Nadig: Net Asset Values Can Fool You

How NAV works differently between ETFs and mutual funds.

Reviewed by: Dave Nadig
Edited by: Dave Nadig
It’s nice to have things you can count on in investing—it’s also pretty rare. One of those stalwart items is the “net asset value” (NAV) 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 NAV Myths

Myth 1: 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.

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 NAV. During the day, Apple was up 10% and Microsoft was down 10%. What happens to your NAV?

You report the fund up 10%.

Sounds insane? Well, standard mutual fund accounting practice is that trades are included in the portfolio for NAV purposes on the day after trade date. The logic is that until a trade is actually affirmed overnight through the National Securities Clearing Corp.’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 rarely happens, 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 NAV, 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: NAV is what all the securities are worth

Even putting aside the first myth, NAV 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 have a discussion about my hypothesized situation. The board might, for instance, adjust the price of Apple used in calculating NAV to reflect changes in Apple’s 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.

In fact, this hypothetical situation 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 The System 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 regulatory permission to basically “make up” a price when an extraordinary event occurred in international markets, which it received. 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 more than 10%. 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 had 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. 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 An ETF NAV 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, NAV 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 it’s trying to communicate with that reference price.

Let’s use the iShares MSCI Emerging Markets ETF (EEM | B-100) 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 determines it to be. The only thing you know for certain is what the prices were when all those markets were last open. But you’re not buying at NAV; you’re buying at a market price.

Authorized Participants who want to make new shares of EEM at 2:00 p.m. New York time don’t buy at NAV either. Instead, they know they have to deliver a basket of international stocks to iShares to get new shares. To get those stocks, they’ll have to wait until those markets reopen. If they put in that creation order, they’re exposed to any price movement in those stocks between 2:00 p.m. and when they can get the trades done.

So what does EEM do with NAV? Well, most of the iShares products were originally designed for institutions looking for exposures to major indexes, as alternatives to things like futures. Consequently, they use NAV as a tool to gauge how well they track indexes. The MSCI Emerging Index doesn’t “fair value” its index levels—it just uses local closing prices—so that’s precisely what EEM does. This gives useful information to investors; they can see a closing prices series to show what their actual EEM investments have done.

They can also compare the NAV to the actual MSCI index to evaluate tracking error. (In fact, the best analysis of index tracking in ETFs was done by the ICE back in 2013, using precisely this set of data.)

Focus On Your Outcomes

For investors, this means one thing primarily: Ignore premiums and discounts (the difference between closing prices and NAVs) as usually displayed anywhere for international ETFs. This may be a controversial statement (and in fact goes directly against a recent Journal of Portfolio Management article arguing that you should pretty much only focus on premiums and discounts, and consider them “transaction costs”).

Instead, I believe you should focus on your outcomes. Consider for a moment what the premiums and discounts look like on EEM …

… versus the competitive fund from Vanguard, the Vanguard Emerging Markets ETF (VWO | B-96):

On average, the difference between the closing price and the NAV is substantially smaller for VWO than it is for EEM. But this ignores the fact that VWO is explicitly fair-valuing its NAV, so you’d expect it to be much closer to market price. Meanwhile, EEM is explicitly not fair-valuing its NAV, so this premium or discount is actually a statement of how much U.S. investors believe the emerging markets will open up or down.

And in fact, neither of these charts says much about how well-run the fund is versus its index. For that, you have to look at actual holding period returns versus hypothetical holding period returns in the ETF. That’s exactly what FactSet does in our “Tracking Difference” analysis. We look at rolling one-year holding periods over a two-year window and find the median difference between the fund return and the index return.

“Perfect” fund management would have your median tracking difference be precisely behind by exactly the fund’s expense ratio. In fact, many funds do better than that due to things like securities lending.

Here's the tracking difference table for EEM:

And for VWO:

In both cases, the funds do better than their expense ratios, and the actual variation in your experiences are slightly wider in VWO than EEM, despite the headline-grabbing premiums and discounts from the first chart (1.34% spread between min and max versus 0.36%).

Adding It Up

The moral of the story is this: In mutual funds, NAVs are a transactional number—what you buy and sell at. But despite decades of refinement and no-action letters from the SEC, arriving at valuations is still an inexact science (and one not immune from error, as the recent spate of NAV restatements in ETFs and mutual funds has shown).

In ETFs, NAVs are, for the most part, reference prices designed to communicate something. The “T” in ETF is incredibly important, and your trading practices will ultimately have an enormous amount to do with what price you arrive at.

In both cases, the important thing is doing your homework and focusing on what actually matters to your investment experience.

At the time of this writing, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.