Charles A. Jaffe: How do those mutual funds actually work?

Mutual funds are supposed to be a simple way for the common person to invest, but that does not mean the average investor understands the basics of how they work. For proof, check out these questions from the reader mailbag:

Question:

My 401(k) just changed the funds in the plan, and my money was moved from an S&P 500 fund worth about $100 a share to another S&P 500 fund where the shares are worth less than $40. It's supposed to be the same index, so how could the price be so different? Did something bad just happen here?

- Kevin in Whitehall Township, Pa.

Answer:

You've made the mistake of thinking that the price of a mutual fund is as meaningful as the price of a stock. It isn't.

In this case, two index funds tracking the same index are investing in a virtually identical fashion, but they set their price points differently. If we were starting two new funds today and each had $1 million to invest, the price they open at is simply a management decision. Fund A wants cheap shares, so they set a price of $10 a share and have 100,000 shares; Fund B wants a more impressive share price, so it slices the assets into 10,000 shares each valued at $100.

Same amount of money, same investments, different prices. If you invest $1,000, you'd get 100 shares of Fund A or 10 shares of Fund B, but there is no monetary difference. The investment has the same value each way.

If the employer has done the math correctly, the change in 401(k) is mostly cosmetic; focus on the key issues that determine performance - such as the costs you are paying to get exposure to the index - rather than the share price.

Q:

I like it when a company splits its stock. Are there mutual funds that have stock splits?

- Bill in West Palm Beach, Fla.

A:

Share splits in mutual funds are rare, mostly because they are cosmetic and not meaningful.

Consider the example from the question on the index fund shares. Fund B could do a 10-for-1 split, which would turn its $100 shares into $10 shares. Now it's at the same price as Fund A, but that doesn't change its potential for growth or persuade more people to buy in; it is still an index fund, buying into the market, and most investors are buying lump-sum amounts, rather than worrying about trading in "round lots" of 100 shares or more.

Moreover, most people buy funds in lumps; if you set $100 a month into a fund account, a lower share price does not actually make the fund "more affordable," because it is still costing you $100 a month to buy the exact same assets, no matter the net asset value of the fund.

Every now and again a fund will split its shares and hype the news as if it is terrific for shareholders; do not buy the hype, because it is a neutral move, not really positive but with no additional downside, either.

Q:

I own some bonds and some bond funds. I don't understand how a bond fund loses money on some days if it holds good bonds. If I own a good bond and hold it to the end, I know I will make money so long as there is no default. Doesn't it work the same way for funds?

- Charley in Metarie, La.

A:

One key difference between individuals and mutual funds is that you do not have to price your portfolio to sell each and every day. Mutual funds must set a daily price, a process known as "marking to market."

Specifically, every day, the fund must set its price, which involves determining what each security in the portfolio would have been worth if it had been sold at the day's closing price.

So let us say you own a bond, and interest rates rise. Bond prices move opposite interest rates, so when rates rise, bond prices fall. As such, the price you can get for any bond in the portfolio on any given day goes down.

If you hold the same bond and simply ride it out to maturity - assuming no default - you will get paid your expected return. So will the bond fund, if it holds the paper to the end - eventually, the net asset value reflects that things turned out OK - but its net asset value will fluctuate every day.

Your net asset value is moving around, too, but no one is calculating it each day as if you needed to sell.

Q:

Is this a good time to invest in mutual funds?

- Olivia in Tucson, Ariz.

A:

Generally speaking, it's always a good time to invest in funds. Not all mutual funds and not all fund types, mind you, but you should worry less about timing and more about what you get for investing through mutual funds.

Mutual funds were built to provide professional management and diversification at a reasonable cost. If you can get those qualities from a fund - especially if your alternative is high-cost, nondiversified, do-it-yourself portfolio construction - then owning funds makes sense in any market environment.