The most prevalent and well-known type of mutual fund operates on an open-ended basis. This means that it continually issues (sells) shares on demand to new investors and existing shareholders who are buying. It redeems (buys back) shares from shareholders who are selling.
Mutual fund shares are bought and sold on the basis of a fund’s net asset value (NAV). Unlike a stock price, which changes constantly according to the forces of supply and demand, NAV is determined by the daily closing value of the underlying securities in a fund’s portfolio (total net assets) on a per share basis.
Net asset value (NAV) represents a fund’s per share market value. This is the price at which investors buy (“bid price”) fund shares from a fund company and sell them (“redemption price”) to a fund company. It is derived by dividing the total value of all the cash and securities in a fund’s portfolio, less any liabilities, by the number of shares outstanding. An NAV computation is undertaken once at the end of each trading day based on the closing market prices of the portfolio’s securities.
For example, if a fund has assets of $50 million and liabilities of $10 million, it would have a NAV of $40 million.
This number is important to investors, because it is from NAV that the price per unit of a fund is calculated. By dividing the NAV of a fund by the number of outstanding units, you are left with the price per unit. In our example, if the fund had 4 million shares outstanding, the price-per-share value would be $40 million divided by 4 million, which equals $10.
This pricing system for the trading of shares in a mutual fund differs significantly from that of common stock issued by a company listed on a stock exchange. In this instance, a company issues a finite number of shares through an initial public offering (IPO), and possibly subsequent additional offerings, which then trade in the secondary market. In this market, stock prices are set by market forces of supply and demand. The pricing system for stocks is based solely on market sentiment.
Because mutual funds distribute virtually all their income and realized capital gains to fund shareholders, a mutual fund’s NAV is relatively unimportant in gauging a fund’s performance, which is best judged by its total return.