The Price May Not Be Right!

Significant events that occur after a market has closed—but before the fund is valued—may lead to consumers buying a fund at an incorrect price due to stale pricing.

Although the Securities and Exchange Commission (SEC) has warned that when significant events occur, mutual funds may need to fair value, European regulators have not yet gone down this road.

However, arbitrage of investment funds is not purely a US problem: similar aspects of the time zone arbitrage also exist in Europe, as documented in a recent Deloitte & Touche report, ‘The Valuation of Globally Invested Portfolios.’

Besides eliminating time zone arbitrage, fair value pricing also enables consumers to buy funds at accurate valuations. Against this background, the debate on fair value is beginning to gather momentum globally.

Essentially, a fair value price is an estimate of the price that would prevail in a liquid market given all of the information available when the fund is priced. It is equivalent to the statistical expectation of the next day’s opening local market price.

Significant Events
In April 2001 the SEC issued a letter to US-based Investment Company Institute clarifying the responsibilities of fund sponsors in creating daily NAVs. The SEC re-emphasized that "fair value prices" should be adopted for international securities whenever a "significant event" has occurred after the local market price is established, but before 16:00 Eastern Time (ET). But what does the SEC actually mean by a significant event?

The only guidance provided to date seems to define a significant event as something that affects the value of a portfolio security so that its closing price is out-of-date (stale) at the time of the fund’s NAV calculation. Many different sorts of events can trigger that result. Market volatility is a more common cause than natural disasters.

For instance, when early in the morning of Sept. 17, 2002, the Iraqi ambassador delivered a message to the United Nations accepting the need for weapons inspections, the Nikkei index—the only major market open—soared in Japan by over 3 percent. The threat of war had subsided slightly and the markets were taking this into account.

When London opened that morning, the FTSE 100 was up 2 percent and at lunch time the US futures markets were also up over 1.5 percent. Any European domiciled investment fund made up of US securities priced on Sept. 17, 2002 before the US market opened at 14:30 BST would be based on the closing price from Sept. 16.

The news clearly changed the value of the US securities, and as a result, any consumer who bought such a fund on Sept. 17 was actually buying securities based on stale prices.

A considerable market movement was also noted on Oct. 17, 2002 when IBM announced its earnings after the US market had closed. IBM’s earnings were better than expected and appeared to give the market the confidence to rally. The US futures market was up by over a staggering 2 percent. As a result, consumers buying a European based fund on Oct. 17 would have bought an undervalued fund as the portfolio stock prices were stale and had not factored in the IBM effect.

The Liquidity Conundrum
When prices are taken from an open liquid market, the consumer will be buying funds at the right price. For instance, at 08:00 BST Japanese funds would be priced correctly, at 12:00 BST European funds would be priced correctly and at 16:00 BST US funds would be priced correctly. However, not all markets are liquid, particularly on the small cap side.

To analyze the IBM effect, FTID randomly selected 20 small cap stocks on Oct. 17, 2002, and calculated the previous close, open, midday NAV and end-of-day close value. There was virtually no overnight change, but during the morning some stocks began to trade higher, resulting in a 9 percent rise in value. In the afternoon the value of the fund rose a further 12 per cent, while the FTSE 100 was fairly static. Illiquid stocks take longer to factor in market information because if there is no trade, there is no price formation.

Based on this analysis, consumers are unlikely to buy a small cap fund at the correct price when there is a significant event. Indeed, the issue of stale pricing for investment funds is a function of the lack of liquidity.

There are a number of potential solutions out there designed to help address these concerns including those offered by fair value information service providers. These services are designed to help eliminate time zone arbitrage and to facilitate a consumerability to buy and sell funds at more accurate valuations.

FT Interactive Data (www.ftinteractivedata.com) is a provider of financial information and analytical software to global markets.Inside Market Data