With International Funds, the Price Isn't Always Right

Last Thursday's tragic events in London had the odd effect of providing a window into a hot subject in mutual funds' efforts to prevent market-timing. Specifically, because of the uneven way that markets around the globe traded after the events, U.S.-sold international funds had to seriously consider using fair-value pricing.

As many investors know, international funds don't always calculate their net asset values by using the closing prices of the stocks that they invest in. Rather, they use some fairly sophisticated pricing tools to arrive at an estimate of what the stocks' prices would be if the exchanges on which they trade were open. The SEC requires funds to use this tactic in instances where market prices are not readily available or are deemed unreliable indicators of an asset's value.

That's fair-value pricing in a nutshell. The reason it's needed is because time differences otherwise make it possible for traders to earn arbitrage profits from funds at the expense of long-term fund holders. When Asian or European markets close essentially flat or down--and remember, they close before the end of the U.S. trading day because of time differences--and a piece of news buoys U.S. markets later in the U.S. trading session, it's usually true that foreign stocks will react to the U.S. rally by rising on their open the next day.

If an international fund sets its NAV based on the closing prices of the securities it owns in these markets and the U.S. market rallies later in the day, traders can jump in and buy shares of the fund at the NAV and be nearly assured that the fund will pop up the following day. In essence, funds that do this are undervaluing the assets they own by failing to take into account news flow that is affecting the value of their foreign securities. It was such discrepancies that allowed market-timers to thrive until Eliot Spitzer forced a crackdown.

Fair-value pricing has its benefits--and we at Morningstar certainly support its use--but as we wrote in 2001, it also creates some confusion. In particular, because there are no clear guidelines on how fair-value pricing should be implemented, funds have a remarkable amount of leeway in setting their NAVs. This can lead to significant discrepancies in pricing between funds and thus have an impact on investors' returns based on who they are buying the fund from.

Still, with fair-value pricing now required by the SEC and its usage gaining in frequency, we wanted to see if there was any improvement in the way fair-value pricing was being applied. We used last Thursday as a test case. The reason for doing so was that most overseas markets were down significantly for the day, largely in response to the events in London. However, the U.S. market staged a late-day rally, likely triggering the need for fair-value pricing.

Our results show that fair-value pricing still leaves a lot to be desired. Indeed, we noticed uneven results by looking specifically at index funds that were benchmarked against the MSCI EAFE Index or one that was similar to it. (For example, T. Rowe Price Equity Index (PIEQX) tracks the FTSE International Limited Developed ex North America Index.) In any case, the EAFE Index closed down approximately 1.3% for the day, but funds that track it or a close variant were all over the map. Among ones we examined,  Vanguard Developed Markets Index  and T. Rowe Price International Equity Index (PIEQX) both slipped 0.77%,  Fidelity Spartan International Index  was down 0.99%, SSgA MSCI EAFE Index  dove 1.26%, State Farm International Index  shed 1.29%, and Dreyfus International Index dropped 1.33% (DIISX).

Clearly, Vanguard, T. Rowe Price, and Fidelity used some form of fair-value pricing on that day while the others did not. Still, the differing returns for the Vanguard and Fidelity funds, for example, reveal that the firms rely on markedly different assumptions in their fair-value pricing methodologies given that their portfolios are essentially identical. Meanwhile, while SSgA can be excused for not using fair-value pricing--new shareholders can't buy the fund because it's being liquidated--I'm surprised that Dreyfus and State Farm didn't make adjustments to their funds. The Investment Company Act of 1940 assigns responsibility for setting a fair price to each mutual fund's board, and I wonder why these boards didn't act on this occasion.

The picture is even less clear when it comes to actively managed funds. Because they have different holdings you wouldn't expect them to move in lockstep regardless of fair-value pricing issues. Among diversified large-cap international funds with more than $100 million in assets,  American Funds EuroPacific Growth (AEPGX) led the way with a 0.45% return. While the fund has exposure to markets such as Korea--one of the few to deliver a positive return that day--it's one of only two diversified large-cap foreign funds to make it into the black that day.

At least anecdotally, it thus appears that the fair-value pricing model used by fund firms, or the trigger for their implementation, varies significantly. If anything, these discrepancies reinforce the need for clearer rules about what is and isn't acceptable when it comes to fair-value pricing. More importantly, if you're an investor buying an international fund, it's worth stressing that redemption fees are probably going to be more effective in keeping market-timers and other problem makers out of the fund. I'd think twice about buying any foreign fund that doesn't impose a redemption fee on investors who don't hold their shares for at least 90 days before selling.