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

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%.)

However, later Tuesday  Matthews Japan (MJFOX) reported that its NAV had not changed at all.  Fidelity Japan (FJPNX) said roughly the same thing--it reported a minuscule gain of 0.1%.  T. Rowe Price Japan (PRJPX) reported a bigger move, posting a loss of 2.7%, but that was still nowhere near the Japanese market's shocking decline.

This was fair value pricing in action. The funds or their pricing services had indications that the Japanese market was primed to rise sharply the next day, so they priced that move into their Tuesday afternoon NAVs. Or, more precisely, they priced in their best estimates of what each stock in their portfolio was worth at that exact time in the afternoon, given all the evidence available then.

As it turned out, they were correct, at least to a large extent. The Japanese market did score a big gain the next day, climbing 5% to 7% depending on the index and currency. In short, using the Tokyo closing price to value the portfolios late Tuesday would have created an exceptional opportunity for time-zone arbitagers had the funds not used fair value pricing.

Not a Perfect Solution
Although it thus can protect long-term fund shareholders, fair value pricing does present two potential problems for them as well. After all, with fair value pricing in common use, a fund's price is no longer being taken from hard data--closing prices--but has become an estimate. Estimates are open to question. If these estimates are too low, that hurts long-term shareholders who want to sell; if they're too high, it penalizes buyers.

Another issue: Fair value pricing assumes the only buyers in such extreme situations are arbitragers taking advantage of a loophole for a quick profit. But what about respectable long-term shareholders of the fund who simply want to add to their stake--in effect, trying to buy low, as they've been told to do for years by Morningstar and every other advisor? In this case, the Japanese market had fallen about 16% in two days. But if a long-term shareholder tried to buy low, the funds did not allow them to--their NAVs had already moved on. It would be understandable if these shareholders felt frustrated.

Total Shutdown
Combating time-zone arbitrage isn't the only reason to use fair value pricing. Sometimes, as happened in Japan itself 11 years ago, a stock will stop trading for days or weeks. Yet it still has to be valued every day by funds that own it. And as we saw in Egypt during the recent turmoil, sometimes entire markets will close for extended periods of time--nearly two months in that case. What then?

In general, the process is the same. Funds and/or their outside services make their best estimates of what the stock or stocks are worth every day, using whatever information they can find. A Vanguard spokesman says that its methods have proved adequate to handle the situations in both Japan and Egypt (although because, like most fund companies, it doesn't provide details on its methods or provide the prices it has used, outside observers can't investigate that claim).

Vanguard doesn't have an Egypt-only or frontier markets fund, though, so the Egypt issue affected only a tiny amount of its stocks firmwide. The only all-Egypt fund in the United States is an exchange-traded fund,  Market Vectors Egypt Index ETF  . That fund's NAV changed throughout the long period of market shutdown, indicating that fair value pricing likely was being used--though ascertaining "proper" prices for some Egyptian stocks that hadn't traded in weeks couldn't have been easy.

In this case, the handful of mutual funds and ETFs with substantial stakes in Egypt were in the position that many fixed-income funds find themselves in on a regular basis. Many securities from standard municipal bonds to esoteric derivatives simply don't trade on a daily basis.

Everyone Can Help
All in all, mutual fund shareholders should be pleased that their fund is using fair value pricing if it is being done responsibly, as we have every reason to assume it is. But regulators, fund companies, mutual fund boards, and shareholders should all play their part in keeping the system running smoothly.

Specifically, regulators should pay close attention to make sure fund companies large and small are doing their fair value pricing as prudently and accurately as possible. Fund companies and fund boards, especially those with funds that invest in foreign stocks or other areas that use fair value methods most often, should make a stronger effort to ensure that fund shareholders understand what this means for them. Simply including the language in a prospectus is not enough. Finally, once shareholders have that understanding, it's up to them to remember that a large one-day rise or fall in a foreign market may not be reflected in their fund's NAV later that day. And for that reason, what may seem to be a prime buying or selling opportunity might in truth be a more complicated situation.