Don't Be Naive About the NAV

A mutual fund calculates its NAV by adding up the current value of all the stocks, bonds, and other securities (including cash) in its portfolio, subtracting the manager's salary and other operating expenses, and then dividing that figure by the fund's total number of shares. For example, a fund with 500,000 shares that owns $9 million in stocks and $1 million in cash has an NAV of $20.

Stock prices change throughout the trading day, but mutual fund NAVs are calculated only once each day, based on the value of their stocks or bonds at the time the market closes. When you purchase a mutual fund, you buy shares at the NAV as of that day's close. As a result, you don't necessarily know the exact NAV of the fund at the time you put in your order to buy or sell.

Mutual funds, however, distribute any income or capital gains they realize to shareholders as dividends, which, in turn, causes their NAVs to fluctuate. Unless you account for such distributions, you could be underestimating a fund's actual performance by looking solely at its NAV. To accurately gauge a fund's performance, you need to examine its total return, which takes into account both the appreciation of the fund's holdings as well as any distributions the fund has paid out.

Yield

A fund's income payout, or yield, tends to interest those investors who need regular income, because they don't necessarily have to tap into their principal for their day-to-day living expenses. Savings accounts and cds pay income, but so do most bonds and some stocks. If you own a mutual fund that buys income-paying stocks or bonds, the manager passes on any income to shareholders.

Yield can be calculated in a variety of ways. Morningstar calculates this figure by summing the income distributions over the trailing 12 months and dividing that by the sum of the last month's ending NAV plus any capital gains distributed over the 12-month period.

Capital Gains 

The second key way you can gain from a fund is through capital appreciation—that is, if one or more of your fund's holdings is selling for a higher price than it was when the manager purchased it. If the manager sells the new, pricier stock or bond, the fund realizes what is called a capital gain. And even if the manager simply hangs on to the stock or bond that has gained in value, the fund will enjoy capital appreciation; in other words, its NAV will increase. That's because the NAV is a reflection of the value of all of the securities in a fund at a given point in time.

Distribution

A distribution can be both forms Yield and Capital gains. A fund's NAV will change whenever a fund makes a payment to its shareholders, otherwise known as a distribution. Whenever a fund passes along income or capital gain to shareholders, its NAV drops. If a fund with an NAV of $10 makes a $4 distribution, its NAV slips to $6. Despite the shrunken NAV, shareholders are none the poorer. They still have $10: $6 in the fund and another $4 in cash. Unless they need the $4 in income to spend, most investors will reinvest their distributions back into the fund.

Total Return

Total return encompasses everything we have discussed thus far: changes in NAV caused by appreciation or depreciation of the underlying portfolio, payment of any income (yield) or capital-gains distributions, and reinvestment of those distributions. So, if you used only your NAV to calculate return that figure would be inaccurate, because you need to factor in the capital-gains distribution that you reinvested.

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