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Mutual Funds
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| | Mutual Funds
New fund rule could cost investors
The SEC wants funds to use fair-value pricing to keep prices up to date. But that means you could buy or sell fund shares on a day when guesses help make up a fund's net asset value.
By Timothy Middleton
How many times will a coin come up heads? Ask a statistician, if you can find one. Theyre all going to be working for mutual funds.
The Securities and Exchange Commission has adopted what might be called the coin-toss rule, and there is one sure loser, and one possible loser. The former includes the big-money investors who were allowed to "market time," or jump in and out of funds, creating profits for them and costing individual investors. The latter is you.
The good news is, youll win as often as you lose. Thats the law of averages, assuming you trade every day. Of course, if you dont trade that often -- the very notion is hostile to mutual fund investing -- maybe you dont have that law on your side. All youve got is the SEC.
The new SEC directive, inspired by the mutual fund scandals, imposes something called fair-value pricing on funds. The idea behind it is to make the prices of securities the fund holds, and in turn the price of the fund shares, as up-to-date as possible. It is, as Martha Stewart would say, a good thing. Except . . .
One of the reasons fair-value pricing has been ineffective . . . across the industry is because people havent known when to use it and how to use it, says Kunal Kapoor, director of fund analysis for Morningstar, the fund-tracking firm. The (SEC) could issue clearer guidelines about how to use it.
In short, professionals know barely more about this bewildering topic than you or I do. Its goal is to ensure that the price you pay for fund shares is fair; hence the name. The problem is, fair prices are made up.
Swapping truth for estimates
Fair-value pricing is a slippery solution to a concrete problem. It substitutes guesses -- albeit informed ones -- about the value of securities for their actual market prices. Its akin to making a fund companys accountants report to a philosopher (though critics would say an astrologer).
Fair-value pricing is goofy, says Jim Atkinson, president of Guinness Atkinson Asset Management, which invests primarily in foreign stocks. As a bedrock matter of principle, the price (of a fund) every day needs to be exactly accurate. Why are we throwing out this concept of accuracy and embracing inexactitude?
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Over long periods, mistakes in fair-value pricing should be smoothed into imperceptibility, and fund shareholders ought to be long-term holders. But we have to buy, and eventually to sell, on certain dates. So on any given day, our fate is in the hands of the stars, by government rule.
When fair value is useful
Fair value is the antidote to stale pricing, or using out-of-date quotes. The clearest example of its utility came in 1997, amid the Asian debt crisis.
On Oct. 27, the Dow Jones Industrial Average ($INDU) plunged 554 points, or more than 7%. The Hong Kong exchange followed, as overseas markets often do. It shed 14% of its value the following day, which was the middle of the same U.S. night.
On Oct. 28, the Dow rebounded 337 points. Fidelity Investments realized its 13-hour-old Hong Kong prices were combustible. Traders could have bought Fidelitys Asian funds that day and been almost guaranteed a substantial profit because it was likely that Hong Kong would climb as well. Long-term shareholders who happened to sell beforehand would've been scalped.
So, Fidelity estimated that Hong Kong stocks would rise 10%, and priced its fund shares accordingly. Fidelity was close to right: Hong Kong stocks jumped 14% when they reopened.
Most mutual funds owning Asian stocks, however, didn't use fair-value pricing, allowing professionals called arbitrageurs, who take advantage of pricing discrepancies, to make a killing. Such feedback among global markets is continuous and opportunities to arbitrage so numerous that Eric Zitzewitz, a Stanford University economics professor, estimated in a study that arbs skim $5 billion a year from long-term holders of international mutual funds, or 1.1% of their assets.
Zitzewitzs estimate was cited by New York Attorney General Eliot Spitzer in September when he launched the legal cases that unearthed the scandals. The SEC, embarrassed, has been playing catch-up ever since.
Missing the mark
Officially, fair-value pricing has been required since the modern mutual fund industry was created by the Investment Company Act of 1940. But it has been observed mostly in the breach, because it couldn't have anticipated todays worldwide market.
The '40 act was passed in 1940, notes Don Cassidy, senior research analyst for fund consulting firm Lipper. It could not envision time-zone arbitrage across global securities markets.
Last month, the SEC adopted a rule requiring that by Dec. 5, mutual funds disclose in their prospectuses both the circumstances under which they will use fair-value pricing and the effects of using fair-value pricing. Implicit in the order is a requirement that fair-value pricing be employed.
The problem with that is this: Fair-value pricing is only approximate, based on a statistical analysis of the way prices have behaved before. Fidelity was off by four percentage points, or more than 28% in 1997.
The concept itself is even more elusive than that: Any two funds could come up with significantly different prices and both be correct.
What price is right?
Zitzewitz helped design a computer model used to establish fair prices that is used by FT Interactive Data, one of several companies that supply them to the mutual fund industry.
The concept of fair value is a fund-specific one," says Ian Blance, a London-based executive of FT Interactive Data. "It would take into account the circumstances of that fund: How much of a security they hold, whether they intend to liquidate very soon. The way the regulations are set up would theoretically allow for a completely different price to be used at each fund in question. The service we provide is intended to provide a baseline for those calculations.
But issues persist.
Leslie Rahl, president of Capital Market Risk Advisors, a Wall Street consulting firm, says: I have gone into the market for clients for a convertible bond and gotten prices as much as eight full points apart. When you get markets that wide, what is the fair value?
Any number of approaches can be used to find fair value, Rahl says. Possible pieces of the equation include the bid price, the offer, half the distance between the two, the median of most-recent trades or the judgment of the firms traders of the market effect of transactions they plan. More commonly it's some blend of all of these.
Another tactic
Atkinsons small mutual fund complex has opted out of the debate, instead relying on actual market prices. Its funds, including Guinness Atkinson China & Hong Kong (ICHKX), have set a deadline of 12:30 a.m. Eastern Time to get that days pricing in a transaction. That is before some Asian markets have closed and 15 1/2 hours before the 4 p.m. deadline the rest of the industry observes. It is, in most time zones, yesterday.
Atkinsons deadline assures that investors have placed their orders well before price changes between Western and Eastern bourses can be arbitraged. Net asset values of his funds are actually calculated at 9:30 a.m., when all Eastern markets have closed. (It isnt published until after 4 p.m.)
But the early close does at least assure that investors will get genuine prices. Everybody else will have to trust that fair value will be real value.
Meanwhile, market-timing hedge funds will have been flushed out, although both Zitzewitz and Atkinson worry that they could simply modify their strategies to fit the new rules.
And if we lose a few extra bucks buying a fund on a bad fair-value day, and lose five times more when we sell 30 years later, well never know. Funds dont have to disclose every niggling little detail. The SEC cant make funds do this well; it can only make them do it.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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