The Biggest Myths In Net Asset Value by Dave Nadig, FactSet

It’s nice to have things you can count on in investing – and pretty rare. One of those stalwart items is the “Net Asset Value” calculated by all mutual funds and ETFs. It’s a nearly paternalistic piece of data-from-above that tells you with absolute certainty “this is what your investment is worth.”

Alas, it’s not, really, and it’s important to understand why.

The Two Biggest Net Asset Value Myths

Myth 1: The NAV is the portfolio holdings divided by the number of shares in the fund or ETF.

Let’s start with the biggest myth of all, which is that NAV is a snapshot in time of precisely what’s going on in a fund. Unfortunately, that’s not really the case.

[drizzle]Imagine you’re an active equity fund manager. You start the day 100% in Apple, but right on the open, you decide to sell your 100% Apple position and buy Microsoft instead. At 4:00 p.m. the market closes, and you have to report your Net Asset Value. During the day, Apple was up 10 percent and Microsoft was down 10 percent. What happens to your NAV?

You report the fund up 10 percent.

Sound insane? Well, standard mutual fund accounting practice is that trades are included in the portfolio for NAV purposes on T+1. The logic is that until a trade is actually affirmed overnight through the NSCC’s continuous net settlement process, it’s not a “real” trade. It’s not done. Theoretically, the trade could be unwound for some reason. While it happens pretty rarely now, back before computers, it happened all the time.

So what happens if a mutual fund investor puts in an order to buy new shares that day? Well, the NAV will be inflated, and they’ll actually get fewer shares than they might otherwise. Of course, a seller would get more cash than they might otherwise.

In the real world, few mutual funds make huge position changes that have meaningful impacts on Net Asset Value, but this is, in fact, how the math works, and it makes NAV, at best, a “good guess” as to what the portfolio is worth. Today’s NAV is always, in fact, yesterday’s closing portfolio, marked to today’s closing prices.

Myth 2: Net Asset Value is what all the securities are worth.

Even putting aside the first myth, Net Asset Value is still just a very good guess on valuation. Let’s imagine you run an S&P 500 index mutual fund. There have been no additions or dividends or anything else that requires any trading in days, so the previous myth is irrelevant. At the end of the day, what’s your NAV?

Well, there’s a very specific definition (SEC rule 270.1a-4), which says:

“Portfolio securities with respect to which market quotations are readily available shall be valued at current market value, and other securities and assets shall be valued at fair value as determined in good faith by the board of directors of the registered company.”

So if every security in the fund is trading up to the close, well, you just use the closing price. But what happens if, say, Apple, at 3:00 p.m., is halted for trading because of a pending announcement and doesn’t reopen before the close.

What’s Apple worth at 4:00 p.m.?

That’s where humans get involved. Every mutual fund and most ETFs (which are just mutual funds under the hood) have a board of directors, and the board sets policies about what to do in situations like this. In rare cases, the directors might even get on the phone and have a discussion about a situation like I hypothesized here. The board might, for instance, adjust the price of Apple used in calculating Net Asset Value to reflect changes in Apples options, if shares were still trading. The board might choose to do nothing. Or it might look at how the stock of related companies traded into the close.

This hypothetical situation, in fact, happens every single day with any mutual fund or ETF that owns international securities or any bond other than a U.S. Treasury. In those cases, there’s no “4:00 p.m. price” because in the case of international stocks, they probably closed hours ago, and in the case of bonds, they may not have traded in days, or even weeks.

How Blue Monday Gamed Investors

There’s no hard and fast rule about how to handle these situations. There are various pieces of guidance from accounting and regulatory authorities, but it ultimately comes down to what’s defensible by the fund boards. And different fund families, and even individual funds, can use very different standards.

Back in 1981, Putnam asked for permission to basically “make up” a price when an extraordinary event occurred in international markets, which it received, and that opened the door for a whole cadre of fair-value models that take closed securities and “update” their prices to reflect new information between, say, the close in Japan and the close in New York.

In October 1997, these different approaches had their first real moment in the sun, when Hong Kong’s stock market tanked over 10 percent. On the fateful day, most mutual funds invested in the country, in whole or in part, reported NAVs at significant losses, and investors tried to game a potential recovery by placing orders to buy many hours after Hong Kong trading had closed. Fidelity, however, chose to fair value the Hong Kong stock market as being worth much more, and, famously, one fund, the Fidelity Hong Kong and China Fund, actually reported being up a fraction of a percent.

Investors were confused and inflamed. They thought they’d gamed the system, when the system gamed them.

In the end, the SEC didn’t mandate fair value pricing, but over the course of the next decade it forced boards to adopt more clearly written policies on when and how they adjust valuations, and, for now, most traditional actively managed mutual funds do in fact fair value their NAVs for international funds to prevent the kind of timing games investors tried in 1997.

Why ETF Net Asset Value is Different

When thinking about the second myth here as it relates to ETFs, it’s important to think about why ETFs are and aren’t just like mutual funds. The most important thing about ETFs is that NAV isn’t a transactional price. With the exception of some fixed income funds that use cash creations, Net Asset Value isn’t actually used for anything. It’s a reference price. Most ETF transactions happen in the open market, at a market derived price, and the creation process doesn’t intersect with NAV at all. And as a reference price, the ETF issuer has to decide what they’re trying to communicate with that reference price.

Let’s use the iShares Emerging Markets ETF (EEM) as the poster child. EEM holds some 800 or so stocks from markets all over the world, from Russia to Brazil. Most of these markets close at a time different than 4:00 p.m. in New York. At FactSet, we publish a statistic called “Market Hours Overlap” to assess the disconnect, and the market hours overlap between EEM and its holdings is only 14%.

So what’s the “fair” price of EEM at, say, 2:00 p.m. New York-time  when you go to make a trade? Well, it’s whatever the market

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