Guinness Flight fights arbitrage with early order deadline
January 11, 1999
Guinness Flight Investment Funds has taken a novel step to combat arbitrageurs who have tried to use its Asian mutual funds to exploit market volatility in the past 15 months.
Beginning Feb. 15, four Asian-oriented Guinness Flight funds will move the daily closing time for purchase and sale orders from 4 p.m. to 9:30 a.m. eastern time. Purchase and sales orders received after 9:30 a.m. will be executed based on net asset values (NAV) set the following business day. Although fund companies have moved up order deadlines for operational reasons on occasion, the Guinness Flight move appears to be the first time a fund company has established such an across-the-board early order deadline to deter arbitrage.
The early deadline is intended to deny arbitrageurs a chance to make a quick, low-risk profit from swings in the value of securities between the time Asian markets close -- roughly 4 a.m. eastern time -- and the 4 p.m. closing of U.S. markets, James J. Atkinson, president of Guinness Flight, said last week. Atkinson informed Guinness Flight shareholders of the move in a letter dated Jan. 4.
"Simply put, it is not sensible to accept transactions in a mutual fund when the pricing point for valuing the portfolio assets precedes the order deadline by 12 or so hours," Atkinson wrote.
Guinness Flight, based in Pasadena, Calif., has approximately $217 million in assets in Asian markets through its Asia Blue Chip, Asia Small Cap, China & Hong Kong and Mainland China funds. The fund group offers three other funds and has total assets under management of approximately $241 million.
Arbitrage in Asian funds and the pricing of securities in those funds became an issue on Oct. 28, 1997. On that day, Asian markets fell after a one-day market drop of seven percent in U.S. markets on Oct. 27. But U.S. markets rallied during the day on Oct. 28. Arbitrageurs guessed, correctly as it turned out, that Asian markets would rise in reaction to the U.S. rally when they reopened on Oct. 29. In effect, investors bought Asian funds on Oct. 28 at a discount. A subsequent SEC investigation found that there were frequent incidents of investors attempting to exploit the market volatility.
Some mutual fund companies, including Fidelity Investments, however, short-circuited the problem by using the so-called "fair value" method of setting the prices for securities. Rather than use the closing market prices from Asia, Fidelity adjusted the prices upward because of the rally in U.S. markets. SEC officials ultimately endorsed the move, saying such adjustments were an attempt to reflect the true value of a fund's holdings.
But officials at smaller fund groups warned that, as a practical matter, it was virtually impossible for them to institute fair value pricing. Atkinson said fair value pricing has "a certain arbitrariness" both in when and how it is applied. Guinness Flight has rejected it in favor of the earlier deadline.
"Fair value is really nothing more than a way to finesse the problem," Atkinson said.
The problem of investors seeking to exploit market volatility has recurred several time since October, 1997, and has become increasingly serious, Atkinson said.
Guinness Flight has moved up order deadlines on an ad hoc basis and occasionally refused to honor large trade requests, Atkinson said.
The mutual fund supermarkets at Fidelity and Charles Schwab & Co. have agreed to new deadline on a trial basis, Guinness Flight officials said. Greg Gable, a spokesman for Schwab, said the early deadline poses some operational difficulties which Schwab wants to assess during a trial period.