Net asset value(NAV) is one of the most important concepts in fund investing, and for good reason -- investors who know how to use NAV to determine a fund's fair value actually have a tool to unearth funds poised to outperform. Consider this: investors can use NAV to discover funds trading below the actual value of their portfolios -- meaning you can pick up a fund's assets for a discount to what they are really worth.
But before you can take advantage of what NAV is telling you about a fund, you need to understand what NAV is.
The Ins and Outs of Net Asset Value
Put simply, net asset value measures the value of a fund's assets, minus its liabilities. The formula for calculating NAV is:
NAV per share = (Market value of all securities held by fund + Cash and equivalent holdings - Fund liabilities) / Total fund shares outstanding
So if a particular fund held $8,500,000 worth of securities, $2,000,000 of cash, $500,000 of liabilities and had 1,000,000 shares outstanding, then the fund's NAV per share would be:
NAV = ($8,500,000 + $2,000,000 - $500,000) / 1,000,000 = $10.00
The NAV changes daily as the value of a fund's securities, cash held, liabilities, and the number of shares outstanding fluctuates.
Traditional open-end mutual funds and their closed-end cousins share many common traits, but also a few key differences. For example, CEFs are more liquid, can use leverage to boost returns, and don't have to raise cash to meet shareholder redemptions.
Of course, the most striking difference is that open-end mutual funds trade precisely at their net asset value (NAV). By contrast, CEFs can -- and often do -- trade above (premium) or below (discount) the value of their underlying assets.
While there will be situations in which it is acceptable to buy funds changing hands at a premium, it is generally more advantageous to look for those that are currently on sale. After all, if the net value for our fictional fund above ends up at $10 per share, yet its current market price is just $9, then investors are being handed the rare opportunity to scoop up $1 worth of assets for just 90 cents.
When Mr. Market tosses a stock in the bargain bin, it's often because the company has suffered deteriorating operating performance or is facing some other obstacle. However, this isn't necessarily the case with closed-end funds -- many funds with rock-bottom price tags happen to be top-tier performers.
Because CEFs trade on the open market, they are subject to the whims of supply and demand. As such, there is typically a discrepancy between price and value -- sometimes a wide one.
There is no single reason to explain why a fund might trade below its NAV, but academic studies have isolated several contributing factors, most notably: relative performance, embedded unrealized capital gains, investor sentiment, scarcity of competing funds, the name-brand recognition of the manager or fund company, and the existence of a managed distribution policy Regardless of the cause, if you can swoop in on a discounted fund at the right time, you can reap huge rewards.