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Why Cheap Fund Shares May Not Be a Bargain

Some investors make the mistake of treating a mutual fund’s share price the way they would a stock’s share price, but they’re actually quite different. When considering two mutual funds of comparable quality, choosing the one with the cheapest share price may not be the best way to go.

A stock’s share price represents the market value of one small slice of equity in a company. If the company appears to be growing, demand for its shares may increase because investors expect its earnings (and, thus, its dividends) to grow and/or because they think they will later be able to sell the shares at a higher price. This increased demand for the shares drives the share price higher. If demand decreases–perhaps due to a lousy earnings report or a product recall–its share price is likely to fall.

In contrast, a mutual fund’s share price is determined not by market demand for the shares themselves but rather by the value of the fund’s underlying holdings. This is expressed as the fund’s net asset value, or NAV, meaning the value of all its holdings and cash after expenses are paid divided by the number of shares outstanding. (Also, investors can own fractional shares of mutual funds—something they can’t do with stocks.)

To illustrate, let’s say that the holdings in a fund’s portfolio are worth a combined total of $1 billion after fund expenses are paid, and that the fund has 10 million shares outstanding. Therefore, the net asset value of each of those shares is $100, or $1 billion divided by 10 million.

But what if another fund of comparable quality has a share price of just $75? That’s a much better deal, right?

Not necessarily. Remember that a fund’s share price is determined in part by the number of shares outstanding. So, the lower share price may have nothing to do with the quality of the fund’s holdings and everything to do with the fact that it simply has issued more shares.

As an example, let’s say that Fund A has a NAV of $20 per share with 100 million shares outstanding and Fund B has a NAV of $15 per share with 200 million shares outstanding. This means that Fund A’s holdings collectively are worth $2 billion (after fund expenses are taken into account) while Fund B’s holdings are worth a combined $3 billion. (The fund’s net asset value also includes the value of any capital gains or dividends received by the fund until they are distributed to shareholders. This is why a fund’s NAV typically drops once those distributions are made.)

But the larger point is that it doesn’t really matter what a fund’s share price is, other than for record-keeping and tax purposes to compute gains and losses. What matters in terms of performance is the change in price on a percentage basis. A fund with a NAV of $5 per share that sees its holdings perform well enough to lift its NAV to $6 per share has effectively provided its investors with a return of 20%. But a fund with a NAV of $20 per share that increases to $21 per share has provided a much lower return of just 5%. Again, it’s not the absolute price of the mutual fund’s shares that matters to investors but rather the percentage change in that price.

Returns and principal invested in stocks are not guaranteed. Investing does not ensure a profitable outcome and always involves risk of loss. The investment return and principal value of mutual funds will fluctuate and shares, when sold, may be worth more or less than their original cost. Mutual funds are sold by prospectus, which can be obtained from your financial professional or the company and which contains complete information, including investment objectives, risks, charges and expenses. Investors should read the prospectus and consider this information carefully before investing or sending money.

©2015 Morningstar, Inc.

 
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