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.