In assessing mutual fund returns, investors using the change in net asset value as the only measure of performance may underestimate the performance of a bond fund. A mutual fund’s net asset value, or NAV, is the price at which investors can buy or sell one share in the fund, and many investors evaluate a fund’s performance based on changes in NAV over time. However, tracking changes in a fund’s NAV gives an incomplete picture of the fund’s total return because this calculation excludes capital gains and dividends. Omitting these important elements of return can give investors an incomplete picture of the fund’s true performance, particularly with bond funds. In this article, we’ll examine how a fund’s NAV is calculated and illustrate the difference between a fund’s NAV and its absolute total return.
 
Decoding the NAV
The net asset value of a mutual fund share is, in simplest terms, the current market value of the fund’s assets minus the current market value of any liabilities the fund might have (such as unsettled trades), divided by the number of outstanding shares. For example, a fund with $110 million in assets and $10 million in liabilities would have outstanding net assets of $100 million. To calculate the fund’s NAV, we divide the fund’s total outstanding net assets by the number of shares outstanding.

Continuing the previous example, a fund with net assets of $100 million and with 10 million shares outstanding would have an NAV of $10 per share, meaning a new investor in the fund would pay $10 per share. Because the NAV indicates the price per share of a fund, investors often use a fund’s NAV as a measure of performance, similar to the way a stock’s performance is tracked based on price-per-share. However, tracking changes in NAV does not provide a true indicator of a fund’s performance because returns indicated by NAV changes do not include two key components of a fund’s total return: dividends and capital gains.

Understanding the difference between NAV and total return is particularly important when evaluating a bond fund’s performance, because capital gains and dividends (in the form of bond coupon payments) tend to contribute more to a bond fund’s return than is typically the case with an equity fund. In other words, a bond fund’s total return can be significantly higher than the return indicated by changes in the fund’s NAV.

Total Return: The Big Picture
To illustrate the difference between NAV and total return, let’s look at the different ways that dividends and capital gains can contribute to an investor’s return from a fund.

• Dividends: Most individual bonds and many individual stocks provide investors with regular cash payments known as coupons or dividends. In the case of a bond fund, the fund collects the coupon payments and then passes them along to fund investors, in the form of dividends, in one of the following two ways: In a daily accrual fund, which is the most common type, dividends and coupons from the fund’s holdings are placed into an accrual account each day and then distributed to shareholders on a per-share basis at the end of each month. Most investors choose to reinvest those dividends, and instead of cash they receive additional shares in the fund, priced at the month-end NAV. All of PIMCO’s traditional fixed-income funds declare fund dividends daily and pay them monthly. Quarterly accrual funds generally declare and pay any fund dividends that have accrued to shareholders on a quarterly basis. Some PIMCO funds, such as PIMCO StocksPLUS, PIMCO All Asset and PIMCO CommodityRealReturn Strategy Funds, declare and pay dividends quarterly.
• Capital Gains: Mutual funds buy and sell securities over the course of a year,and in doing so they  generate capital gains and capital losses. A capital gain occurs when you buy a security at one price and sell it at a higher price, while a capital loss occurs when you buy a security at one price and sell it at a lower price. All domestic funds distribute capital gains they accrue over the course of a year to investors. Capital gains distributions take place at least once a year, usually near the end of the year, irrespective of whether the funds are daily accrual or quarterly accrual funds. When cash is distributed to a fund’s shareholders, whether in the form of dividends or capital gains, those payments add to the investor’s total return. However, a return calculated by simply tracking the change in a fund’s NAV over time would miss these payments.
  

The Impact of Distributions on NAV
To illustrate how various distributions impact a fund’s NAV and its total return, a sample fund and returns are shown below. The chart shows monthly returns and changes in NAV of a daily accrual fund, assuming the reinvestment of all distributions. The darker line shows the fund’s total return, while the lighter line tracks returns based on NAV changes, on a monthly basis.

Source: PIMCO
This chart is hypothetical and is not indicative of any past or future performance of any Allianz Global Investors Product.

As the chart shows, a sharp discrepancy between the fund’s total return and NAV return occurred in December due to dividend and capital gain payments. The chart also clearly illustrates that the fund’s monthly total return exceeded the return indicated by the fund’s NAV, reflecting the fact that dividend payments are included in the total return calculation but not in the NAV number. Over the first 11 months, this difference resulted in total returns that exceeded returns indicated by changes in the fund’s NAV by an average of 45 basis points. The sample fund had a 12-month total return of 11.74%, while the return indicated by changes in the Fund’s NAV during that same period was 2.76%.

Now that we have illustrated the effect of dividends and capital gains on a daily accrual fund, let’s look at quarterly accrual funds. When a quarterly accrual fund distributes dividends to shareholders who have opted for reinvestment, the dividends received by the fund are embedded in the NAV (rather than kept in an accrual account as with daily accrual funds). On the date the fund pays dividends, the NAV will fall by the per-share amount of the dividend, plus or minus the day’s change due to market activity. For example, let’s assume you have a fund with a $10.00 NAV that is paying a $0.25 quarterly dividend. If the fund’s portfolio closed unchanged on the dividend day, our sample fund’s NAV would decline from $10.00 to $9.75, reflecting the $0.25 dividend payment. However, investors opting to reinvest proceeds would receive new shares in the fund equal to the value of that distribution. Therefore, the value of investors’ holdings would remain the same, even though the fund’s NAV declined. Capital gains are handled the same way for both daily and quarterly accrual funds.
 
Total Return: The Full Measure of a Fund’s Performance

When evaluating the performance of a mutual fund, the NAV provides a quick summary and is available in newspapers and on the Internet—but that summary can be misleading in that NAVs do not accurately calculate a fund’s true total return. Total returns, which factor in both dividend distributions and capital gains, can provide a better understanding of a fund’s performance and are usually available in the fund’s quarterly and annual statements or on the fund manager’s website.