It may be the mechanism to derail market timers.
Will fair-value pricing boost a foreign stock fund's performance by keeping market-timing arbitrageurs out of the fund?
Recent research says yes, but it may be too early to evaluate the impact of fair-value pricing on a fund's total return. The reason: No one knows how many funds use a fair-value price model. Spokespersons for Morningstar Inc. and Lipper Inc. say they do not have an official list. They have not conducted research comparing the performance of fair-value priced funds versus non-fair-value priced funds.
One thing is clear, however. Without fair-value pricing, foreign-fund arbitrageurs definitely dilute fund performance. "Every time a shareholder buys fund shares at stale prices, other shareholders eat the difference," says Mercer Bullard, former assistant chief counsel at the Securities and Exchange Commission and CEO of Fund Democracy, based in Oxford, Miss. "As money flows into and out of the funds over time, the effect on shareholders is negligible. But that is little solace to individual shareholders who, unknowingly, were on the short end of the bargain."
Market timers cause cash-flow management problems for all types of open-end mutual funds, Bullard says. Most importantly, timers dilute fund performance and increase fund expenses. Short-term arbitrageurs' money often is just held in cash and not invested in stocks.
Here's how arbitrageurs take advantage of time zone differences to legally profit from next-day changes in overseas stock prices: International mutual funds calculate their net asset value at 4 p.m. Eastern Standard Time. But prices in the United States may be based on prices at the market closing, for example, in Asia, which occurs ten hours earlier. So a market timer with information about the Asian market could invest in a foreign fund right before the 4 p.m. United States deadline. The next day, the timer would sell the fund for a profit when the Asian market rises, based on the prior day's activity.
The SEC in 2001 gave mutual funds the green light to use fair-value pricing, which uses information that arises between the closing of foreign markets and the U.S. market, to adjust a fund's U.S. net asset value. Factors that may be considered in fair-value pricing, however, can vary dramatically. Examples might range from adjusting values for an announcement by a foreign company to considering how exchange-traded funds tracking foreign indexes move on U.S. exchanges.
Bullard used Morningstar data to evaluate the impact of market-timing arbitrage on international funds without fair-value pricing. For example, on Friday, April 14, 2000, the S&P 500 index declined 5.78%. The Asian markets declined the following Monday. After the Asian markets closed, the S&P 500 rebounded 3.25%. By 4 p.m. EST, when the funds priced their portfolios in the United States, it was clear the Asian markets would rally on Tuesday.
Based on his analysis, a number of foreign funds lost assets when the S&P 500 rallied on Monday and the arbitrageurs took profits. Some of the funds included: ABN AMRO Asian Tigers Fund, which lost 0.81% of assets; Chase Vista Japan, which lost 0.73% of assets; Invesco Pacific Basin, which lost 072% of assets; and Merrill Lynch Dragon, which lost 0.67% of assets.
"The best way to judge if arbitrageurs are moving in and out of the fund is to look at the cash-flow data," Bullard says. "But funds will not give investors that information." Bullard suggests that financial advisors look at the correlation of a foreign fund's net asset value to the U.S. markets, futures markets and American Depository Receipts to see if the fund's net asset value needs to be updated.
"The correlations will tell what the price should be," he says. "If the net asset value is undervalued, you can tell they are using stale prices."