What Happens Inside A Fund When You Sell

Selling units in an open-ended fund is not the same as selling shares to another buyer. The fund itself is often the counterparty, and that changes what happens next.

Open-ended funds expand and contract

An open-ended fund creates units when money comes in and cancels them when money goes out. The number of units in issue changes daily rather than staying fixed.

When a holder redeems, the fund must find cash. It can use money already held, match the redemption against new subscriptions, or sell some of its holdings.

Matching is the cheapest route and happens constantly, because most funds have inflows and outflows on the same day. Only the net figure needs to be dealt.

Dealing costs have to fall on someone

If the fund sells holdings to meet a redemption, it pays spreads and commissions. Left unaddressed, those costs would be borne by the investors who stayed.

This is the dilution problem, and it is the reason funds have pricing mechanisms rather than simply transacting everyone at net asset value.

Swing pricing adjusts the dealing price on days with large net flows, so the price moves against those transacting. Dilution levies achieve a similar result by a different route.

Forward pricing removes the timing advantage

Most open-ended funds deal at a price calculated after the order deadline, not at a price already published. An order is placed without knowing the exact price.

This prevents someone from buying at a stale price when they already know markets have moved. Trading on known information at an old valuation would come at other holders' expense.

The consequence is that instructions are given blind, and the deal, valuation and settlement steps each take time. Cash does not arrive the same day.

Liquidity mismatch is the structural tension

A fund offering daily dealing may hold assets that take much longer to sell, such as property or less traded credit. In calm conditions the mismatch is invisible.

When many holders redeem at once, the fund may have to sell its most liquid holdings first, leaving remaining investors with a less liquid portfolio.

Suspension powers exist for this reason. They allow a fund to stop dealing rather than sell assets at damaging prices, and the rules governing them vary by jurisdiction.

Closed-ended structures work differently

An investment trust has a fixed number of shares, so a seller finds a buyer on the exchange rather than redeeming from the fund.

The manager is not forced to sell anything, which is why closed-ended structures are often used for less liquid assets.

The trade-off appears in the share price, which can sit at a discount or premium to net asset value depending on demand for the shares themselves.