Zaks Investment Advisory Service

Net Asset Value of Mutual Funds, and a Bit About Taxes

We have started discussing Mutual Funds. Mutual Funds are one of the main investment instruments available to individual investors. We talked about the advantages of investing in Mutual Funds over buying individual stocks and bonds, and also paused to note the associated expenses, as well as which expense items are worth taking into particular account. If you missed these programs, you may find them on our site, www.zaksinvest.com.

One of the basic notions associated with Mutual Funds is NAV, or Net Asset Value. If you look up a fund price on the Internet or in a newspaper, what you will see quoted is the NAV.

NAV is a concept similar to share prices of regular companies. NAV, as the name implies, is the sum of all fund assets minus its liabilities. Liabilities, for example, could include the money a fund is due its staff and the managers who oversee the investments. Assets, on the other hand, are mostly made up of securities obtained by the fund. The prices of these securities, like of all securities on the stock exchange, change constantly. NAV is calculated by taking the price of securities at market close, and dividing the net assets (i.e. assets minus liabilities) by the number of shares in the fund. Because a fund has very few expenses compared to assets, the NAV is very close to the value of all securities, calculated per share. Each Mutual Fund must calculate its NAV at the end of every trading day. On the following day, this figure is used to calculate prices at which shares are bought and sold. As we explained in our previous program, additional expenses such as a sales load may be added to this base price. But many funds (such as no-load funds, for example) buy and sell their shares at the NAV price.

When stocks (or bonds) in a Mutual Fund portfolio grow in price, the NAV grows along with them. But a rise in share price is not the only source of investor return (or potential return). For example, some stocks in the fund portfolio may pay dividends. These dividends are added to the fund’s assets. Bond coupons add to the returns in the same manner. Managers of many funds buy and sell shares: they sell those they think will be growing slowly in the future, or simply falling; they buy those they believe will see faster growth. When managers sell some shares, then the capital gains, i.e. the price difference between when a share was bought and sold, become part of the fund’s assets. Up to a certain point, the dividends, coupons and capital gains accumulate on the fund’s accounts. But periodically – at the end of a quarter or the end of a year – all the dividends and capital gains (minus expenses of the fund itself) are paid to the investors. These payments are made in accordance with a rule introduced by the SEC, the Securities and Exchange Commission, which boils down to the idea that Mutual Funds may not earn any returns – these must all go to the shareholders.

When Mutual Funds make dividend and capital gains payments, the NAV falls: you may have noticed this by following the NAV chart of almost any Mutual Fund: its NAV falls sharply the moment the fund’s dividend payments are made. But this is understandable and should not be of concern to the investor: the total amount of money does not change, only a part of it moves from the fund to the investors. The investors must pay a tax on the earned dividends. Even if you have selected the so-called “automatic reinvestments” option, i.e. automatically use the earned dividends to purchase additional fund shares (and thus not get any cash dividend payments), you will still have to pay the tax. I recently mentioned that the dividend and capital gains payments made into an IRA account are not taxed. But if you invest money into a regular investment account (and not one of your IRA or 401(k) accounts), then you must pay taxes on the earned dividends and capital gains. Thus a paradoxical situation may arise where, as a result of a market fall, your investments lose value (i.e. the NAV price falls), but you must still pay a tax. Fortunately, this does not happen too often. Also, investors should pay attention to the fund’s distribution dates when they plan to invest money at the end of the year. Otherwise, they may be surprised by an unintended tax liability.

Next time, we will discuss various types of funds. There are numerous types of Mutual Funds to suit the taste of almost any investor. We have already mentioned Index Funds. Perhaps the largest sector is made up of the widely diversified stock funds, which are sometimes called “blended funds.” One such example is Magellan, a gigantic fund of the Fidelity company. We will also make sense of what value funds and growth funds are, as well as of bonds funds and money market funds.

With this, we will draw our program to a close. This was Sergey Zaks. Thank you for your attention and until next time.