Mutual Fund Nav Prices

Mutual funds: Understanding share price adjustments

Every December, investors see huge drops in the NAV (net asset value, or share price) of their mutual funds. They panic and scramble to call the mutual fund company. The hold time is longer than usual. The investor frets, sweats, and gets increasingly desperate. Finally they get a person on the other end of the line.

“That’s not a real drop,” the agent says in a calm, soothing voice. “That’s just a distribution.”

What’s the difference between a distribution and a drop in share price? Why does it happen every year? This article explains the way share price adjustments work in mutual funds.

Income: dividends, interest payments and capital gains

Mutual funds make income from two sources: dividends and interest paid by underlying assets, and capitalgains from selling assets.

Dividends are simply cash distributions paid by stocks. Financial stocks and high-risk stocks tend to pay the highest dividends. Some small or high-growth companies don’t pay dividends at all. When a mutual fund collects dividend payments from stocks, the money is reinvested and the value of the assets the mutual fund holds will increase.

Example: My Example Mutual Fund (NYSE:MEMFX) has $100 in assets. A stock owned by MEMFX pays a dividend of $3. MEMFX managers reinvest the $3 in other stocks. Now, the total assets owned by MEMFX total $103.

Bonds earn interest payments that work pretty much the same way as dividend payments outlined above. However, bond funds generally pay interest on a monthly basis. Most dividends are issued on a quarterly or annual basis.

Both dividends and bond interest payments are taxable income for most individuals.

Capital gains occur when a mutual fund sells a stock at a profit. The proceeds are reinvested.

Example: MEMFX owns $100 in assets. Thanks to a good year, XYZ stock’s price rises by 10%. MEMFX owns $10 in XYZ stock, which is now worth $11. The underlying NAV (net asset value, or total asset value) of MEMFX is now $101. If MEMFX managers sell XYZ stock, they will make a total of $11 which will be reinvested.

Capital gains are considered to be taxable income for most individuals.

Mutual fund income vs. asset value

Now, just because stocks or bonds make dividends or interest payments, a mutual fund may not make a payment to investors. Think about it: if every time an individual asset made income, the mutual fund made a payment, there would be constant, almost daily, small payments to investors. (Some mutual funds own more than a thousand separate assets!). To avoid all this, most mutual funds make payments (called “distributions”) on a quarterly or annual basis. Bond funds generally pay interest income every month.

Note that these payments are called distributions in the mutual fund industry. This is because mutual fund income is generally derived from a combination of capital gains, dividend income and interest income so it’s not technically a dividend.

Let’s go back to My Example Mutual Fund. If MEMFX pays a distribution of $1 per share, and an investor owns 10 shares, the investor has two choices: she can either take the $10 distribution as income, or she can choose to reinvest the $10 back into MEMFX. Because many investors put money in mutual funds so that it will grow over time, they choose to reinvest their distributions instead of taking them as income. Our example investor now owns $10 more in MEMFX shares.

Here’s where things get a little tricky.

Distribution reinvestment and share price
When MEMFX pays a distribution, the value of its underlying assets drops by the amount it pays out. For example, if MEMFX has $100 in assets and pays out $2 in distributions, the remaining assets will be worth $98.

However, as discussed above, some investors will choose to reinvest distributions back into the fund. Because the value of the underlying assets has dropped (because some investors took the money), the NAV or share price will drop. Investors who reinvest distributions will be able to buy more shares. So the overall value, whether investors choose to take their distributions as income or to reinvest them into the mutual fund, stays the same for the individual.

Here’s an example: MEMFX has $100 in assets. There are 10 shares, valued at $10 each. MEMFX pays a distribution of $1 per share. Half of the investors reinvest their distribution and the other half take the distribution as income. Now MEMFX has ($100-$5=) $95 in net asset value, so each of the original 10 shares is worth ($95/10=) $9.50 each. $5 has been removed from the NAV, but the investors who reinvested have the equivalent of $1 each in new shares. So, even though the per-share price has fallen, investors are in exactly the same place.

So remember, especially in December: when your mutual fund NAV or per-share price drops, don’t panic! Be happy that you’ve made either a big distribution, or now are the proud owner of a lot more shares of the mutual fund. Of course if you have any questions contact the mutual fund management company – but they’ll tell you the same thing.