Today’s post is inspired by Charlemagne, who writes in to ask about a sudden drop in value of one of his investments. Concerned about his holding Super-short Duration Debentures mutual fund (ticker: SSDD), Charlemagne writes in to say:

Do you have an idea why the mutual fund SSDD is getting so ‘hammered?’ This is especially disconcerting considering that the stock market overall is doing so well.  I’ve lost $4,000 today alone!

Fortunately, Charlemagne did not lose $4,000 yesterday. It just looks that way. This is because of how cash distributions affect the net asset value (NAV) of mutual funds. (In fact, we’ve even indirectly written about this subject before, when we discussed total return investing.) That is, in order to accurately compute your investment return, you must account for both NAV and any cash distributions. To explain . . .

[big_title2]Mutual Fund Distributions[/big_title2]

What are mutual fund distributions? Mutual fund distributions are cash disbursements from the fund. These cash disbursements go directly to the fund share owners, proportional to the amount of shares that they own. (In this instance, a $4,000 cash disbursement goes to Charlemagne because he owns one share of SSDD.) The reason why it looks like Charlemagne lost money on his mutual fund investment yesterday is because his calculation of investment return (erroneously) does not include the value of the cash distribution.

[big_title2]Net Asset Value (NAV)[/big_title2]

The value of the mutual fund, the line item that Charlemagne sees in his investment account, is based on the net asset value (NAV) of the mutual fund. NAV is the sum total of Charlemagne’s proportional share of investments in the mutual fund. These investments inside the mutual fund can be stocks, bonds, cash, or other investments.

When the mutual fund makes a distribution of cash to the mutual fund holders (i.e. Charlemagne et al.), the NAV of the fund decreases. This because money is leaving the mutual fund. Since that money has left the fund, that money can no longer be included as an asset on the mutual fund’s balance sheet.

However, though the value of the fund decreases, the ultimate wealth of Charlemagne remains the same. In short, it’s a zero sum game. Money moves from one hand to the other, but the person holding the money still holds the same amount of money. Consider the chart below:

Mutual Fund Share NAV table-page-001

Let’s return to our example with Charlemagne:

Charlemagne’s single investment is one share of “Super-short Duration Debentures” fund (ticker: SSDD). (Obviously, his portfolio is not very diversified.) The NAV of the fund is $100,000. Therefore, Charlemagne’s investment account value is $100,000.

SSDD makes a dividend distribution of $4,000. The NAV of SSDD appropriately decreases by the same amount, $4,000. This leaves the SSDD NAV at $96,000. But, the value of Charlemagne’s investment account still equals $100,000, when including for both the $96,000 mutual fund NAV, and the $4,000 of cash now sitting in the account.

Cash distributions from mutual funds are usually either deposited into investor’s money market fund, or re-invested to purchase additional shares of the mutual fund. Either way, the total account value remains the same.

It is normal operating procedures for mutual funds to make cash distributions. This is especially the case at this time of year. So, if you see a radical drop in your mutual fund value, don’t panic. Look to see if the mutual fund has issued a cash distribution.

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