ASK KIM
Forget About Fund Share Prices
by Kimberly Lankford

I've heard that I should never purchase a mutual fund based on its net asset value. But I just can't get a handle on the wisdom of this advice. Could you explain why this is so?

Let's say you had a top ten list of issues to review before investing in a fund. The NAV -- or, more simply, its share price -- would be somewhere around 26th. In other words, it's irrelevant.

The net asset value is simply the value of the fund's assets (minus any liabilities) divided by the number of shares outstanding. With this basic understanding, let's look at what could impact the NAV:

• Asset size. Don't confuse the fund's NAV with its total asset size. Nothing kills a fund's performance faster than too much money to manage -- especially when it comes in too quickly or when the fund invests in smaller companies.
  
  The reason: If a small-company fund becomes too big, it must buy such large blocks of stock that it adversely affects the price when it buys and sells. A fund may also end up owning stock in more companies than its manager can research well.
  
  Where do you draw the line? If you're looking for a rule of thumb, avoid or sell a small-company fund that keeps its doors open to new investors after crossing the $1 billion mark. Funds that target midsize companies tend to run into trouble at about $10 billion.
  
  
• Shares outstanding. The problem with looking only at the NAV is that a share price of, say, $20 could be hiding a total asset size of more than $1 billion if there are 50 million shares outstanding.
  
  Open-ended mutual funds never stop selling shares, affecting the rules of supply and demand. For example, when stocks become popular, demand for shares cause an increase in price. But when an open-ended fund becomes popular, it simply issues more shares. (Supply and demand for "closed-end funds" and exchange-traded funds more closely resemble stocks.)
  
  
• Extraneous factors. Other factors also influence a fund's value, such as how long it has been in existence (all else being equal, older funds will have larger NAVs than younger funds) and the size and frequency of capital-gains and income distributions (funds reduce their NAVs by the amounts of these payouts).

For more advice on building a portfolio of mutual funds, see Growing a Fund Portfolio and our recommended fund portfolios for various investing time frames.