A reader writes in, asking:
“What happens when an investor in a fund sells their shares? Who buys the shares? And what happens if more people want to sell than buy? Is it possible to have something like a ‘run on the bank’ in which the fund crashes because many investors pull their money out at the same time?”
What happens when you sell a fund depends on whether it’s:
- an ETF (or closed end fund) or
- a traditional (“open-end”) mutual fund.
When you sell an ETF or closed-end fund, the transaction is between you and a third-party buyer. And the price of the fund will be determined by what the buyer is willing to pay for it. (The share price of the fund, however, is typically very close to the value of the underlying investments because institutional investors perform arbitrage trading in order to capitalize on — and eliminate — any such discrepancies.)
When you place a sell order for an open-end fund (e.g., Vanguard’s ordinary mutual funds), the transaction is between you and the fund company. The fund simply pays you cash equal to the NAV of the share you sold.
Background: At the end of trading each day, the total value of the assets the fund holds is divided by the number of shares outstanding. The result is the Net Asset Value (NAV), which is the price at which buy and sell orders of the fund will be executed that day.
In other words, as a fund shareholder, the value of your fund shares will be determined primarily (or exclusively) by the value of the underlying assets held by the fund. And, for the most part, the value of the underlying investments won’t be strongly affected by the actions of other investors in the fund, because most funds own only a small percentage of the total market value of each of their holdings.
For example, Vanguard’s Total Stock Market Index Fund — an absolutely massive fund — owned $5.63 billion of Exxon stock as of the end of 2011, according to Morningstar. Given Exxon’s total market capitalization of $401 billion, that’s just 1.4% of the company. Obviously the actions of the other 98.6% of the stock’s shareholders will be the dominant factor in the stock’s performance. And the same sort of analysis applies for most holdings in mutual funds.
Conclusion: When you own a mutual fund, the bulk of the risk you take on is the result of factors outside of the fund itself, not the result of actions by other shareholders in the fund.