Does a mutual fund buy new shares when it issues new units for individuals?

Question

You may ponder what is the significance of this question. Consider a mutual fund that has achieved a high return rate possibly because it has bought a profitable share at a low price months ago.

Now, suppose that the whole stock index has raised significantly for a while and many individuals are willing to invest in the market. Due to fund fame, many of them will select this mutual fund. The recent significant index raise has caused bubbles in the stock price. Thus, currently, buying new shares does not seem rational.

Now, the question comes in. Does a mutual fund must buy new shares when it issues new units for individuals? If yes, then a negative return rate for the fund is expected after bubble burst if it has issued many units when the market is inflated. Is it correct?

Thank you

Answer 1

I'm going to limit the answer to Mutual Funds, since ETF shares are not bought from the fund but are exchanged between investors, so the money going to the fund itself follows a different mechanism (a single "authorized participant" handles the inflows to the ETF). In other words, when you buy an ETF, you're likely buying it from someone else, not from the fund itself. The authorized participant creates or removes units as needed to provide liquidity, so the answers below are similar for both, but the mechanisms are different.

Thus, currently, buying new shares does not seem rational.

Why not? The fund is only passing through the buyer's money. Ideally the buyer knows what the fund holds, and if they think that the assets are overpriced then they shouldn't buy the fund. So if anyone is being irrational, it's the buyer, not the fund.

Does a mutual fund must buy new shares when it issues new units for individuals?

It depends on the type of fund and how much is bought. If a fund is a tracking (passive) fund, then it may just use futures on the index it's tracking until it has enough cash to purchase the underlying stocks without getting out of balance. It may also keep cash on account to handle both buys and sells without having too much churn (which increases transaction costs).

For active funds, they'll use whatever cash (or margin) they have buy and sell stocks that achieve their investment objective. They don't necessarily have to buy the same stocks they already own - they can look for new stocks or adjust their balance.

Answer 2

Mutual funds and ETFs follow an investment objective or benchmark.

If they didn't rebalance or buy/sell shares shares regularly, their NAV (net asset value) would stray too far from the market price and the tracking error would increase.

These funds make money through the fees they charge on assets under management, not the performance of their portfolio.