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."

Fair-value pricing seems to make it less profitable for arbitrageurs to time foreign funds. Ananth Madhavan, managing director at Barclays Global Investors, San Francisco, used a stock-specific regression model based on 2001 overnight returns of 10,000 foreign stocks in the Bloomberg database. The results of his study, "Fair Value Adjusted Indexes," published in the Second Quarter 2003 edition of the Journal of Indexes: Fair-value pricing reduces arbitrageurs' profits by 91.7%.

In the past, fund groups attempted to restrict market-timing activity by limiting trades and/or charging exit fees. But research in 2002 by Eric Zitzewitz, a Stanford University assistant professor of finance, found that while redemption fees to limit trading help somewhat, timers still reap profits even after paying those fees.

As a result, the rapid-fire trading of foreign stock funds costs shareholders millions of dollars. Current Zitzewitz research on fund cash-flow data found that late trading occurs in 14 of 50 fund families with international funds and in 12 of 96 fund families with domestic stock funds. Late trading, he concluded, costs investors at least $400 million per year, or 1% to 2% of assets, in lost annual profits.

To ameliorate the problem, fund groups now use fair-value pricing on overseas funds. The consensus among the experts is that the major funds, such as Fidelity, Vanguard, T. Rowe Price, MFS, Putnam and others, use fair-value pricing. Small shops, like Matthews and Oakmark, also use a fair-value model.

"We don't have a list and we have not compared the performance of funds that do and do not fair-value price," says Morningstar analyst Greg Wolper. "A list would be difficult to come by. Those that are doing it use different methods. And it's hard to tell how often they are doing it."

Fund managers say that fair-value pricing works and keeps the arbitrageurs out of their funds. The Preferred Group of Mutual Funds, a Peoria, Ill.-based fund group with $2 billion in assets under management, has adopted an automated fair-value model to further reduce the effect of market-timing activity on its two international stock funds.

"We have seen a number of market timers in our funds, have taken a number of actions and slowed the activity dramatically," says David L. Bomberger, president of the fund group and Caterpillar Investment Management, the fund's investment advisor. "Automated fair-value pricing is the best solution to keep timers out of the fund. Market timers cause our portfolio managers to hold onto cash to meet redemptions when they could be investing the money for our shareholders."

Prior to establishing an automated fair-value pricing system in October 2003, the fund group required a 120-day holding period before allowing a trade. The fund group also removed its funds from discount brokerage mutual fund supermarkets, which he says facilitate market timers.

Bomberger said his company analyzed several automated pricing models before selecting the system of Investment Technology Group (ITG) in New York, which performed best based on back testing. "We liked the quantitative process they applied because it identifies changes in the U.S. market that trigger fair-value pricing," he says. "In our back testing, we were satisfied with the direction of the corrections of the fair-value adjustments and the accuracy of the adjusted price to the next day's opening price."

Bomberger says that its International Value and International Growth funds have been using fair-value pricing since the beginning of October. And the adjustments were accurate.

Although fair-value pricing should help foreign funds keep out market timers and improve performance, the strategy is not perfect. James Atkinson, president of the Guinness Atkinson Funds, doesn't like it. Deciding on what data to enter into the fair-value pricing model is subjective. A fund could intentionally misprice its portfolio to cut volatility or boost quarterly or annual performance. "There is a great deal of subjectivity for something that should be 100% objective," he says. "There is room for abuse."

Atkinson doesn't use fair-value pricing on his Guinness Asia Focus Fund and Guinness Flight China Hong Kong Fund. He values the portfolios at 9:30 a.m. EST. This cuts down the ten-to-13-hour time lag between the close of Asian markets and the New York Stock Exchange.

Madhavan of Barclays says fair-value pricing can introduce tracking error for a fund relative to its benchmark. This can lead to inaccurate pricing because benchmark indexes do not use fair-value pricing. In addition, he says, short-term performance can be distorted if different fund groups adopt different fair-value methodologies.

"If a fund uses fair-value adjustments, but the public benchmark is based on closing prices, there will likely be a greater performance dispersion because the benchmark is using stale foreign prices to calculate its index. One solution is for index providers to also compute fair-value benchmarks."