Why Mutual Fund Prices Drop (Other than Simply Going Down in Value)

USA Today does a great (and simple) job of explaining why mutual fund prices sometimes drop. Of course, they fluctuate day-to-day simply because the value of the underlying securities changes, but there's another reason for the drop that isn't bad (it's neutral):

A mutual fund's NAV (net asset value) is equal to the value of the stocks it owns plus cash. At the end of the year, mutual funds are required to distribute any cash dividends they receive and any capital gains to shareholders. When the funds make these distributions, that reduces the amount of cash they hold. That, in turn, reduces the NAV of the fund, and the share price, by the size of the distributions.

So let's say you own a share of a fund and that share has a value of $20. If the fund has to distribute $1 per share in cash dividends and capital gains, then that $1 is sent to you (added to your account) and the new value of your share is $19. You still own the same amount -- it's just now in two places.

This explains why you may think your funds have done rather poorly at the start of the year. For instance, I track my investments in Quicken and at the end of every month I update the value of my stocks and funds. However, I add dividends and capital gains later, when they are sent to me via mail. So on December 31, 2007, my Quicken portfolio showed simply the NAV at the end of the month -- it did not account for the dividends and capital gains distributed. If I simply looked at this information, it would have appeared that my funds took a major hit that month. But I knew better, so I waited a few days until my year-end statements arrived, I plugged in the dividends and capital gains information, and then I could see the true performance and value of my investments.

Comments

[beastlike]

Interesting...

[Matt]

That's also an important thing to keep in mind when you look at Yahoo Finance Charts or any of the other free ones. They only show NAV and have no option to assume reinvestment of dividends.

One time I was trying to compare Fidelity's REIT managed fund (FRESX) to Vanguard's REIT index fund (VGSIX). My retirement plan at work is with Fidelity, and I wanted to see if their managed fund does a reasonably good job of tracking the index. Yahoo Finance's charts showed them staying very close together until early September, when Fidelity's fund suddenly dropped 10% vs. Vanguard's. See for yourself. Not knowing about the NAV/dividends issue, I thought Fidelity's fund managers had lost a big bet. But then I noticed that the same thing happened a year earlier too. If you reinvest the dividends, Fidelity's fund is almost as good as the index (its expense ratio is still too high vs. Vanguard's).

Until those charts make an option available to reinvest dividends (or better yet, make it the default) they're basically useless. You can't be sure you're making apples-to-apples comparisons.