Vanguard Takes On Overseas Arbitrage Traders
May 5, 2003
Launching what it is calling a pre-emptive strike against arbitrage traders, Vanguard of Valley Forge, Pa., announced plans to charge these opportunists a 2% redemption fee on the sale of shares held less than two months on nine of its international equity funds.
The new fees are aimed at discouraging investors from using these funds to take advantage of pricing differences between U.S. and international markets, Vanguard said. Some investors engage in short-term trading of these international fund shares, attempting to profit from pricing differences arising from the varying closing times of exchanges in the U.S., Europe and Asia.
The threat of arbitrage trading is "real and growing," according to Mercer Bullard, founder of investor advocacy group Fund Democracy and an assistant law professor at the University of Mississippi. "As funds become more complex and concentrated, especially on foreign exchanges, the risk has grown substantially," he said.
Funds that invest primarily in foreign stocks are susceptible to arbitrage trading, Vanguard said. A fund's net asset value is determined at the close of the New York Stock Exchange, but when calculating a fund's NAV, foreign securities owned by the fund typically are valued at the last quoted sale price on the foreign exchange on which it is listed. Since foreign exchanges often close hours before the NYSE, the prices do not reflect events that have transpired after their close, but before the fund prices its holdings. This is the area in which arbitrage traders make their profits.
This affects shareholders adversely, Vanguard, the country's second-largest mutual fund company said, because the frequent in-and-out trading forces managers to buy and sell stocks much more frequently. That leads to higher transaction costs, thereby diminishing returns for the shareholders and creating potential tax liabilities.
The new fees, which apply to all shares purchased on or after June 27, will affect the following funds: Vanguard International Growth, Vanguard International Value, Vanguard International Explorer, Vanguard Total International Stock Index, Vanguard European Stock Index, Vanguard Pacific Stock Index, Vanguard Developed Markets Index, Vanguard Institutional Developed Markets Index and Vanguard Emerging Markets Index.
These funds have about $14.5 billion in combined assets. Vanguard serves 17 million shareholder accounts and manages more than $575 billion in U.S. assets, with more than $180 billion in employer-sponsored retirement plans.
The Vanguard Tax-Managed International Fund, which already assesses a short-term redemption fee, and Vanguard Global Equity Fund, which invests heavily in U.S. stocks, are not instituting the new policy, Vanguard said.
There are numerous approaches to preventing arbitrage trading in foreign funds, according to Bullard. One way is to front-end load the fund so that it is not profitable to move in and out of it. He said funds can also put a "round trip restriction" on a trader, in which the number of times a trader can move in and out of the fund is limited. They can also refuse to accept the transaction of a known arbitrage trader, he said.
And the fund giant, which offers 112 funds to U.S. investors and an additional 36 in foreign markets, has utilized some of these techniques in the past. Last year, the firm began limiting shareholders to two telephone or online exchanges out of a fund within a rolling 12-month period. And these transactions are only allowed until 2:30 p.m. Eastern time, well before the close of the U.S. markets.
Vanguard said these policies did help to curb some arbitrage trading, but the firm feels more stringent measures are in order. "Our primary concern is to protect the interests of our long-term shareholders, by ensuring that fund returns are not eroded by the exploitive actions of a few shareholders," Gus Sauter, managing director of Vanguard's Quantitative Equity Group, said in a statement. "This is a redemption fee. However, we hope to never collect." Vanguard did not return calls seeking further comment.
Numerous funds that use stale prices to calculate their net asset value give arbitrageurs a chance to invest in shares they know will rise the following day. It is known as "dilution," and it is the job of the fund's board of directors to prevent it.
However, arbitragers may not be the real problem, according to Bullard. Some funds have been criticized for using the fair value pricing approach. "Some funds are using redemption fees instead of facing the real problem that they're using stale pricing," he said. "When you know the stock price is inaccurate, why isn't it being dealt with accurately?" Bullard asked.
And this may not be a move directed only at arbitrage traders. "Even if prices are always accurate, they may be also trying to deter market timing," Bullard said. "That's not arbitrage."
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