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T+1 Accounting Leads to Stale Fund Pricing

Accounting that allows for settlement of mutual fund trades one day past the trade, or T+1, uses stale portfolio valuations, leading to variations between funds' reported net asset values (NAVs) and their true worth, a new study warns investors.

The study, "Live Prices And Stale Quantities: T+1 Accounting and Mutual Fund Mispricing," was conducted by Ryan Taliaferro, a doctoral student at Harvard Business School; Michael Quinn, vice president at Analysis Group; and Peter Tufano, a professor at Harvard Business School. The researchers found that the assumption that mutual funds' NAV, which is calculated once a day, reflects the trading activity that took place that day, is a false assumption.

"This set of accounting rules, which is used by virtually all U.S. mutual funds, drives a wedge between reported accounting' NAVs used to calculate the prices at which funds are bought and sold and the actual economic' NAVs, which represent the true value of the funds' portfolios," the report noted.

The study also says that any calculations that rely on the T+1 accounting methods may be misrepresented, flawed or distorted, as it is standard practice for mutual funds to calculate their NAV by applying the closing prices of the day to what their portfolios had at the close of trading the previous day. Thus, the calculated value does not actually represent any of the trading practices that took place on the day the NAV is tallied. In fact, the price used in the calculation of a NAV is very often more than 12 hours old.

Not only is the mutual fund being mispriced, but this also opens the door for false inferences about fund returns and performance. In addition, stale NAVs can also allow some shareholders to profit at the expense of other shareholders.

The T+1 accounting mispricing is not the same thing as stale pricing, the researchers stressed. Stale pricing emerged as a major problem during the mutual fund late-trading and market-timing scandal.

The researchers received access to the daily trading records for 26 domestic equity funds for a multi-year period, from which they calculated the distortions. For each of the funds, the team re-calculated daily returns using penny-rounded economic NAVs, and then compared these returns to the accounting NAVs.

"Our empirical investigation demonstrates that NAV distortions are common and occasionally large in size," particularly on heavy trading days, the report noted. Funds that invest in volatile stocks and that place trades early in the day were also found to be more likely to have inaccurate prices, as that leaves more time for intraday prices to drift.

However, NAV distortions are smaller for funds with larger portfolios. "These observations explain perhaps why we would expect the NAV distortion problem to be far more pronounced among actively managed funds than index funds, as the latter would tend to hold more securities and to trade to produce a NAV that reflects the closing value of the index," the report noted.

The researchers found that there is an 8% probability that the NAV will always be off by a half-penny or more and a 10% probability that it will be off by a penny. A fund's returns were also found to become distorted when using the T+1 accounting method. In fact, it is 61% likely that daily reported returns and economic returns would differ by half a basis point, although the range is often one to three basis points. In the worst-case scenarios, the researchers found that there is a 0.5% chance that the daily return will be distorted by 10 basis points.

The research team concluded that not only can NAV distortions occur, and occur frequently in certain instances, but daily returns are often distorted as well. The larger a fund's market cap and NAV, however, the less likely these distortions are likely to occur.

As to what, if anything, should be done about the observed distortions, the researchers acknowledged that changing the industry practice would be costly, especially at a time when compliance costs are weighing heavily on fund firms. Still, they noted, "financial economists rarely applaud situations when prices and returns are not faithfully reported, and regulators and consumers do not normally condone practices in which parties transact at incorrect prices."

Perhaps, they suggested, funds could simply disclose their method of calculating NAVs - whether they use a T+1 or a same-day trade (T, or straight-through-processing) method. Many funds have been working toward building straight-through-processing systems, the researchers noted, so "the change to T accounting should have relatively small costs." Or, regulators could simply require all fund companies to settle their prices on the same day they place their trades.

"A change to T accounting would lead to harmonization between the NAVs in financial statements and those reported to investors on a daily basis," the report said. "Were T accounting not mandated, but encouraged through disclosure, firms that produced more timely information might enjoy a competitive advantage to the extent that investors preferred up-to-date NAVs and returns."

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