Open-end mutual fund redemptions (part 2) | Finance & Capital Markets | Khan Academy


Let’s continue with the
story of Pete’s mutual fund. So let’s say that a year goes by
and that even after paying Pete the 1%, so it had $500 of
assets under management, this whole assets under
management a year later, let’s say it goes
to, like I mentioned at the end of the
last video, $1,000. So Pete either is really
good at 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 that
$1,000, and it still has the same five
investors here. And I’m lucky enough
to be one of them. So here are the five investors. Let me draw the shares. So there’s one, two,
three, four, five shares. Now, each of the
shares– well, the $1,000 is called the NAV, or
the net asset value. So let me give you that
piece of terminology, just means net asset value. And so there’s an NAV per share. The NAV per share right
over here is $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 at the close, or at
the end of every day, either new shares can
be removed from the fund or could 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 increase the NAV. And it also increased
the number of shares. He had to create a
share for me to buy, he didn’t sell me 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 five 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 five new shares. So one, two, three, four, five. If there was only
one person that day it would create
one share that day. If there was 10
people that they would create 10 shares that day. And it could keep doing this. And the NAV of each
of these are $200. So it gives the shares
to each of these people. And they had to contribute $200. So essentially it puts
another $1,000 into the pool that Pete can now manage. And so now 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 that we
fast forward a little bit. We fast forward a
little bit to let’s say Pete starts having
a not so good year. So let’s say we fast
forward a year past that and Pete has a
negative 10% return. So if you started at
$2,000, and that’s when you include taking
his management fee out, you start at $2,000, you
lose 10% in one year. So it goes down to $1,800. Let me do this in a new color. So now he’s at $1,800. It’s not completely
drawn to scale, but hopefully you get the idea. So now he is at $1,800. But you still have a
total of 10 shares. So let me do my best
to draw the 10 shares. So I have one, two, three, four,
five, six, seven, eight, nine, 10. These should be of equal size. And now 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 from me. So what Pete does is he
would give me back $180. So the total NAV
would lose $180. So it would go down to $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
one 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
one $180 per share. But this is the nature
of an open-ended fund. You can 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 it 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 could be 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% to 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 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 in order to be able to
buy people’s shares back.

2 thoughts on “Open-end mutual fund redemptions (part 2) | Finance & Capital Markets | Khan Academy

  1. @shresht123 Buy back shares means for Pete (the company) to literally buy back the share, and thus, eliminating a share from the pool of total shares (decreasing right hand side of balance sheet)…This also decreased the total pool of money (decreasing the left hand side of balance sheet)…Therefore, the share was completely eliminated, decreasing the total size of the mutual fund. Hope this helps.

  2. What is the company doing with the AUM? I'm assuming that money is going toward the company to keep it running in some way?

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