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There's a relationship among net asset value (NAV), yield and total return, but it's complicated. Did you know that a fund's NAV can fall and you can still make money? Or that a fund can yield less than 1% -- in fact, it can yield nothing at all -- and yet its returns can still be at the top of the charts?

Before we go further, though, let's review the two key components of total return. You can earn money from your investment in two ways: income (often called yield) and capital appreciation.

Income and capital appreciation

Income: A fund's income payout, or yield, tends to interest those investors who need regular income, because they don't necessarily have to tap into their principal for their day-to-day living expenses. Savings accounts and CDs pay income, but so do most bonds and some stocks. If you own a mutual fund that buys income-paying stocks or bonds, the manager passes on any income to shareholders (after taking expenses off the top, of course).

Yield can be calculated in a variety of ways. Morningstar calculates yield for the past 12 months. In other words, we add up all of a fund's income payments over the past year and divide the total by the most recent month-end NAV.

Capital appreciation: The second key way you can gain from a fund is through capital appreciation -- that is, if one or more of your fund's holdings is selling for a higher price than it was when the manager purchased it. If the manager sells the new, pricier stock or bond, the fund clocks what is called a capital gain. And even if the manager simply hangs on to the stock or bond that has gained in value, the fund will enjoy capital appreciation; in other words, its NAV will increase. That's because the NAV is a reflection of the value of all of the securities in a fund at a given point in time.


As counterintuitive as it may seem, looking at a fund's NAV in isolation isn't always the best way to check up on its performance. That's because the NAV is vulnerable to changes that don't necessarily affect the true value of the fund.

For example, a fund's NAV will change whenever a fund makes a payment to its shareholders, otherwise known as a distribution. By law, mutual funds must distribute any income they have received from their stocks or bonds, as well as any capital gains they have realized from their holdings. (A fund "realizes" a capital gain when it sells a stock or bond for a higher price than when it was purchased.) But whenever a fund passes along either income or capital gains to shareholders, its NAV drops.If a fund with an NAV of $10 makes a $4 distribution, its NAV slips to $6.

Despite the shrunken NAV, shareholders are none the poorer. They still have $10: $6 in the fund and another $4 in cash. Unless they need the $4 in income to spend, most investors will reinvest their distributions back into the fund; in other words, they instruct the fund company to use that cash to buy new shares of the fund. Most total-return numbers reported in newspapers or on the Web, including those used by Morningstar, assume that you reinvest your distributions.

Back to total return

Total return encompasses everything we have discussed thus far: changes in NAV caused by appreciation or depreciation of the underlying portfolio, payment of any income (yield) or capital-gains distributions and reinvestment of those distributions.

Here's how it works. Say you buy 10 shares of Fund A at $9 per share. After a few months, the fund's NAV rises to $12. The fund sells some of its winning stocks and makes a $2 per-share capital-gains distribution. It makes no income distributions. As a result, the fund's NAV falls to $10. Your distribution of $20 ($2 x 10 shares) is used to buy two more shares at the new $10 price. Finally, say the fund's NAV rises again, this time to $11 share.

So what is the yield on this investment? Zero, because it has not paid out any income. What about your overall return? Well, if you used only your NAV to calculate return, your shares would be worth the fund's final $11 NAV times your initial 10 shares, or $110. That's an NAV return of 22% on your original investment.

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But that figure would be inaccurate, because you need to factor in the capital-gains distribution that you reinvested. Add that back in and you'll find your investment is actually worth that $110 plus the $22 your two new shares are worth, for a grand total of $132. Your total return is really 47%. Not too shabby.