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Fair Value Pricing Isn't Always Fair, but It's Needed

Events in Japan and Egypt have again brought this topic to the fore.

Gregg Wolper, Morningstar Senior Mutual Fund Analyist, 04/04/2011

The tragedy and turbulence in Japan and the Middle East have led to gyrations in global stock markets over the past few weeks. These financial concerns take a back seat to more important considerations of survival and rescue. But here in the United States, ordinary investors do have some legitimate questions that have arisen during this unsettling period. It's worth the time to look at one of them: the use of fair value pricing.

Fair value pricing occurs when U.S.-based mutual funds assess their net asset values, a task they must do at the end of every trading day. When events occur during the U.S trading day that could have an impact on foreign prices, at a time when the foreign markets are not open to reflect that, funds can use fair value pricing to provide what they consider a more reasonable NAV. Sometimes a different scenario inspires the use of fair value pricing: A stock, or an entire market, isn't trading at all.

What Is Fair Value Pricing, and Why Use It?
Fair value pricing is the effort to assign a more accurate price to a security when a fund firm determines that the typical way of assigning value--simply taking the closing price on the exchange--is no longer adequate. In the mutual fund world, it first came to wide attention in the late 1990s and early 2000s, when the bubble and then the crash created opportunities for what's often called market-timing but is more accurately known as time-zone arbitrage.

Without fair value pricing, traders could buy--for example--an Asian fund during the U.S. trading session following a down day for Asia when the U.S. market had rallied sharply on breaking news. The fund's NAV would be determined in the late afternoon (New York time) based on the depressed Asian closing prices from the morning (New York time)--even though by that point it was almost guaranteed that Asian markets would rise sharply in their next session. So, a buyer could get fund shares at what could be considered an artificially low price, sell them one day later, and pocket a gain that in some cases reached 5% or more.

Some might say there's nothing wrong with this--it's just a clever trade. The problem is that the added trading costs for the fund to service these brief visitors were passed on to long-term shareholders. The practice also caused problems for fund managers who never knew how much cash they needed on hand to pay out to departing shareholders that evening. (That's always uncertain, of course, but usually is much more predictable.)

To combat this, the SEC encouraged funds to use fair value pricing, and many funds adopted the practice in the early 2000s. It is now commonplace. Using a variety of inputs, such as futures prices, prices of shares that trade in New York as ADRs or on foreign exchanges, and other means, funds--often relying on outside pricing services--determine value for the stocks and thus the portfolio. In theory, these figures represent the up-to-date value of the fund, not what the value had been 10 or 15 hours earlier.

The Method in Practice
Fund companies tend not to provide details about when they use fair value pricing and how their process works, in order to avoid tipping off anyone still trying to take advantage. For example, in response to our queries, spokespeople for both Vanguard and Fidelity declined to state specifically when they have used fair value pricing in recent weeks. But in certain cases it is obvious when fair value pricing is having an impact. One such occasion was Tuesday, March 15, the second trading day after the earthquake and tsunami had struck Japan.

The earthquake had struck with just minutes left in the trading session on the previous Friday afternoon. After dropping sharply on Monday, the Japanese market plummeted another 10.6% in its Tuesday session, which closed in the wee hours of Tuesday morning New York time. (That figure is for the Nikkei 225 in local-currency terms; the MSCI Japan Index in dollar terms fell sharply as well, losing 8.2%.)

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