In order to understand the concept of NAV, it is important to have a basic understanding of how a mutual fund works. Forgive the basic primer, but essentially a mutual fund allows a group of investors to pool their money together in order to achieve a predetermined investment goal. A fund manager (or team of managers) is responsible for investing the pooled funds in various assets. When you invest in a mutual fund, you are essentially buying a portion (called a unit) of the fund’s assets. The value of these assets changes over time. You invest in the fund with the hope of these assets becoming more valuable. NAV stands for “net asset value” – the total value of the assets held in the fund – measured per unit.
NAV is calculated as follows:
NAV = (Total Asset Value – Operating Expenses) / Number of Units
For example:
If a mutual fund’s assets consisted of 10 shares and yesterday’s closing price per share was $500, then the fund’s total asset value would be $5000. Assume now that there are 1000 units in the fund, and that it costs $100 to operate the fund. The fund’s NAV would be $4.90.
NAV is the price of one mutual fund unit. Therefore, in the above example the price for one unit is $4.90. If the price of the shares held by the fund moved from $500 to $600, then the fund’s NAV will increase from $4.90 to $5.90. If you owned one unit in that mutual fund you would be $1 or 20% richer.
So when conducting mutual fund analysis, can you use NAV to measure mutual fund performance? Yes, but it is not the best measure of performance. Mutual funds generally distribute capital gains and income earned to investors. A fund’s NAV will decrease when the fund makes distributions because assets are leaving the fund. If a fund with an NAV of $5.90 makes a $2 distribution, its NAV will drop to $3.90. Despite the lower NAV, investors are no worse off. They still have $5.90, made up of $3.90 invested in the fund and $2 in cash. Investors can then decide whether they wish to reinvest the $2 back into the fund by purchasing additional units at the current market price ($3.90) or to keep their $2 cash.
In conducting your mutual fund research, bear in mind therefore that changes to a fund’s NAV are therefore not a good measure of a fund’s performance. Total return is a better measure of performance as it takes all of a mutual fund’s returns into account, including capital gains and income for a given period, less operating and marketing expenses.
The take-away for investors when it comes to mutual fund analysis:
NAV is the price of one mutual fund unit. NAV measures the value of the assets held by a mutual fund on a per unit basis. This is important to investors since they are investing with the expectation that these assets will increase in value. That said, NAV is not the best measure of performance because a fund’s NAV will decrease when the fund makes a distribution. So when comparing mutual funds or evaluating a mutual fund’s past performance, rather look at total returns.
