ETF Net Asset Values: Fact & Fiction

September 08, 2015

With all the chaos surrounding miscalculated net asset values in ETFs and mutual funds, it might be smart to understand what the heck NAVs are, and why they do—and don’t—matter.

Imagine you were making the very first mutual fund. You and your best friend each put $10,000 into a brokerage account, and you agree to hire Bill & Ted’s Excellent Investors (BTEI) to run the money for you. You agree to pay BTEI 1 percent to take care of it all.

But how do you actually keep track of everything? You could just share the login to the brokerage account and figure that since you went in with equal amounts, you were entitled to half of the balance. But what happens when you want your money out? Or you want to add more? Keeping track of your ownership stake gets tricky fast.

Unit-Based Accounting
That’s where the idea of unit-based accounting comes in. Instead of just keeping the account in one big dollar amount, we decide that our new fund will issue 100 shares when we launch it. Since we’re putting in $20,000, each share will be initially worth $200.

Now, if we want to see how we’re doing, all that we have to do every day is take the pile of money in the account, divide it by 100, and we have a per-share value. Simple, right?

The good news is that the structure is really just about that simple. Every fund has a custodian, just like I personally have a Schwab brokerage account. That custodial account holds all the assets of the fund, and also records any structural liabilities (like, being short a stock).

In principle, this is all an ETF or mutual fund net asset value is. It’s a unit measurement. But there are issues and rules about each one of the words in “net asset value.”


Let’s start with “Net.” NAVs are net, in the sense that they are the sum of all of the assets in the account, minus all the liabilities. But there are things not necessarily obvious that have to be “netted” to. Someone has to keep track of how much money we owe Bill and Ted. Someone has to keep track of any expenses (like paying the custodian). In addition, things like dividends you’re owed or paid can complicate the calculation.

Because of all this netting, the role of calculating this is considered an entire separate job: fund accountant. Many custodians simply do this in-house using proprietary software and dedicated employees. Some outsource it, or use third-party software vendors.

Next up on the opportunity for confusion is “Asset.” This would seem very simple: The fund either owns something or it doesn’t. Unfortunately, the mutual fund industry is governed by an 80-year-old document called the Investment Company Act of 1940. The specific rules for what counts as an asset include this little-known fact (from Rule 2a-4):

“Changes in holdings of portfolio securities shall be reflected no later than in the first calculation on the first business day following the trade date.”

What that means is that if, at 9:30 this morning, BTEI decides to sell all of its Apple stock and buy IBM instead, that trade will not actually be reflected in the pool of assets used to calculate total value at 4 p.m. tonight. If Apple were up and IBM were down since that opening trade, the investor won’t actually experience the pain of IBM’s decline until tomorrow’s NAV. This means that in a very real sense, the NAV of a fund on a day that involved a single portfolio transaction is a fiction.

Put another way, NAV is yesterday’s portfolio, processed with today’s prices. This fiction can and does lead to real distortions in performance statistics (there’s a great 2006 paper on the subject essentially proving it.)

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