Funds collect money from a pool of investors, then use the collected money to invest in stocks and other financial securities that fit the defined investment objective of the fund. Investors each get a specified number of shares corresponding to how much they have invested, and can sell the fund shares they own at a later date.
But they aren't really "selling" shares so much as redeeming them for a set value.
How is that value determined? By calculating the Net Asset Value (NAV) of their holdings.
What Is Net Asset Value?
The easiest way to describe NAV is that it represents the value of underlying assets minus liabilities, divided by outstanding shares.
As funds are really securities bundled in a single investment package and sold in shares (portions), and fund managers try to improve the investments' value and return by trading positions, resulting in gains but also sometimes losses, with taxes and fees, NAV is the best method to establish the value of investors' shares.
Funds try to determine NAV daily, weekly, or monthly. But most often, as a means of tracking, NAV is calculated at the close of the markets in which the investments trade each day.
How Do You Calculate Net Asset Value?
Put another way, the assets of a fund are determined based on shares existing in underlying market positions, the closing price each day of those positions, plus realized gains, minus fees, losses and other expenses. And that value is then reduced to a per share representation.
The basic formula for calculating NAV is:
(Assets - Liabilities) / Total number of outstanding shares = NAV
To determine NAV, the total market value of the fund's investments, cash and equivalents, money earned by the fund but yet to be received (accrued income) and receivables, like dividend or interest payments. The sum of these items constitutes the fund's assets.
A mutual fund's liabilities include money owed to lenders, pending payments and charges or fees owed to associated entities, as well as foreign liabilities like shares issued to non-residents, income or dividends pending to non-residents, and sale proceeds when shares are repatriated. These items are either classified as long-term or short-term liabilities, depending on when the payments are due. Accrued expenses, such as staff salaries, utilities, operating expenses, custodian and audit fees, distribution and marketing expenses, management expenses, operating expenses, utilities and staff salaries also must be calculated.
All such items must be included in determining NAV for any particular day.
The shares of any fund tend to trade in the market for more or less than their NAV. If the fund is trading above its NAV, it is said to be trading at "a premium." If the fund's shares are trading below their NAV, they are said to be trading at "a discount."
So, NAV helps traders determine if a funds' shares are at the moment overvalued or undervalued in the market.
But, while stock prices change with every passing second, mutual funds don't actually "trade" in real time - the value of their underlying securities are based on NAV at the end of each trading day.
Also, because of the variables of each fund, you can't really use NAV to compare the performance of different funds. To determine which of, say, two funds is doing better, you need to look at the performance history of each fund, the securities held within each fund, and experience and longevity of both funds' managers -- also how each fund performs against a benchmark, like the S&P 500 Index or other index or average.
However, if one fund's net asset value goes to $20 from $10, compared with another fund whose NAV went to $15 from $10, the fund with a 100% gain in its NAV is the better performer.
Example of Net Asset Value
Let's look at an example. Say your mutual fund has $100 million worth of total investments in a host of different, bundled securities, calculated on the day's closing prices for each individual asset, $7 million in cash and cash equivalents, and $4 million in total receivables. For the current day, your accrued income is $75,000, or a total of $111,075,000 worth of assets.
Meanwhile, it also has $13 million in short-term liabilities, $2 million in long-term liabilities, and accrued expenses of $10,000 for the day, giving you total liabilities of $15,010,000.
Your mutual fund currently also has 5 million shares outstanding.
($111,075,000 - $15,010,000) = $96,065,000/5,000,000 = $19.21/share.
So, on that day, your mutual fund's shares will be traded at $19.21 per share.
Because NAV is computed and reported as pertaining to a particular business date, all the buy and sell orders for mutual funds are processed based on a cutoff time at the NAV of the trade date.
If regulators, for example, mandate a cutoff time, buy and sell orders received before that time will be executed at the NAV of that particular date. However, any orders received after the mandated cutoff time are based on the NAV of the next business day.
One way for investors to try and assess their mutual fund's performance is to calculate the direction and differential of the fund's NAV between two dates. As an example, you might compare your fund's NAV from Jan. 1 to its NAV on Dec. 31 -- the difference and direction of the values can help you gauge the fund's performance. But changes in NAV between two dates, unlike stock prices, aren't considered the best representation of your fund's performance.
This is because mutual funds pay out almost all of their income, like dividends and interest earned, to their shareholders. Also, mutual funds are obligated to distribute accumulated realized capital gains to their shareholders. Such a gain occurs when any security -- or fund shares' underlying securities -- are sold for a price higher than the purchase price. As income and gains are regularly paid out, the fund's NAV decreases correspondingly. So, while investors gain such intermediate income and returns, they aren't reflected in absolute NAV values when comparing two dates.
A better measure for mutual fund performance is annual total return, or the actual rate of return of an investment or pool of investments over a given period of evaluation. Analysts and investors also look at compounded annual growth rate, which represents the mean annual growth rate of the investment over a period of time longer than one year, provided that all intermediate payments of income and gains are accounted for.
Exchange traded funds and other closed-end funds also calculate NAV, but because they trade like stocks on exchanges, their shares trade at either a premium or discount to the actual NAV.
Such an arrangement offers active ETF traders profitable opportunities if they can spot such opportunities to make some money on the difference to the day's NAV. In addition to calculating their NAV daily at the close of the market, for reporting purposes, ETFs also calculate and disseminate intra-day NAV -- multiple times per minute, in real time.