring out the best place to invest this money.
- And it's usually on the order of about 1%, sometimes a little bit less
- sometimes a little bit more, so 1% per year.
- So right now with only $400 under management, it would only be about $4 per year
- but since he registered with the SEC
- he can call himself a mutual fund and he can
- solicit funds from the public. So it is a mutual fund
- he has met, he has jumped through all the hoops
- that the SEC sets up for him, so he can market
- he can market himself as some type of great fund manager
- we don't know if that true or not,
- and he can also solicit funds from the public
- So from the public.
- And we're gonna see in future videos there are other funds,
- especially hedge funds, that can't just, that one
- they can't market, and they can't take funds from the public,
- those can only take funds from certain types of sophisticated
- investors. And what happens in Pete's fund
- and this isn't going to be an open-ended mutual fund,
- that we're showing here, and most mutual funds are like that
- let's say that Sal comes along, he likes Pete's marketing materials,
- and he says, "Hey, I want Pete to manage my money too!"
- So Sal goes and he gives $100 and says "Pete, give me a share!"
- So Pete creates another share right over here
- he creates another share, he gives it to Sal
- so he gets 1 share -- that's me, I get 1 share,
- an in exchange I give $100 to the fund,
- and now the fund has, the fund has $500
- So this is another $100 right over here,
- and now Pete's annual fee is going to be 1% of this whole thing
- or $5 a year, and if this whole thing grows,
- let's say this whole thing doubles from $500,
- let's say it doubles to $1,000,
- then that $1,000 is essentially split amongst these
- 5 shares now, so all of the people will essentially have
- their money doubled, minus whatever Pete's expenses are.
- So let's say that a year goes by,
- and then even after paying Pete the 1%
- So we had $500 of assets under management,
- this whole assets under management a year later
- goes to, let's say it goes to $1,000
- So Pete is either really good or really lucky
- or a little bit of both. So it goes to $1,000.
- So let me draw it like this.
- So now it is at $1,000 and it still has the same 5 investors here
- and I'm lucky enough to be one of them.
- So here, the 5 investors. Let me draw the shares,
- so there's 1, 2, 3, 4, 5 shares.
- Now each of these shares, well the $1,000 is called the
- NAV, the Net Asset Value, so let me give you that
- piece of terminology, it just means
- Net Asset Value, and so there's an NAV
- per share, the NAV per share over here his $200
- I just took the total NAV and I just divided it by the shares,
- and what's special about an open-ended mutual fund
- is that the close, or at the end of every day
- either new shares can be removed from the fund
- or can be created for the fund. So in the first video
- I showed how I wanted to buy into the fund,
- so I bought a share, and that increased the NAV
- and also increased the number of shares,
- he had to create a share for me to buy,
- he didn't sell me a share that already existed.
- So you can imagine after this type of performance
- more people would want to buy shares,
- so now they would have to buy in to make things fair
- at $200 per share, because that's the current NAV per share
- so let's say that 5 more people want to buy in
- at $200 per share. So what Pete would do, or what
- this mutual fund, it's not Pete really, it's the corporation
- it would create 5 new shares, so 1, 2, 3, 4, 5,
- if there was only 1 person that day, it would create 1 share
- that day, if there were 10 people that day,
- it would create 10 shares that day
- and it could keep doing this, and the NAV of each of these
- are $200, so it gives these shares to each of these people
- and they have to contribute $200, so essentially
- it puts another $1,000 into the pool that Pete
- can now manage, and so now he's met the total
- NAV for the fund is $2,000 now, and Pete
- will get his 1% management fee off of this entire
- $2,000. Now let's say we fast forward a little bit,
- we fast forward a little bit to-
- let's say Pete start having a not-so-good year.
- So let's say we fast forward a year past that,
- and Pete's has a minus, a negative 10% return.
- So if we started at $2,000, and that's when you include
- taking his management fee out. You start at $2,000
- you lose 10% in 1 year, so it goes down to $1,800
- Let me put this in a new color.
- So now he's at $1,800. That's not completely drawn to scale,
- but hopefully you get the idea.
- So now he's at $1,800.
- But you still have a total of 10 shares,
- So let me try to do my best to draw the 10 shares,
- So I have 1, 2, 3, 4, 5, 6, 7, 8, 9, 10.
- These should be of equal size.
- And now the NAV per share, the NAV per share
- is going to be $1,800 divided by 10, or $180
- And let's say that I get a little bit freaked out
- by this recent performance, and I have some
- other commitments with my money,
- so I say, "Pete, you need to buy my share back for me."
- So what Pete does, is he would give me back $180,
- so the total NAV would lose $180, so it would go down $180
- So we would take this out of it,
- $1,800 minus $180 is $1,620. So now it is $1,620.
- And they would buy back a share from me,
- so they would cancel 1 of the shares,
- but notice, the NAV per share does not change,
- by me redeeming my share, it does not change
- what happens to everyone else.
- Now you have $1,620 divided by 9 shares,
- that should still get you to be $180 per share.
- If I did my math right.
- So $1,800 minus $180 gets you $1,620,
- it should still be $180 per share,
- but this is the nature of an open-ended fund,
- you could keep creating shares and selling them to the public to raise more money
- or when someone wants their money back
- you essentially buy the share back from them
- give them their money when you buy the share back
- and you remove that share.
- So an open-ended fund, really at the close of every
- trading day can keep growing or shrinking.
- It can keep adding more and more investors,
- or their investors can take their money back.
- What's difficult about this from the fund manager's point of view
- is that they have to manage this,
- they have to manage this constant buying and selling
- with the public, they have to manage the paperwork,
- and if you think about it, they can't have all of their money invested
- in relatively illiquid assets,
- or even in regular stocks,
- they have to keep some amount of their money
- and it's usually like 3-5%, they have to keep some of this
- $2,000 (before he lost my money)
- they have to keep some of it in cash.
- And from an investor's point of view,
- they would say, "Well, if I'm good at investing,
- I should try to minimize the amount of cash that I have,
- because I'm not getting a return on cash,
- but because it's open-ended, because investors
- might come by and say, "Hey, I want my money"
- you have to have a little bit of cash as part of the asset pool
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