The law has always permitted funds to estimate the "fair value" of securities in their portfolios when market quotes aren't readily available. That used to apply mainly to funds that invested in illiquid investments such as nonrated municipal bonds or bank loans. But two years ago, the Securities & Exchange Commission told mutual funds that invest in non-U.S. stocks that they could also use fair value. Since then, 75% of foreign fund managers, running some $3 trillion in total assets, have adopted fair value pricing, according to a recent survey conducted by accounting firm Deloitte & Touche.
Time zone differences are the primary reason for the change. Since U.S.-based investors buy and sell funds at hours when most overseas markets are closed, prices of the non-U.S. stocks in these funds' portfolios may be hours old by the time managers calculate their net asset values. Because foreign markets often move in tandem with our own, such pricing may not reflect changing conditions. Market timers and arbitrageurs take advantage of this situation to game foreign funds. If, for instance, the President announced that the U.S. military had captured Osama bin Laden after the Tokyo Stock Exchange closed, a trader could buy a Japan fund at the pre-announcement price, knowing full well that when the Japanese market opened, it would soar.
The SEC's definition of fair value attempts to thwart market timers by allowing these funds to synchronize their pricing with U.S. stocks whenever a "significant event" occurs after foreign markets close. The only problem is, regulators haven't strictly defined what constitutes a significant event. It could be a certain percentage move in U.S. market indexes or a certain type of industry or stock-specific news.
Nor has the SEC delineated any specific methodology for calculating fair value. "Fair value methodologies differ widely across the fund industry," says Paul Kraft, a Deloitte & Touche partner. Managers may value their portfolios based on how futures or exchange-traded funds that track foreign indexes move on U.S. exchanges. Or they may look at American depositary receipts (ADRs) for certain foreign stocks or study the correlation between foreign markets and the U.S. and adjust according to a formula.
What this ultimately means is that two foreign funds could own exactly the same stocks and price them differently at the end of the day. And there's no way of knowing who is right because at the time of purchase, no current prices existed for the stocks. So even if your money manager priced Sony (SNE
) at $30 and the Tokyo exchange at opening the next day priced it at $33, the manager could argue that at the time he valued Sony, it was worth only $30.
This creates a potential for conflicts of interest. For instance, if a fund manager has a big shareholder redemption, he could intentionally mark the fund's value down so he has to pay out less. Fund companies have valuation committees that are charged with preventing such conflicts. But such groups can't catch every infraction, and they can't stop unintentional miscalculations. These errors will be greatest on volatile market days. So if you own a foreign fund, it's best not to trade on such days.
It's clear the SEC needs to rethink the fair value rule. It should either establish a uniform standard for fair value pricing or force funds to disclose in detail their pricing methods -- or get rid of fair value for foreign stock funds altogether. There are other ways of fighting market timers, such as charging an exit fee to short-term traders or delaying their redemptions. Giving every shareholder a different price shouldn't be one of them. Personal Finance Editor Braham writes about mutual funds.