Critics decry uneven use of 'fair-value pricing'

Fund firms employ strategy to thwart market-timing tricks

By Andrew Caffrey, Globe Staff, 9/12/2003

To avoid "time zone arbitrage" and other market-timing tricks at the center of the current investigations into mutual funds, many major fund companies -- including Fidelity Investments -- sometimes use a method known as "fair-value pricing" to update prices on foreign stocks that are as much as 12 hours old and other securities for which there aren't fresh quotes.

While its proponents argue the practice allows them to take into account market-moving events that occur after overseas exchanges have closed, fair-value pricing is used unevenly in the industry and its critics say it gives too much discretion to mutual fund companies, rather than markets, to set security prices.

Though the Securities and Exchange Commission wants mutual funds to have fair-value procedures in place for "significant events," there are no uniform guidelines on when funds should use them, and how they should adjust prices. That means on a day of market moving news, one mutual fund could choose to use stale prices, while two other funds with similar holdings could each use its own fair value mechanism. The result: different prices for the same security.

"It's all over the place," said Leslie Rahl, president of Capital Markets Risk Advisors Inc., a New York firm that has studied how money managers "mark to market" the value of their securities. The uneven application could throw fund performance in doubt. "When you think one fund is doing better than the other, it may or may not be," Rahl said.

Mutual funds say they typically use fair-value pricing only when trading has halted in a stock or there aren't recent prices on thinly-traded securities. Also, it's used when major events roil global trading markets around the clock to the point where the old overseas closing prices on foreign securities no longer accurately reflect their value. For example, on Oct. 28, 1997, when markets around the world were in turmoil, Fidelity used fair-value pricing to value Hong Kong securities up an average 10 percent, even though the Hong Kong market was down 13.7 percent when it closed 13 hours earlier.

Fidelity justified its decision on the grounds that later-trading markets were rebounding, and indeed, Hong Kong itself surged 14 percent when it opened the next day. "Fair-value pricing made sure that investors who were buying or selling Fidelity funds that day got a true 4 p.m. price for their funds -- not an artificial price based on stale data from a computer file," Fidelity said in a note to shareholders.

And, as Fidelity and others argue, fair-value pricing also deters market timers who seek to exploit time-zone differences at the expense of long-term investors. Essentially, a market timer would buy into a mutual fund on a day when positive news comes out after the overseas markets have closed. The mutual fund would calculate its value using the old, or stale prices of the foreign securities. Then, when overseas markets open the next day, traders there act on the news, sending those security prices higher, and with the mutual fund's value also higher, the market timer sells at a profit. Last year, Stanford University professor Eric Zitzewitz calculated that long-term fund holders lose $5 billion a year to arbitrageurs.

Back then, Fidelity was criticized by a few investors who didn't get to buy funds at stale prices, but the SEC has endorsed the practice, and now, after the investigations into market-timing broke open, wants mutual funds to, among other matters, again review their use of fair-value pricing.

But even now, there appears to be a disparity in when and how mutual funds use fair value pricing. Rahl said her company's surveys found some money managers selected the halfway point between a security's bid and offer prices as the fair value, while others used the bid price.

The concern for fund holders, Rahl said, is if the money manager uses calculations that, for example, set the price too low. "If you're buying in, you're getting an extra good deal, whereas if you're selling, you're getting a bad deal, and vice versa," said Rahl, "but you'd probably never know."

Indeed, some mutual fund companies use pricing tools from different vendors that could produce different results; MFS Investment Management and Putnam Investment use International Technology Group Inc., for example, while Eaton Vance Corp. uses FT Interactive Data. Up until a few months ago, Baltimore-based T. Rowe Price had an internal system of its own before hiring ITG.

Putnam said it adjusts the price of a foreign security when the computer model prices it more than 3 percent above its market close. "Putnam prefers a defined systematic approach based on investment and statistical principles, rather than an ad-hoc approach," said senior vice president David Depew.

MFS won't disclose what "triggers" it uses to make price adjustments, because it doesn't want to tip off market timers. Also, Mac Hisey, treasurer of MFS Funds, said the company doesn't automatically adjust prices when the computer model says to, but internally performs "an extra review to make sure we're comfortable. We don't blindly trust the model and let it run into the portfolio." Hisey said testing has shown fair-value pricing has removed more than "90 percent" of the opportunities for arbitrageurs to market time. "It's a real service being done to the shareholder," he added.

Fidelity, meanwhile, would not disclose its fair-value process in detail. "In the process of monitoring for significant events we examine a number of market indicators, such as futures and closed end funds that are generally traded in the US," spokeswoman Anne Crowley said in a statement.

Investors are also unlikely to know when fund companies adjust stock prices. Fidelity won't say how often it does it. Hisey said "it happens frequently enough" at MFS; T. Rowe Price said it's adjusted prices 14 times this year through August, while Putnam said there have been only four times in the last year and a half when it's had to adjust more than 10 percent of its international holdings. But Jim Atkinson, president of Guiness Atkinson Funds in Los Angeles, which runs two Asia mutual funds, said fair-valuing pricing undermines the objectivity of security prices that are set by markets. "You are purposely injecting into the process some subjectivity," Atkinson said. "Once you start making up your own price, what's to keep you from making your own price higher?"

Instead, Atkinson's company closes off orders for its Asia funds at 9:30 a.m. Eastern time, to minimize the time lag from the close of Asian markets. Orders put in after that time will be priced at the next day's value.

Noting the analogy that stale prices allow market-timers to bet on a race as the horses are running, Atkinson said, "The answer is not adjusting the results after the race is run. You close the betting windows before the race is underway."

Andrew Caffrey can be reached at caffrey@globe.com.