How Purchases and Redemptions Impact Index Funds

Index funds are great product for investors who are looking for a diversified investment that mirrors a benchmark with a low-cost entry point.

However, unlike stocks or exchange-traded funds (ETFs), index funds do not trade throughout the day on an exchange. This can be tricky for investors who are unfamiliar with how index funds are traded and how the price is calculated on a daily basis.

The article will discuss how index funds are traded, how they are priced and potential issues investors may face when buying or selling.

The Significance of NAV

Index funds are not priced throughout the day like a stock or exchange-traded fund. Instead, an index fund calculates its price at the end of the day through its Net Asset Value (NAV). To determine the NAV, the fund will take its total assets minus its liabilities and divide the amount by the number of shares outstanding. So for example, a mutual fund with $500 million in assets, $100 million in liabilities and 75 million shares outstanding will have an NAV of $5.33 per share.

Since index funds invest in underlying securities, the asset level of the fund can rise or fall with the value of those invested securities. The NAV price is also not affected by the public’s demand for the index fund. Every time a share is purchased by an investor, the fund company issues a new share. Therefore, even though the fund’s assets are growing with new money, the assets are diluted by the additional share prices that are issued. For more information on NAV, check out the article on “Understanding Mutual Fund Net Asset Value (NAV)”.

Understanding How You Can Trade in Index Funds

When investors buys a common stock, they can do so at any point in the day. With an index fund, an investor can signify a certain amount of shares or a set dollar amount. Unlike a stock, mutual funds are purchased at the end of the day with a cut-off time of 4:00 p.m. After the fund calculates each of its underlying holdings’ closing prices, it will calculate the NAV.

The same goes for when investors want to sell or redeem shares from an index fund. They can submit to either redeem shares or in a fixed dollar amount, and are still required to submit the order prior to the 4:00 p.m. cutoff. Any orders that are placed after the 4:00pm cut-off will be queued as a next day trade.

Familiarize With the Fee Structures

Unlike stocks and ETFs that trade on a commission basis outside of the price of the stock, index funds can be bought with a variety of share classes and have internal fees. Index funds have other costs than ETFs, which can ultimately make them more expensive. Index funds constantly rebalance because of daily net redemptions. This results in explicit costs in commissions and implicit costs in the form of bid-ask spreads on the underlying fund. ETFs do not have this issue because they trade with a creation/redemption in-kind process that avoids these transaction costs. So, it is imperative that investors be careful when purchasing or redeeming shares of an index fund due to possible fluctuation of NAV on a daily basis.

Meanwhile, index funds are relatively less expensive compared to actively managed funds because the passive strategy of index funds is designed to track a benchmark. Vanguard, for example, has several index funds that are passive in strategy, with an expense ratio that is 82% lower than the industry average. The Vanguard 500 Index Fund Admiral Shares (VFIAX), for example, is designed to mirror the S&P 500 and has an expense ratio of 0.05%. Although this fee is relatively low, the expense ratio is taken out of the fund’s NAV on a daily basis. For a more detail on mutual fund fees, read the “Complete Guide to Mutual Fund Expenses”.

Interpreting the Tracking Error

Anytime a typical mutual fund is bought by an investor, the new money is equally divided into the fund’s current holdings. Depending on the size of the mutual fund, there are anywhere from 100 to 300 individual investment positions. Fund managers also tend to leave a cash buffer to cover any sudden amounts that need to be redeemed without having to sell-off positions.

In an effort to keep expenses low, many index funds like those offered by Vanguard use a technique called sampling or mirroring of the index. This is where the fund buys a smaller quantity in order to replicate the benchmark’s return. It would be far too costly to have to constantly buy and sell holdings to replicate the actual benchmark. For example, the Russell 3000 Index is comprised of 3,000 stocks and would be too hard for a fund manager to keep up. With this sacrifice, index funds may not have the exact same return as its benchmark. This difference between the fund return and the benchmark is called the tracking error. The lower the tracking error, the better the fund represents the benchmark.

Issues With Excessive Redemptions

One of the big issues that fund managers have with excessive redemptions is when the fund outflows exceed the fund’s cash cushion. At this point, the fund manager will need to liquidate current holdings in order to meet the outflow demand. This may reduce the fund’s performance because the manager originally did not plan to sell the security.

This is extremely important for index funds because the fund’s goal is to mirror the benchmark. If the manager needs to liquidate in order to accommodate excess redemptions, it will further deviate from the benchmark and returns will suffer.

Another issue with selling securities under pressure of redemptions is that it may cause unintended tax distributions. When a fund manager sells an underlying security with a capital gain, those gains are passed on to the investor. One of the ways index funds help reduce excessive outflow is by having redemption fees for early withdrawals. This is designed to discourage investors who excessively trade in and out of the fund, leading to higher costs for the fund managers.

The Bottom Line

When buying an index fund or any mutual fund in general, there are several factors that go into purchasing or redeeming shares. Mutual funds are different from stocks and ETFs in how they are priced using NAV and only traded at the end of day. They can also cause issues for both the fund managers and investors if there are excessive redemptions, which seem to happen infrequently. Nevertheless, index funds are excellent, low-cost investment choices for investors looking for a diversified way to get exposure to the stock market.

To learn more about index funds, check out our our Index Fund Center.