How A Unit Trust Works

...the fund builds a portfolio of securities, such as stocks and bonds, and then divides it into equal portions. When you buy a share of mutual fund, you are actually buying a small portion of ALL the securities in the fund's portfolio.

Shares are "manufactured" daily. The number of shares produced depends on the number of investors who want to buy them and the number of investors who want to return, or redeem, them. 

Similar to a product manufactured in a factory, the price of each share is based on the value of its parts — the stocks and bonds in the portfolio, for example — including the costs of production and distribution.

In other ways, a mutual fund bears very little resemblance to a widget manufacturer. Would it surprise you to find out that a mutual fund is a virtual company with no employees? It's true.

Each mutual fund is set up as an individual company — a registered investment company — that enjoys tax-free status by paying out, or distributing, all of its gains and profits to its shareowners.

Because a registered investment company passes along all of its net income from dividends, capital gains, and bond interest payments to you, the shareowner, it pays no income taxes.  

Shareowners may be taxed on income and net gains realized in the fund each year.  You also realize a capital gain or loss when you sell your shares.

So, if the fund has no employees, who does all the work? The fund's board works with the sponsor to get the fund started. The board then oversees the "manufacturing" process and is responsible for hiring service providers to perform all the functions that keep the fund running.

The investment adviser selects the fund's investments, managing the portfolio.  Advisers may hire specialty subadvisers.

The fund accountant keeps records of the portfolio, and determines the daily price per share, or Net Asset Value.

The administrator keeps fund records up to date, creates offering documents, and makes reports for shareowners, the board, and regulators.

The fund has its own compliance officer reporting directly to the board on all aspects of fund operations.

The shareowner servicing agent communicates with investors, keeping the records of their investments in the fund.

The distributor communicates with selling dealers and wealth managers to create investor interest.

Security brokers execute trades for the fund's portfolio, as directed by the adviser.

An independent custodian holds the fund's securities and cash.

An independent, registered public accounting firm audits the fund's financials, which can increase your confidence in their accuracy.

A specialist law firm consults with the board and the fund as another check on legal operations.

It takes all of these service providers working together to keep the fund running.

...your order is routed to the fund's shareowner servicing agent.

Think of the shareowner servicing agent as a customer service rep and cashier. The shareowner agent answers questions and provides information about the fund. It also processes money flowing in and out of the fund. The shareowner agent keeps records of the number of shares that you own, provides confirmations of your purchases and redemptions, and sends you statements of your account.

Again, mutual funds are made of many securities pooled together as one product. Shares of a mutual fund are shares of a portfolio of securities, such as stocks and bonds. Portfolio Managers buy and sell securities throughout the day. The value of the entire mutual fund portfolio is calculated once daily, using the closing market price of each individual security in the portfolio. This process is known as "computing the NAV."

After you place your order, the shareowner agent holds your investment until the fund's accountants compute the NAV. The NAV, or net asset value, is the price of one share of the mutual fund portfolio.

Fund accountants have to make sure they have the correct market value for each security in the portfolio and they must also account for all cash flowing into and out of the fund. They keep track of shares issued, exchanged, or redeemed, and all of the fund's expenses. Fund accountants also keep track of the adviser's purchases and sales in the portfolio.

Once the NAV is set, the fund's shareowner servicing agent processes all pending investor purchases, exchanges, and redemptions at that day's NAV. Additional shares are issued for new money invested.

This daily cycle applies to "open-end" funds, which can issue an unlimited number of shares according to investor demand.

When buying an open-end mutual fund, the NAV isn't necessarily the total price you pay for your shares. There may be a sales charge, or sales load, added to the NAV. A mutual fund may offer a variety of share classes to cater to different types of investors, and have varying sales charges for the services involved.

This is easier to understand if we think back to the widget manufacturer. A large retail chain buying large volumes of widgets would expect to pay less per widget than an individual customer who buys only one or two. This is similar to the way share classes work. A large pension plan that invests millions of dollars in a fund would get a "volume discount" by qualifying for a share class that has very low or no sales charges. An individual who makes a much smaller investment may be required to pay a fee, or load, in addition to the NAV.

You can avoid these sales charges by buying no-load funds.

A fund's prospectus will explain its different share classes and their associated charges, if any.

When you purchase or redeem a fund, you may also pay a commission to your brokerage or your wealth manager.

Many funds prefer to send these reports via email.

A fund will distribute its net investment income and capital gains to you according to a schedule outlined in its prospectus.

Distributions are made at least yearly, if there are any, but can occur more often depending on the type of fund.

This brings us to the fund's investment process. A fund's objective and strategy will dictate the type of securities it will invest in. The fund hires an investment adviser to carry out the fund's objective. The investment adviser employs portfolio managers and investment analysts to research securities and choose the ones that best fit the fund's overall strategy. It's best to own funds where the portfolio managers have significant investment in their fund.

A wide variety of fund objectives exist to serve the diverse investing needs of individuals and institutions.

A fund with an objective to provide income will typically invest in bonds that pay interest and possibly other securities that pay dividends. A fund with an objective of capital appreciation will invest in stocks that are expected to increase in value.

A fund may not always achieve its stated objective.

An index fund attempts to mimic the performance of a certain index, such as the S&P 500. This type of fund is often described as "passively managed" because the adviser avoids subjective investment decisions by mirroring the index in the fund's portfolio.

In contrast, "actively managed" funds rely on the judgment of the adviser's portfolio managers to choose securities. Often, these portfolio managers have significant flexibility within the strategy of the fund to meet its objective.

The fund pays a management fee, and sometimes a performance bonus, to its adviser. The adviser also produces marketing materials to increase investor awareness of the fund and to provide information about the fund's investment process and returns.

The fund may also pay 12b-1 fees to its distributor to reimburse it for costs associated with maintaining the distribution network that allows you to purchase the fund from a variety of different sources.

Management fees paid to the adviser and 12b-1 fees paid to the distributor are fund expenses, and they contribute to the fund's expense ratio.

A fund's expense ratio is the percent of average net assets used to operate the fund. As we have seen, since the fund is a virtual company with no employees, these expenses consist mainly of payments to service providers. All funds have operating expenses.

Unlike sales loads and commissions, you don't pay fund expenses directly. The fund's operating costs are deducted on a daily basis from the value of your investment and are already factored into the returns reported to you.

...line of defense. They have a duty to encourage the best possible outcome for you, the shareowner. The trustees hire an independent public accounting firm to audit the fund's financial statements yearly, and they regularly review the performance of all the fund's service providers.

They also retain a compliance officer and legal counsel who are responsible for making sure that the fund complies with all applicable rules and regulations.

The Securities and Exchange Commission, or SEC, and the Financial Industry Regulatory Authority, or FINRA, provide further oversight. These organizations create and enforce industry regulations that are designed to ensure that investors are treated fairly and honestly.

As an investor, you can also play an important role. Regulatory authorities, like police officers, can't be everywhere at once. They rely on tips and feedback from the public to reduce fraud.  While you can lose money on a mutual fund investment if its portfolio holdings decline in price, mutual funds have an excellent record of honest and transparent operations.

Mutual funds make it easy for investors to own a diverse portfolio of securities. Always read a fund's prospectus or summary prospectus before you invest.