If you are like most individual investors, you track your investments carefully. For your stock investments that means watching the share price, and for bonds that means watching the bond price.
What about mutual funds?
Many individuals track the fund’s net asset value (NAV). And in the process they may have found that their fund’s NAV has barely moved, prompting considerable consternation, unhappiness and unprofitable (and perhaps unutterable) comments about the fund.
However, tracking a fund’s NAV as an indication of performance can be highly misleading, unless you understand the various components that affect net asset value—not all of which are related to the fund’s performance.
The Factors Affecting Net Asset Value
The net asset value per share of a mutual fund jumps around for all kinds of reasons. NAV per share is the market value of all assets, less any liabilities, divided by the number of shares outstanding. The assets of a common stock or bond mutual fund are the securities they hold, whose market values constantly change. So, the net asset value of a fund will change as the markets change.
A fund’s NAV can also change as a result of distributions. Mutual funds are required to distribute income and net realized capital gains to shareholders. These distributions are made from fund assets—the fund, in essence, is transferring assets from the fund to individual shareholders. Therefore, any distributions will decrease net asset value.
Unless you take these distributions into consideration, you may be seriously misled as to the performance of the fund by just looking at changes in net asset value. For instance, a fund that over the course of the year has been extremely successful in its investments but that has realized and distributed capital gains, may have a net asset value at year-end that is the same as or less than its net asset value at the beginning of the year.
Analyzing Net Asset Value Changes
The per-share data section of a mutual fund’s prospectus and annual report is a starting point for understanding how distributions and investment successes or failures affect the net asset value. The per-share data section presented in Figure 1 as an example is from the Dreyfus Third Century Fund annual report; all mutual funds, however, are required to report this information in essentially the same format.
One of the first items you should note is the time period that the data covers, which is based on the fund’s fiscal year. Mutual funds often have fiscal years that differ from calendar years. In this case, the Dreyfus fiscal year ends on May 31. If you are calculating a fund’s performance based on this data and then comparing it with data from other sources, make sure the time periods are the same; performance comparisons between returns that do not cover the same time periods are meaningless.
For the Dreyfus Third Century Fund, the net asset value of $7.42 at the beginning of the 1986 fiscal year and the net asset value of $7.01 at the end of the 1990 fiscal year on the surface provide little reason for joy. But as we shall see, the fund has not done badly over this time period. In order to understand why, it is useful to move step-by-step down the per-share data section to see what has affected net asset value during this time period.
An examination of fiscal-year 1990 provides an indication of how net asset value can be affected during the course of a single year. For fiscal-year 1990, Dreyfus Third Century produced $0.28 per share in income from stock dividends and interest on short-term investments. Investment income increases net asset value, but must be distributed to shareholders.
Expenses of $0.07 a share represent management, legal and accounting fees along with the expenses of distributing prospectuses and other shareholder information. These expenses reduce net asset value.
Investment income net of expenses, which was $0.21 a share, simply offsets these expenses against income. Bracketed items reduce net asset value by the amount shown. But this format traditionally has not bracketed the expenses because they are explicitly subtracted from income to arrive at net income.
The next line, net realized and unrealized gains (or losses) on investments, is not so simple. “Realized” means that securities have been sold for a gain or loss; “unrealized” gains or losses are paper profits or losses—the market values of the securities have either increased or declined, but they are still being held.
If realized and unrealized gains and losses together result in a gain, then the fund’s NAV rises; if they result in a loss, then NAV declines. For 1990, this amount was $0.84, increasing net asset value by that amount. However, this figure can be negative, reflecting overall losses, as it was in 1988: The loss of $0.53 reflected the October 1987 market collapse, which fell within the fund’s 1988 fiscal year.
A fund is required to distribute net income or net realized gains by the end of the calendar year in which they were earned. Mutual fund investors are taxed on income and gains with the fund acting as a financial pipeline. For fiscal-year 1990, $0.18 in net income and $0.19 in net realized capital gains were distributed in December of 1989. These distributions do not always match up with the fiscal net income and net realized gains because the distributions are made on a calendar-year basis.
Any distribution made reduces net asset value by the amount of the distribution.; the example in the box below explains how this works. For fiscal 1990, net asset value for Dreyfus Third Century went from $6.33 to $7.01. The change in NAV can be explained by summarizing the information from the per-share data section:
- $6.33 Beginning Net Asset Value
0.21 Net Investment income
0.84 Net Realized and Unrealized Gains (Losses)
– 0.18 Dividend From Net Investment Income
– 0.19 Dividend From Net Realized Investment Gain
$7.01 Ending Net Asset Value
Net investment income and net realized and unrealized gains could be negative, and in such a case, they would be subtracted rather than added to the beginning net asset value. For fiscal years 1986, 1987, 1988 and 1989, similar analyses can be made to determine what affected net asset value.
What about the decline of $0.41 in NAV from the beginning of fiscal 1986 to the end of fiscal 1990? This view fails to include all those distributions over the five-year period. A simple calculation that assumes that distributions were not reinvested and compounded shows that the fund increased in value by 55.8% over the five years. The general formula for return is as follows:
For the Dreyfus Third Century Fund over this time period, dividends from net investment income totaled $1.36 and dividends from net realized gains in investments totaled $3.19. Substituting these numbers into the equation, the return is:
Had these dividends been reinvested, the compound total return would have been 87.8% over five years, and the annual compound return would have been 13.4%.
Even in fiscal-year 1988, a year that encompassed the crash of 1987, the net asset value dropped from $7.73 to $5.76, a substantial loss before distributions. However, after considering the distributions, the loss was not as severe as the drop in net asset value would indicate:
Remember the caution about comparing same-period returns? For calendar year 1988, Dreyfus Third Century returned 23.2% with distributions reinvested, a much different performance than the –4.4% for the fiscal year.
More numbers are pouring out from more sources, and all are landing in front of individual investors. While the numbers are rarely incorrect, their interpretation often can be. Be careful before you jump to conclusions about your fund’s performance if you are basing it simply on tracking its net asset value.
NAVs and the Difference a Distribution Can Make
Distributions cause the net asset value of a fund to drop by the amount of the distribution. So, if you pick up the newspaper and find that your mutual fund has suddenly and for no apparent market reason sunk, check to see if a distribution was made. An ex-distribution notation will appear in the newspaper listing the day after the distribution occurred. You can also call the fund directly to ask if a distribution recently took place.
Figure 2 illustrates the impact of a distribution on net asset value, which in this instance occurred with the IAI family of funds.
The data for June 24, 1990, indicates the net asset values for the funds on the day of the distribution; the data for June 25, 1990, indicates NAV on the day after the distribution. The “e” after the Apollo Fund is a notation indicating that capital gains were distributed; an “x” indicates an income distribution. [Most newspaper listings use similar notations but check the key in the paper you read to be sure.]
The listings indicate that Apollo dropped from $12.95 to $11.33 in one day. But a bit of research puts this drop into perspective. The net realized capital gain distribution for Apollo was $1.56, which means that only $0.06 of the decline was due to portfolio market action. Look at the fine print before you leap for a telephone transfer.
This article was written by John Markese for the November 1990 issue of the AAII Journal. At the time, Markese was executive vice president and director of research at AAII. He is also a former president and current chairman of AAII.