What Your Fund's NAV Isn't Telling You

Don't focus on NAV when measuring a fund's performance or gauging its attractiveness Many investors think that Fund A . ....

Karen Wallace 14.12.2006
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Don't focus on NAV when measuring a fund's performance or gauging its attractiveness. Many investors think that Fund A is a better deal than Fund B because the former's net asset value is lower, however, it's wrong. These kinds of flawed perceptions are stemming from mixing mutual fund's net asset value with a company's stock price, which have some crucial differences between them. Morningstar US Research Team has provided some ideas of what NAV exactly is, and better ways to evaluate mutual funds performance qualitatively.

How Is NAV Like a Stock Price?
There are similarities between a mutual fund's net asset value and a stock's share price, as each represents the price of one share of an in

vestment. Moreover, the calculations are somewhat similar, too:

For a company's stock price: A share of Microsoft (MSFT) (as of Nov. 9, 2006) cost $29.24--that's the price that investors were willing to pay for one share of Microsoft. Multiply that number by the number of shares outstanding, 9.83 billion, and that gives us the value of the company's shares in the marketplace (known as market capitalization), which is currently $287.46 billion.

For a mutual fund's per-share NAV: We take the value of its assets (stocks, bonds, and cash), subtract its liabilities (expenses), and divide by the total number of share outstanding. For example, as of the May 31, 2006, semiannual report Fairholme filed with the SEC, the Fairholme Fund (FAIRX) had total assets of $2.54 billion and 92.48 million shares, which yields a net asset value of $27.46.

Stock Price and NAV Move for Different Reasons
Despite key similarities between stock price and NAV, they move for different reasons. Stock prices are influenced by the forces of supply and demand, while NAVs aren't.

For share price: When more investors are buying shares of a company than are selling, its share price rises because the company has a finite number of shares in the open market. Besides, investors can anticipate a company's future in the light of the share price movement; for example, investor may anticipate that a company will post a better than expectation earning, because of a sharp rise in its share price. Factors that are external to the company can also influence stock prices, such as investors' perception of a slowing economy or geopolitical instability.

For NAV: It isn't affected by whether investors are buying in droves or redeeming their shares--at least not directly. An open-end fund creates new shares when new money is invested, and when investors redeem their shares, the fund can reduce the number of shares outstanding on the other hand. The only way a fund's NAV can increase or decline is if the value of the underlying securities increases or declines or if the fund makes a distribution to shareholders, which we will explain shortly.

Funds Are Priced Only Once a Day
Funds and stocks also differ in the frequency of their pricing. A stock's price can fluctuate up and down all day depending on investors' trading activity on that particular day. Mutual funds, however, are priced only once per day, at 4:00 p.m. Eastern time. (Pricing times are different in Hong Kong and most funds are quoted daily.) Any purchase or sale order placed for a mutual fund during the day will be processed at that day's 4:00 p.m. price.

Distributions Will Reduce a Fund's NAV While Share Price Won't
Mutual fund NAVs can be affected by tax consequences. Stock share prices aren't--at least not directly. When a mutual fund sells a security for a profit--say, it buys a company for $10 and sells it when it's trading at $15--it can't retain that $5 gain but instead must distribute it to shareholders in the form of a capital gain. Such distributions do reduce a fund's NAV but don't have a direct impact on a fund's published total return.

NAV Shouldn't Be Used to Compare Funds
As mentioned before, NAV can be affected by factors unrelated to the value of the holdings, therefore it's a mistake to use it as a gauge of a fund's attractiveness. (A stock's price isn't necessarily a great way to value a stock either), or in other words, NAV can tell little about funds' performance.

Let's take the example of two S&P 500 Index funds. These funds' portfolios are extremely similar--they each own around 500 stocks in virtually the same weightings. Let's say you have $10,000 to invest. You look at Vanguard 500 Index (VFINX), which has an NAV of $127.19, and T. Rowe Price Equity Index 500 (PREIX), which has an NAV of $37.05. If you opt for Vanguard, you would be buying 78.6 fund shares, whereas if you went with T. Rowe Price, you would have purchased 269.9. It may seem that you're getting more for your money with the T. Rowe fund, but it's really the dollar value of your shares that matters, not the NAVs.

Comparing the 10-year returns of both funds shows that the returns are very similar. Over the past 10 years, the Vanguard fund has returned 8.56% per year (as of Oct. 31, 2006), while the T. Rowe Price fund has returned 8.33% per year over the same time period. The disparity between the funds' returns can be attributed, primarily, to the fact that the Vanguard fund has had lower expenses over the 10-year period.

Use Better Evaluation Measures
Rather than focusing on NAV to gauge a fund's attractiveness, you'll need to dig beneath the surface. A fund's total return is the best gauge of how strong its results have been; be sure to compare a fund's return with that of its category average or an appropriate market benchmark.

By the same token, don't use NAV to assess whether a fund's holdings are cheap or expensive. Morningstar's stock analysts use a valuation-based system to assign star ratings to individual stocks, so eyeballing the star rating for a portfolio's equity holdings can give you a sense of whether it's an opportune time to buy a fund or not. A fund's expense ratio, meanwhile, is your bottom-line guide to whether a fund will be expensive or cheap to own--a fund's NAV won't tell you that.

Besides the total return we mentioned before, here's a short list of other important qualitative factors for both existing and prospective investors to consider when evaluating funds: expenses, manager tenure, investing style, volatility, and after-tax results.

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Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.

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