Performance is one of the key considerations when selecting a mutual fund or exchange-traded fund (ETF). However, this is a secondary consideration after identifying funds that meet your risk, style and time horizon preferences.
Just like with stocks, there are a couple of different returns to consider. With stocks, there is the simple price return, which merely calculates the percentage change in price from one point in time to another. Additionally, there is total return, which considers the reinvestment of dividends paid.
With mutual funds and ETFs, you are often presented with two returns: price and NAV. This installment of Making the Grade discusses these two different returns and how investors can use them to evaluate a fund.
The net asset value (NAV) represents the net value of a fund or ETF and is calculated as the total value of the fund’s assets minus the total value of its liabilities. Most commonly used in the context of a mutual fund or an ETF, the NAV represents the per share or unit price of the fund on a specific date or time. NAV is the price at which the shares or units of the funds are traded.
Net asset value is commonly used to identify potential investment opportunities within mutual funds or ETFs. A fund works by collecting money from a large number of investors. It then uses the collected capital to invest in various stocks and other financial securities that fit the fund’s investment objective.
Each investor gets a specified number of shares in proportion to their invested amount, and they are free to sell (redeem the value of) their fund shares at a later date and pocket the profit or loss. Since regular buying (investment) and selling (redemption) of fund shares start after the fund’s launch, a mechanism is required to price the shares of the fund. This pricing mechanism is based on NAV. Consequently, when a mutual fund’s NAV updates, so too does its price.
Unlike a stock, whose price changes with every passing second, mutual funds don’t trade in real time. Instead, mutual funds are priced on the end-of-the-day methodology based on their assets and liabilities.
A mutual fund’s assets include the total market value of the fund’s investments, cash and cash equivalents, receivables and accrued income. The fund’s market value is computed once per day based on the closing prices of the securities held in the fund’s portfolio. Since a fund may have a certain amount of capital in cash and liquid assets, that portion is accounted for under the cash and cash equivalents heading. Receivables include items such as dividend or interest payments applicable on that day, while accrued income is money that is earned by a fund but yet to be received. The sum of all these items and any of their qualifying variants constitute the fund’s assets.
A mutual fund’s liabilities typically include money owed to lending banks, pending payments and charges and fees owed to various associated entities. Additionally, a fund may have foreign liabilities that may be the shares issued to non-residents, income or dividend for which payments are pending to non-residents and sale proceeds pending repatriation. All such outflows may be classified as long-term and short-term liabilities, depending upon the payment horizon. A fund’s liabilities also include accrued expenses, such as staff salaries, utilities, operating expenses, management expenses, distribution and marketing expenses, transfer agent fees, custodian and audit fees and other operational expenses.
To compute the NAV for a particular day, all these various items falling under assets and liabilities are taken as of the end of a specific business day.
Like mutual funds, ETFs also calculate their NAV daily at the close of the market for reporting purposes. Additionally, they also calculate and disseminate intraday NAVs multiple times per minute in real time.
An exchange-traded fund’s market price is the price at which shares in the ETF can be bought or sold on the exchanges during trading hours. Because ETFs trade like shares of stocks listed on exchanges, the market price will fluctuate throughout the day as investors buy and sell shares of the ETF.
Because ETFs trade like stocks on exchanges, their shares trade at a market value that can be cents or even dollars above (trading at a premium) or below (trading at a discount) the actual NAV. This allows for profitable trading opportunities to active ETF traders who can spot and capitalize on such opportunities in time.
The difference between the market price and NAV for an ETF is due to its redemption mechanism. Redemption mechanisms keep an ETF’s market value and NAV reasonably close. The ETF uses an authorized participant (AP) to form creation units. For an ETF tracking the S&P 500 index, an AP would form a creation unit of shares in all the S&P 500 companies in a weighting equal to that of the underlying index. The AP would then transfer the creation unit to the ETF provider on an equal NAV basis. In return, the AP would receive a similarly valued block of shares in the ETF. The AP can then sell those shares in the open market.
The redemption mechanism helps keep the market value and NAV in line. The AP can easily arbitrage any discrepancies between the market value and the NAV during the course of the trading day. The ETF shares’ market value naturally fluctuates during the trading day. If the market value gets too high compared to the NAV, the AP can step in and buy the ETF’s underlying constituent components while simultaneously selling ETF shares.
Alternatively, the AP can buy the ETF shares and sell the underlying components if the ETF market value gets too far below the NAV. These opportunities can provide a quick and relatively risk-free profit for the AP, while also keeping the values close together. There may be multiple APs for an ETF, ensuring that more than one party can step in to arbitrage away any price discrepancies.
The NAV return is the change in a mutual fund or ETF’s net asset value over a given period. The NAV return is calculated based on the fund’s daily NAV reported after the stock market’s close each trading day. The NAV changes daily with the fluctuation of assets based on market value. The NAV return is a transparent accounting measure that reports the fund’s actual assets at the end of the day. Therefore, dividends, interest and capital gains distributions paid out to shareholders would not be included in the total assets unless they were reinvested.
For ETFs, we calculate the total market price return by taking the change in the ETF’s market price, reinvesting all income and capital gains distributions during the period and dividing by the starting market price.
The market return, not the NAV return, is the return actually earned by ETF investors, except for those who hold creation units.
The Fund and ETF Evaluators that are part of AAII and A+ Investor provide an array of performance data for ETFs and mutual funds on both a trailing and annual basis. Morningstar is the mutual fund and ETF data provider for AAII and A+ Investor.
Only NAV returns are provided for mutual funds since they do not trade like ETFs and do not have a separate market price.
The table below shows the annual NAV total returns for the Vanguard 500 Index fund 
(VFINX) as of March 31, 2022.
Morningstar’s calculation of total return is determined by taking the change in net asset value, reinvesting all income and capital gains distributions during that month and dividing by the starting NAV. Reinvestments are made using the actual reinvestment NAV, and daily payoffs are reinvested monthly.
Unless otherwise noted, Morningstar does not adjust total returns for sales charges (such as front-end loads, deferred loads and redemption fees), preferring to give a clearer picture of a fund’s performance. The total returns do account for management, administrative, 12b-1 fees and other costs taken out of fund assets.
Depending on an investor’s specific cash flows, their total returns may differ from the total returns shown on the Evaluator page. This is because these total returns consider the compounded appreciation and income on the (assumed) reinvested amount.
For ETFs, both NAV and price total returns are provided. Here are the annual NAV and price returns for the iShares Core S&P 500 ETF (IVV) as of March 31, 2022:
The total price return tracks the change in the market (trading) price of the ETF for the specified period and assumes reinvestment of all income and capital gains distributions during the period.
Don’t be surprised if you see a difference in an ETF’s NAV return and price return. When an ETF makes dividend and capital gains distributions in a period, these distributions are taken out of its assets, lowering the NAV. However, these distributions are still part of the investor’s total return.
Total price return, therefore, gives a more accurate representation of the return that shareholders actually see.
ETFs that trade at significant premiums or discounts to the NAV will see a larger difference between the price return and the NAV return.
