Mutual funds help millions of investors get the diversification they need to build a viable investment portfolio. But mutual funds have to follow rules from securities regulators to ensure that they handle trades properly, and the rules for clearing and settling mutual fund trades are slightly different than the corresponding rules that brokers follow with stock purchases and sales.
Different processes for different funds
Most mutual funds only set a share price once per day at the close of market trading. In order to prevent mutual fund traders from gaining an unfair advantage, purchases and sales of mutual fund shares are accepted only once daily, with trade requests received before a set deadline all occurring at the same time at the end of the trading day.
However, the clearing process differs depending on the type of mutual fund. Money-market mutual funds give investors a liquid investment vehicle that's similar to holding cash. In order to reflect the need for liquidity, money market mutual fund trades generally clear and settle on the same day that the investor makes a trade. The speed with which these trades clear makes money market mutual funds a viable choice for financial institutions to use them as cash equivalents for purposes of trading other types of securities.
Most other mutual funds follow a procedure that's lengthier than for mutual funds but which still happens more quickly than stock trades. Mutual funds typically settle transactions on the next business day after the trade is executed. Occasionally, certain specialty funds that deal in illiquid securities might provide for longer periods to clear and settle a fund trade, and the prospectus and shareholder agreement will specify the maximum waiting period if this is the case.
The upshot of the clearing and settling process for mutual funds is that fund buyers need to have cash available to settle their purchase more quickly than the three-day period that prevails for most stock transactions. Sellers, on the other hand, get access to their cash more quickly with a fund sale than with a stock sale, but they'll still have to wait a day to use the money for other purposes.
Finally, remember that these rules apply to traditional mutual funds. Closed-end funds and exchange-traded funds that trade on exchanges throughout the day typically have different rules, and many follow the same three-day clearing and settlement process that applies to stocks.
Knowing how mutual fund trades clear and settle will make you a smarter investor. In particular, it can be helpful to avoid some of the potential pitfalls in mixing up settlement periods for funds versus stocks and other assets.
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