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Saturday, October 14, 2006

Franchising Mutual funds - Redemptions

By: A. Chowdhury

On the stock markets, every time someone sells a share, someone buys it, or in other words, equal numbers of opposing bets on the future are placed each day. However, in the case of open-end mutual funds, every dollar redeemed in a day isn't necessarily replaced by an invested dollar, and every dollar invested in a day doesn't go to someone redeeming shares. Still, although mutual fund shares are not sold directly by one investor to another investor, the underlying situation is the same as stocks.

If a mutual fund has no cash, any redemption requires the fund manager to sell an appropriate amount of shares to cover the redemption; i.e., someone would have to be found to buy those shares. Similarly, any new investment would require the manager to find someone to sell shares so the new investment can be put to work. So the manager acts somewhat like the fund investor's representative in buying/selling shares.

A typical mutual fund has some cash to use as a buffer, which confuses the issue but doesn't fundamentally change it. Some money comes in, and some flows out, much of it cancels each other out. If there is a small imbalance, it can be covered from the fund's cash position, but not if there is a big imbalance. If the manager covers your sale from the fund's cash, he/she is reducing the fund's cash and so increasing the fund's stock exposure (%), in other words he/she is betting on the market at the same time as you are betting against it. Of course if there is a large imbalance between money coming in and out, exceeding the cash on hand, then the manager has to go to the stock market to buy/sell. And so forth.

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