Question: When considering two mutual funds of comparable quality, does it make sense to go with the one with the cheapest share price?
Answer: Some investors make the mistake of treating a mutual fund's share price the way they would a stock's share price, but they're actually quite different.
A stock's share price represents the market value of one small slice of equity in a company. If the company appears to be growing, demand for its shares may increase because investors expect its earnings (and, thus, its dividends) to grow and/or because they think they will later be able to sell the shares at a higher price. This increased demand for the shares drives the share price higher. If demand decreases--perhaps due to a lousy earnings report or a product recall--its share price is likely to fall.
In contrast, a mutual fund's share price is determined not by market demand for the shares themselves but rather by the value of the fund's underlying holdings. This is expressed as the fund's net asset value, or NAV, meaning the value of all its holdings and cash after expenses are paid divided by the number of shares outstanding. (Also, investors can own fractional shares of mutual funds--something they can't do with stocks.)
To illustrate, let's say that the holdings in a fund's portfolio are worth a combined total of $1 billion after fund expenses are paid, and that the fund has 10 million shares outstanding. Therefore, the net asset value of each of those shares is $100, or $1 billion divided by 10 million.
Not the Place to Compare Sticker Prices
But what if another fund of comparable quality has a share price of just $75. That's a much better deal, right?
Not necessarily. Remember that a fund's share price is determined in part by the number of shares outstanding. So, the lower share price may have nothing to do with the quality of the fund's holdings and everything to do with the fact that it simply has issued more shares.
As an example, let's say that Fund A has a NAV of $20 per share with 100 million shares outstanding and Fund B has a NAV of $15 per share with 200 million shares outstanding. This means that Fund A's holdings collectively are worth $2 billion (after fund expenses are taken into account) while Fund B's holdings are worth a combined $3 billion. (The fund's net asset value also includes the value of any capital gains or dividends received by the fund until they are distributed to shareholders. This is why a fund's NAV typically drops once those distributions are made.)
But the larger point is that it doesn't really matter what a fund's share price is, other than for record-keeping and tax purposes to compute gains and losses. What matters in terms of performance is the change in price on a percentage basis. A fund with a NAV of $5 per share that sees its holdings perform well enough to lift its NAV to $6 per share has effectively provided its investors with a return of 20%. But a fund with a NAV of $20 per share that increases to $21 per share has provided a much lower return of just 5%. Again, it's not the absolute price of the mutual fund's shares that matters to investors but rather the percentage change in that price.
A (Slightly) Different Story With ETFs
It's worth mentioning that while NAV and share price are virtually synonymous when it comes to traditional mutual funds, the same is not quite true when it comes to exchange-traded funds, or ETFs.
Although ETFs have net asset values that are computed the same way mutual fund NAVs are--based on the value of their underlying holdings divided by the number of shares outstanding--the fact that ETFs are traded on exchanges the same way stocks are means that an ETF's NAV and its share price can sometimes diverge. As a result, ETF shares may trade at a premium or discount to their NAVs. Often this difference amounts to just pennies per share, although with less liquid (more thinly traded) ETFs it can be larger. One reason ETF premiums and discounts aren't a bigger issue for investors is that the institutions that operate individual ETFs--known in investing parlance as authorized participants--can create or redeem shares as needed to maintain a balance between the share price and the NAV.
Morningstar.com lists both ETF share prices and NAVs on its ETF quote pages as well as the ETF's Intraday Indicative Value, an estimate of its fair price based on how its underlying holdings are performing during the trading day. The NAV reading that is provided represents the ETF's net asset value at the close of the previous trading day.
Typically, it's an ETF's share price that matters most to investors as this determines what they can get for the security on the open market. The fact that an ETF you own is trading at a premium or discount to its NAV may make you feel better or worse about owning it, but it's unlikely to have much of an impact on the ETF's performance.
