Exchange Shutdown Demands Ingenuity
September 13, 1999
When international stock markets shut down, as they did as a result of the Aug. 17 earthquake in Turkey, U.S. fund managers can be sent scrambling for a new method of pricing their funds in order to keep them operating.
Eleven open-end mutual funds, including emerging market fund offerings from Merrill Lynch of New York, Federated Investors of Pittsburgh, Pa., Putnam Investments of Boston, Vontobel Funds of New York and OppenheimerFunds of New York were holding a five percent or larger block of Turkish securities in recent months (see chart), according to Morningstar, the fund data tracker in Chicago.
In the aftermath of the earthquake, Turkey's stock exchange, the Istanbul Exchange, shut down for two days, causing fund managers to seek alternative means of pricing the securities. Open-end mutual funds are required to price all of their portfolio securities to market on a daily basis. From those collective valuations of individual securities, fund advisers must then derive a fund's daily net asset value.
If trading in any world stock exchange is halted, for whatever reason, fund managers can find themselves unable to price these fund securities against the open market. In such cases managers must switch to an alternate securities pricing method called fair value pricing. Fair value pricing allows for a fund to use alternate means to calculate the value of fund securities. It is very unusual for a stock exchange to close for any reason.
The closed-end Turkish Investment Fund managed by Morgan Stanley was quick to alert shareholders that it was temporarily computing its net asset value using fair value pricing. The fund manager cited significant power outages and numerous communications failures, in addition to the closing of Turkey's stock exchange as cause for shifting to the alternative method. Open-end funds have language in their prospectus that allows them to switch to this alternate pricing method in crisis situations without alerting shareholders.
When a stock market shuts down, fund managers often look to other stock markets to gauge the prices at which fund holdings are trading, said Douglas Dooley, portfolio manager of the J.P. Morgan Emerging Markets Fund. J.P. Morgan currently holds approximately two percent of its $200 million emerging markets fund in Turkish securities, said Dooley.
Fund managers will also try to find out from word-of-mouth among other brokers if individual securities are trading in an "off market" or privately, said Dooley. If so, they will try to derive valuations from such trading. Moreover, portfolio managers will seek out brokers in local foreign markets to assess how individual companies are faring in a crisis.
In addition, equity analysts within a fund group can help fund managers to determine the impact of an earthquake or other event on individual companies, said Dooley. If, for instance, a Turkish company is headquartered in Istanbul but its operations are miles away from the area of damage from an earthquake, that knowledge can help appropriately price securities.
Under SEC investment company regulations, a fund's board of directors must approve and oversee the methods employed to price funds daily. When individual security prices are difficult to determine, such as for thinly-traded, private or illiquid securities, those securities must be valued at fair market price as determined by or under the supervision of the board.
Often a fund board will delegate this task to a valuation committee, one key board member or even to the adviser, said Carl Frischling, partner with Kramer, Levin, Naftalis & Frankel in New York.
Although closed-end funds, like open-end funds, must come up with alternative values in the event of a stock exchange shutdown, those alternative valuations are less significant because closed-end funds trade on the stock exchange. It is the value the stock exchange sets for the funds which is the most important. Also, although closed-end funds must calculate daily net asset values, they are only required to price their fund portfolios once a week.
Single-country closed-end funds are likely to be the most affected by an event like an earthquake, said Larry Kantor manager of the Lexington Funds of Saddle Brook, N.J., adviser to the $70 million, open-end Lexington Worldwide Emerging Markets Fund. According to Morningstar, the fund data tracking firm in Chicago, as of June 30, Turkish securities accounted for close to 12 percent of the Lexington emerging markets fund. That made it the number one open-end mutual fund in terms of exposure to the Turkish market at the time of the earthquake, according to the best data available from Morningstar.
Open-End Mutual Funds with the Largest Holdings in Turkey
(Percentage of holdings)
Lexington Worldwide Emerging Markets 11.88 (6/30/99)
Merrill Lynch Middle East/Africa 10.02 (5/31/99)
DFA Emerging Markets 7.77 (5/31/99)
Pictet Global Emerging Markets 7.76 (3/31/99)
Federated Emerging Markets 7.50 (8/24/99)
Putnam Emerging Markets 6.73 (2/28/99)
Vontobel Emerging Markets 6.72 (12/31/98)
AXP Emerging Markets 6.57 (7/31/99)
Excelsior Emerging Markets 5.74 (3/31/99)
Bernstein Emerging Markets Value 5.60 (3/31/99)
Oppenheimer Developing Markets 5.39 (2/28/99)
Holdings are as of dates in parentheses Source: Morningstar, Inc.