APRIL 2003

Lesson 203

Net Asset Value

Net Asset Value Formula

Fund Distributions

Net Asset Value

In Lesson 104, Understanding Mutual Fund Listings, we gave you a fairly simplistic definition of net asset value (NAV). Here, we'll expand on that and explain the term in more detail.

A stock mutual fund is a portfolio of company stocks. Each company in a fund's portfolio is valued differently from the others. The stock prices of individual companies are affected by internal and external events. There are many internal company factors that can affect its stock price.

For example, if a successful, well-known Chief Executive Officer (CEO) suddenly resigns, a company's stock price would likely decline. On the other hand, if a company released a revolutionary new product, its stock price would likely increase. Externally, national or world economic factors, supply and demand and even speculation and rumor can affect stock prices, either positively or negatively.

A mutual fund's share price is determined by its net asset value. A fund's net asset value rises and falls depending on how the companies in the fund's portfolio are performing.

Net Asset Value Formula

A stock fund's net asset value is determined by the following formula:

Stock Portfolio Value + Cash - Fund Expenses & Other Liabilities = NAV

Total Number of Fund Shares Outstanding

Here's an example of how net asset value is calculated: Growth Fund XYZ's stock portfolio value at the end of the trading day is $9.5 million and the fund holds $500,000 in cash. The fund's expenses and liabilities are $100,000 and the fund has 1 million shares outstanding. Using these figures, we can determine what the XYZ Growth Fund's net asset value would be at the end of the trading day:

$10,000,000 - $100,000 = $9.90

$1,000,000

Fund companies determine a fund's net asset value at the end of regular trading hours each day that the market is open. If you decided to redeem your shares of XYZ Growth Fund, you would receive $9.90 per share as long as your shares weren't subject to any back-end loads. The purchase price would depend on whether there are any front-end loads associated with purchasing fund shares.

Just as stock prices fluctuate, a fund's net asset value can vary from day to day. It is wise not to place too much emphasis on daily movements in net asset value. Stock prices and fund net asset values fluctuate for many reasons. Long-term investors should stick with their funds unless there has been a fundamental, negative change in the fund's portfolio, management or costs.

Fund Distributions

Assessment of a fund's long-term track record is complicated because of the role played by dividend and capital gain distributions. You might think that if you owned a mutual fund with a net asset value of $10 a share on Jan. 1, 1993 and that fund's net asset value rose to $20 a share on Jan. 1, 1998 that your fund had doubled in value.

But you'd be wrong. A fund's net asset value is only one piece of the puzzle that you use to determine it's long term performance.

Dividends and capital gains also need to be taken into account when assessing a fund's long-term performance. Funds are required to pass both of these on to fund shareholders.

A dividend is a payment a company makes to its shareholders from retained earnings. A mutual fund investor who owns shares of a fund that holds dividend-paying companies in its portfolio will receive the dividends when the fund makes a distribution.

Capital gains are incurred when a fund manager sells stock in the funds portfolio at a profit. Fund managers can offset capital gains with capital losses. Capital losses are when a fund manager sells a stock at a loss.

However, if a fund manager has more capital gains than capital losses, or doesn't want to sell losing positions, he must distribute these gains to fund shareholders in the form of a capital gains distribution. While distributions are usually made in December, income-oriented funds may distribute them more often, typically two or four times a year.

Dividends and capital gains distributions affect fund net asset value in the following way. If a fund with a net asset value of $20 per share distributes $2 per share to shareholders in dividends and capital gains, the fund's net asset value would drop to $18. Fund shareholders haven't lost anything because the $18 in net asset value plus the $2 in distributions equals the former net asset value of $20.

Fund shareholders can either take distributions in cash or reinvest them in fund shares. In either case however, when a distribution is made shareholders must pay taxes on the distributions if they hold their funds in taxable accounts. No taxes are owed on distributions made in tax-deferred vehicles, such as IRA, 401(k) or 403(b) accounts.

By adding a fund's dividend and capital gain distributions to its net asset value each year, you can determine what the fund's total return has been. Changes in a fund's net asset value and dividend and capital gain distributions are taken into account when a fund company, newspaper or investment information company calculates a fund's total return, so you don't need to make these calculations yourself.