Here are some definitions of investment concepts related to the value of mutual funds:
NAV is computed on a daily basis by the fund company and is the price at which shares may be purchased or sold at that time.* Daily, the fund’s accounting agent will sum up the current market value of all the securities owned by the fund, plus any income or earnings that have not been distributed to shareholders.
For example, a fund owns 10 shares of XYZ, which currently is trading for $10 per share. The total value of the fund is $100. From this amount, the fund’s accountant subtracts the costs of running the fund, which we’ll assume equals $2. The value of the securities and the income (if any), less the fund’s costs, is then divided by the number of shares of the fund that have been sold (we’ll assume 20 shares have been sold).
In this example, $100 - $2 = $98. Dividing $98 by 20 shares results in an NAV of $4.90 per share. If a fund charges an up-front sales commission (front-end load), the sales charge on purchases is calculated as a percentage of the NAV and added to the purchase price.
As the value of the fund’s holdings fluctuates, so too does the fund’s NAV. The difference between what you paid for a fund and what it is worth today is your potential appreciation (or depreciation if the NAV has declined). Remember that appreciation (or depreciation) is only a potential that is not realized unless you sell your shares.
Once you do sell your shares, any realized gains may be subject to taxes. Money market mutual funds strive to maintain a constant NAV of $1, so they offer no opportunity for appreciation.**
Fund Distributions
There are generally two types of fund distributions: dividends and capital gains. Mutual funds invest in a variety of securities, including stocks, bonds and/or money market instruments. When these securities pay interest or dividends, the fund is required to pass them along to its shareholders (less a portion of the costs of managing the fund). A bond fund, for example, generally buys bonds that pay interest that the fund then passes on to you in the form of a dividend.
Fund distributions also may include capital gains realized by the fund when it sells portfolio holdings. The difference between what was paid for a security and what it sells for is a capital gain or loss. Short-term capital gains (on securities held by the fund for 12 months or less) are typically passed on to shareholders as a dividend distribution. Long-term capital gains are reported separately as capital gains distributions. You can calculate a fund’s yield by dividing its current NAV by the amount of distributions per share.
Fund Distributions and NAV
Fund distributions affect the NAV of your shares and must be taken into account in determining the performance of your investments. When the fund distributes income to shareholders (monthly, quarterly or annually, depending on the fund), the NAV declines, generally by the per-share amount distributed.
Continuing the previous example, assume that a fund holding 10 shares of stock valued at $10 each receives stock dividends of 10 cents per share. When the dividend is paid to the fund, the inherent value of the stock drops to $9.90 per share. The fund now holds stock worth $99 and has earned income of $1. The total value of the fund is still $100, and the NAV (again assuming $2 in management fees and 20 shares outstanding) is $4.90.
Assume the fund then distributes that $1 in income to fund shareholders. The distribution is equal to $0.05 per share. The total value of the fund is now $99, and the net asset value of each share is $4.85. Shareholders have not lost any money, however, since they received a distribution of $0.05, for a total value of $4.90.
Many mutual fund investors choose to automatically reinvest fund distributions rather than receive them in cash. When distributions are reinvested, the investor receives additional shares (or a fraction of a share) rather than cash. As a result, the total value of the fund investment remains the same, even though the NAV declines by the per-share distributed amount.
Total Return
A fund’s total return includes appreciation and dividends and any dividends or distributions. Total return is expressed as a percentage of the fund’s NAV over a period of time. Let’s say that at the close of business on December 31, 2001, the fund’s NAV is $10. On December 31, 2002, the fund pays a dividend of $1. At the same time, the closing NAV is $11. The total return for the year will be $2 ($1 in distributions and $1 change in NAV) or 20 percent ($2 divided by the $10 NAV at the beginning of the year).
Mutual fund returns are typically reported year-to-date; past 12 months; quarter-end returns for 1-, 3-, 5-, 10- and 20-year intervals; or for the life of the fund (from date of inception). Since returns tend to average out over time, the longer the period analyzed, the better.
It’s important to remember that these returns only reflect what the fund has done in the past and are not indicative of the fund’s future performance. Also, keep in mind that some published returns usually assume that all distributions have been reinvested and that sales commissions (loads) are not included.
A fund’s total return may not be the same as your net return. Did you pay a load to buy or sell the fund? Did you incur any other costs, such as wire transfer fees? These fees will reduce your return. You should also consider how taxes will affect your net “after-tax” return when making investment decisions.
Tax Treatment of Fund Returns
Fund distributions (other than tax-free income distributed by funds investing in municipal bonds) are generally taxable, as are gains realized through appreciation when you sell fund shares. Remember that reinvested distributions are also taxable. Generally, ordinary dividend distributions, including any net short-term capital gains distributed, are taxed as ordinary income, while long-term capital gains are taxed at 20 percent.
However, if you invest through a qualified retirement plan, such as a 401(k), individual retirement account or a variable annuity, you can defer taxes on all investment earnings until the funds are withdrawn from these accounts and not “rolled over” into another such account within a certain time.
Your financial advisor can help you assess the performance of your mutual fund investments and evaluate how short-term changes in NAV affect the long-term potential of your investments. He or she can also help you take any potential taxes into account when choosing and managing your investments.
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