Cracking the Fair Value Pricing Conundrum
October 13, 2003
NEW YORK - The recent market timing and late trading allegations brought forth by New York Attorney General Eliot Spitzer have sparked a renewed interest in how mutual fund firms determine fair value. The crux of the matter is that many fund shares are bought and sold at incorrect prices due to time zone differences. Quantitative research in the past few years has made the industry aware that the use of stale prices affords market timers the opportunity to realize significant gains at the expense of shareholders.
For example, a U. S. fund that invests in Japanese stocks can manipulate the system with a simple strategy. Since the Nikkei will have been closed for hours when this fund calculates the value of its net assets at 4 p.m. in New York, its share price will not reflect any news from the last several hours. Market timers can use this stale pricing to make an easy profit without having to get help from a mutual fund to trade after the market close in New York. Traders can buy foreign funds immediately before the close on a day when the U.S. stock market has enjoyed a nice rally, and sell whenever the market has sharply declined. This strategy exploits the tendency of foreign markets to piggyback the U.S. market.
Fair-value pricing is one way a firm can eliminate the advantage gained by arbitrageurs who are moving nimbly in and out of a fund. Boiling it down, it is a method of estimating the price a security would trade at on the open market at a certain time provided there are a sufficient number of buyers and sellers. But there are different schools of thought when it comes to calculating a fund's net asset value. In fact, there are extraordinary differences of opinion on NAV pricing within the fund industry.
Prudently, a group of investment managers, independent auditors and academics met in New York last week to discuss current best practices for fair valuing international securities at a conference hosted by Investment Technology Group. The New York-based brokerage and technology firm, which operates the POSIT electronic share-matching system, recently teamed up with KPMG to introduce a new fair value benchmark that will help the accounting firm assess whether mutual fund clients have set reasonable prices in fair valuing securities.
"Daily pricing of mutual funds provides liquidity to investors but is subject to valuation errors due to the inability to observe synchronous, fair security prices at the end of a trading day," said William Goetzmann, a finance professor at Yale School of Management and co-author of a research paper on day-trading international mutual funds. He noted that using stale prices to calculate daily NAVs creates predictability in fund returns. "When inaccuracies are forecastable, that is a problem," he said.
Goetzmann argued that when arbitrageurs exploit time-zone differentials, it has an adverse effect on the other shareholders in the fund because it dilutes the overall holdings. While these inaccuracies may be relatively small on a daily basis, over the long haul, it could mean billions of dollars in lost profits. And individual investors are largely in the dark when it comes to these trading practices.
Cracking down on the use of stale prices has been the cause for much debate over the years but even more so now, in light of the rash of illegal trading allegations. Determining which investors are engaging in arbitrage is not an easy task, Goetzmann said. Examining net fund flows is one tactic used in his research to screen timing ability at the individual fund level.
However, the correlation between net flows and returns turned out to be pretty modest for the average fund. Another popular deterrent employed by a majority of fund firms is imposing redemption fees on frequent traders. The problem with that remedy is that it is very unpopular with investors who are already rankled by the fee structure of mutual funds. In addition, fees tend to punish the entire group of shareholders when it is really a small minority engaging in the arbitrage.
A third approach to curb market timing employed by fund companies is using occasional fair value pricing. That involves calculating the fair value of a fund following a major event such as a terrorist attack. Under these circumstances, companies can prevent a gaping hole between a fund's closing price and its price at the start of trading the following day. Still, its shortcoming would be that it would still allow timers to make quick money outside of that trigger event.
Another issue discussed among panel members was how to apply fair value to an individual fund. Some in the industry believe calculating the individual securities in the portfolio is the correct way to adjust the NAV of a fund. Others argue that the fund itself should be treated as one security to determine pricing. The dilemma that arises from using the individual security model is that similar portfolios within a fund complex might be pricing the same stocks differently. "That would give firms pause," said Erik Sirri, associate professor of finance at Babson College.
Professor Sirri questioned the use of third-party quantitative analysis like Goetzmann's, saying, "How can you trust people you've never met?" His concern is how a fund company would know if the people it's hired to do the calculations are right. He called Goetzmann's model "fuzzy, but a move in the right direction." Sirri also said the Securities and Exchange Commission needs to be more aggressive in providing information about what a fair-value pricing model should look like.
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