ShmoopTube

00:00

finance a la shmoop. what are mutual funds? well half a century and change ago

00:07

a bunch of investors wanted to mutually pool their assets to make investments [men carry bags of cash]

00:13

together. they mutually agreed to abide by a relatively simple set of rules and

00:19

then they gathered funds to go invest. well why would they do this?

00:24

well scale. you've heard of the notion that you get a discount when you buy in

00:29

volume or bulk right? well if not check these guys out

00:33

84 pounds of dog food for five bucks. even Fido can appreciate a good deal

00:37

when he sees it. dog food discounts we get but why would

00:40

anyone need to buy in bulk when investing in stocks and bonds?

00:44

well because back in the day the only way investors could invest in the stock

00:48

market was to buy an individual stock directly. same deal with a bond. a

00:53

typical stock might sell for 40 bucks a share. the problem was that if an

00:57

investor didn't buy a round lot of these shares while she was charged a massive

01:02

Commission. almost like a penalty for not being rich enough to buy a Costco type

01:07

portion of shares. well a round lot is any order that comes in blocks of a

01:11

hundred shares. ie 200 shares is a round lot, 500 shares is a round lot 738 shares

01:18

is not a round lot. some high-level calculus there. well the typical round

01:22

lot Commission might be 5%. an odd lot Commission might be 15%. so it made it

01:29

even harder for the small buyer to get invested in the market.

01:37

on a purchase of 100 shares at 40 bucks that's four grand. that's even a lot of

01:41

money today but think about what four grand bought you in 1952. but more than a [calculator showing inflation]

01:47

few hula hoops and a poodle skirt. inflation-adjusted it's almost 40 grand

01:51

today. it bought this and this and yes this so how is the average Josephina

01:56

able to plunk down 40 grand just on one stock?

02:00

well she's not. you know your grandma gooses catchphrase right? well the same

02:04

applies to investing four grand could be a life savings back then, and of a simple

02:09

retail investor put all her money in one stock and that stock tanked, then she was

02:15

Sol or sweetly out of luck. so mutual funds allowed that little guy investor

02:20

with very small amounts of money and for most it was a minimum of about two

02:25

hundred and fifty bucks, and it still applies today to pool his money with

02:28

thousands of other investors and get exposure to a basket of stocks. the fancy

02:34

$5 word here is diversification, and when assets are pooled that four grand of

02:39

mutual fund ownership might look something like this. well if a thousand

02:44

investors each put four grand on average into an investment pot well that would

02:48

give the pot four million dollars of buying power and it allow them easy

02:52

access or liquidity to have their four grand invested in a wide range of stocks

02:57

and bonds in whatever form they want it. and with a large pot of money to put to

03:01

work might they also get the ear of the company's CEO for 15 minutes a quarter?

03:06

would that ear make them invest the dough a bit more readily smartly better?

03:11

well maybe and at the end of the year let's say that four million was invested [chart picturing increase]

03:14

well and it has a value of 4.4 million bucks, that is it went up 10 percent in

03:19

a year. well when the thousand partners formed

03:22

the fund they agreed that they would divide the fund into slices of pie in

03:26

the same way that ownership of a company is divided into shares. well remember

03:31

Apple has over five billion shares outstanding. they trade it in 150 bucks

03:36

or so a share and multiplying the two together gives them a total market value

03:40

today of over 800 billion dollars. well the mutual fund might have two hundred

03:45

thousand shares outstanding so that at four million dollars of value

03:49

you to get the net asset value per share, or nav. you divide that total pi value by

03:56

the number of slices in it to get 4 million over 200,000 or 20 bucks a share.

04:01

now if the fund goes up 10% the number of shares outstanding in this scenario [equation]

04:05

hasn't changed, so the net asset value per share would be 22 bucks a share a

04:10

gain of 10%. in real life however investors buy additional shares in a

04:14

mutual fund and redeem them every day. why well they buy because rich uncle

04:20

Larry died and left him a million bucks and they already had that cool caveman

04:23

stereo. and they might sell because while the fund had a lousy performance and

04:27

their P.O.ed. or they might sell because the fund had great performance

04:31

and since they know that most investments regress to the mean ie

04:35

come average over time, they want to sell their mutual fund shares take their

04:38

chips off the table today and put the dough elsewhere. so let's say a new

04:41

investor comes in and wants to invest 6 grand in the fund, which closed at the

04:46

end of today at exactly 20 dollars a share. well let's also say that on this

04:50

given day everybody was happy with their investment. nobody wanted to sell and

04:55

nobody wanted to buy other than this one guy. well unlike bond shares an Apple

05:00

Walter doesn't need another already existing investor to sell him the shares.

05:04

he can buy six grand divided by $20 or 300 shares of the fund. those shares

05:09

didn't come from a disgruntled or even a gruntled other investor. they were sold

05:14

directly by the fund itself. well the analogous situation would be if

05:17

Apple sold shares directly to the public. those things do happen they're called

05:21

IPOs and they're also called secondary offerings, but they're not a daily event.

05:25

so a mutual fund shares sell to the public every day like we noted, and after

05:29

this transaction the investor now has 300 shares of this fund, a fund which now

05:34

has two hundred thousand three hundred shares outstanding. the value of the fund

05:39

went up the six thousand dollars that was put in so the funds value is now two

05:44

hundred thousand three hundred times twenty bucks or four million six [equation]

05:48

thousand dollars. and Walter now owns three hundred divided by two hundred

05:51

thousand or 0.15 percent of the which is money we're sure he'll

05:55

eventually spend wisely when he cashes out. he's having fun. you'll just have to [man drives red sports car]

06:00

trust us on this one.

Full Transcript