Let's say Pete over here
thinks that he's a pretty good investor.
What he does is, he has an idea that says,
"Look. I'm going to create a corporation
"and I'm going to get a bunch of people to contribute
"money to that corporation.
"Then I'll manage that money
"and maybe I'll take a little fee for myself
"so that I can maybe hire some analysts
"or get some computers or get some office space."
So what he does is he sets up a corporation.
Let's say he sets up a corporation right over here.
The way he first sets up the corporation,
let's say just has 4 shares
and I'm making the number really small
just to make the drawing and math easy.
This wouldn't be realistic.
Normally it would be something in the hundreds
or thousands of shares
or maybe even more than that.
Let's say he has 4 shares
and let's say all of the 4 shares
are owned by P initially
just to simplify the explanation.
He puts in $400 into this corporation.
Another way to think about it,
in exchange for him putting $400 into this corporation
he gets 4 shares or each share is worth $100,
each of these shares right over here.
What he does is he registers this corporation.
I'm talking about a U.S. specific case
but there's similar types of organizations
in other countries.
He registers this organization right over here
with the U.S. SEC, Securities and Exchange Commission.
He also registers himself with the SEC
or even better, he registers a management company
that he runs with the SEC.
Let's call it Pete Inc.,
is a corporation he starts off
that he also registers with the SEC.
When he registers with the SEC he tells them that,
"Look. This company right over here,
"we're going to issue more shares,
"it's for more people to contribute money.
"I'm going to manage this money right over here
"and I'm just going to take a percentage
"of the total assets under management."
Sometimes you'll see AUM,
that just means assets under management.
That will go to Pete Inc. every year
for figuring out the best place to invest this money.
It's usually on the order of about 1%,
sometimes a little bit less,
sometimes a little bit more. 1% per year.
Right now with only $400 under management
it would only be about $4 per year.
Since he registered with the SEC
he can call himself a mutual fund
and he can solicit funds from the public.
It is a mutual fund.
He has jumped through all of the hoops
that the SEC sets up for him
so he can market himself
as some type of great fund manager.
We don't know if that's true or not,
and he can solicit funds from the public.
We're going to see in future videos
there are other funds, especially hedge funds
that one; they can't market
and they can't take funds from the public.
Those can only take funds
from certain types of sophisticated investors.
What happens in Pete's fund
and this is going to be an open-ended mutual fund
that we're showing here
and most mutual funds are like that.
Let's say that Sal comes along,
he likes Pete's marketing materials and he says,
"Hey, I want Pete to manage my money too."
So Sal goes and he gives $100 and says,
"Pete, give me a share."
So Pete creates another share right over here,
he creates another share and he gives it to Sal.
He gets 1 share, that's me. I get 1 share
and in exchange I gave $100 to the fund.
Now the fund has $500.
This is $100 right over here.
Now Pete's annual fee
is going to be 1% of this whole thing or $5 a year.
If this whole thing grows,
let's say this whole thing doubles
from $500, let's say it doubles to $1000
then that $1000 is essentially split
amongst these 5 share now.
All of the people will essentially have their money doubled
minus whatever Pete's expenses are.
Let's say that a year goes by
and ten even after paying Pete the 1%.
We had $500 of assets under management.
This whole assets under management a year later
goes to, let's say it goes to $1000.
Pete either is really good or really lucky
or a little bit of both.
It goes to $1000.
Let me draw it like this.
Now it is at $1000 and it still has the same
5 investors here and I'm lucky enough to be one of them.
Here are the 5 investors.
Let me draw the shares.
There's 1, 2, 3, 4, 5 shares.
Now, each of these shares, well,
this thousand dollars is called the NAV
or the net asset value.
Let me give you that piece of terminology,
just means net asset value.
There's an NAV per share.
The NAV per share right over here is $200.
I just took the total NAV
and I just divided it by the shares.
What's special about an open-ended mutual fund
is that the close or the end of every day,
either new shares can be removed from the fund
or it could be created before the fund.
In the first video I showed how
I wanted to buy into the fund,
so I bought a share
and that increased the NAV
and it also increased the number of shares.
He had to create a share for me to buy.
He didn't sell me a share that already existed.
You could imagine, after this type of a performance
more people would want to buy shares.
Now, they would have to buy in to make things fair
at $200 per share
because that's the current NAV per share.
Let's say that 5 more people
want to buy in at $200 per share.
What Pete would do or what this mutual fund,
it's not Pete really, it's the corporation,
it would create 5 new shares.
1, 2, 3, 4, 5.
If there's only one person that day
it would create 1 share that day.
If there was 10 people that day
it would create 10 shares that day
and it could keep doing this.
The NAV of each of these are $200.
It gives these shares to each of these people
and they had to contribute $200.
Essentially it puts another $1000 into the pool
that Pete can now manage.
Now, the total NAV for the fund is $2000 now
and Pete will get his 1% management fee
off of this entire $2000.
Let's say that we fast-forward a little bit
to, let's say Pete starts having a not so good year.
Let's say we fast-forward a year past that
and Pete has a -10% return.
If you started at $2000 and that's when you include
taking his management fee out.
You started $2000, you lose 10% in 1 year
so it goes down to $1800.
Let me do this in a new color.
Now he's at $1800.
It's not completely drawn to scale
but hopefully you get the idea.
Now he has at $1800
but you still have a total of 10 shares.
Let me do my best to draw the 10 shares.
I have 1, 2, 3, 4, 5, 6, 7, 8, 9, 10.
These should be of equal size,
and now the NAV per share
is going to be 1800 divided by 10 or $180.
Let's say that I get a little bit freaked out
by this recent performance
and I have some other commitments with my money.
I said, "Pete, you need to buy a share back for me."
What Pete does is he would give me back $180.
The total NAV would lose $180, it'd go down $180.
We would take this out of it.
1800 - 180 = 1620
Now it is 1620 and they would buy back a share for me.
They would cancel one of the shares.
Notice, the NAV per share does not change.
By me redeeming my share,
it does not change what happens to everyone else.
You have 1620 divided by 9 shares,
that should still get you to be $180 per share
if I did my math right.
1800 - 180 gets you 1620.
It should still be $180 per share.
This is the nature of an open-ended fund,
you can keep creating shares
and selling them to the public to raise more money
or when someone wants their money back,
you essentially buy the share back from them,
give them their money when you buy it back
and you remove that share.
So an open-ended fund, really,
at the close of every trading day
can keep growing or shrinking.
It could keep adding more and more investors
or their investors can take their money back.
What's difficult about this
from the fund manager's point of view
is that they have to manage this.
They have to manage this constant
buying and selling with the public.
They have to management the paperwork.
If you think about it,
they can't have all of their money invested
in relatively [iliqiud] assets
or even in regular stocks.
They have to keep some amount of their money
and it's usually like 3% to 5%.
They have to keep some of these $2000
before he lost my money.
They have to keep some of it in cash.
From an investor's point of view they would say,
"Well, if I'm good investing
"I should try to minimize the amount of cash that I have
"because I'm not getting return on cash,
but because it's open-ended.
Because investors might come by and say,
"Hey, I want my money."
You have to have a little bit of cash
as part of the asset pool
in order to be able to buy people's shares back.