The Spokesman-Review

Payoff Of Fair-Value Pricing

The severe stresses that hit the Asian stock markets in recent months have served the useful purpose of highlighting a potential weak point in the way mutual funds do business.

The problem concerns the standard once-a-day pricing system used by most funds as of the close of the trading day in New York.

The net asset value (NAV) per share calculated at that moment customarily serves as the base price for executing all the day’s current orders, received by a specified deadline such as noon New York time, to buy new shares and redeem existing shares that investors want to sell.

But markets in other countries and time zones around the world operate on different schedules from Wall Street’s. Suppose that, on a New York morning when Asian markets have been closed for several hours, U.S. stocks (including American depositary receipts of big Asian companies) rise sharply in early trading.

An alert investor has time to put in an order to buy shares of a fund that owns a large number of Asian stocks. The investor can be pretty certain that the Tokyo market will rally overnight, providing the chance to cash out the following day at a higher NAV.

When a situation of this sort arose in late October, the Fidelity Hong Kong & China Fund used a system called “fair-value pricing” to set its NAV, taking prices from financial futures markets and other sources to calculate values for its portfolio holdings that were more current than the last trades on Asian exchanges.

Because of that, the fund wound up showing a small net gain in its NAV on a day when most other Asian and Pacific Basin stock funds recorded sharp losses.

The decision was “generally in shareholders’ best interests,” writes Amy Arnott, editor of the Morningstar Mutual Funds advisory service. “The main problem with fair-value pricing isn’t the theory behind it, but that the fund industry hasn’t consistently applied it in practice.”

The idea has the regulatory blessing of the Securities and Exchange Commission, and has been around for years. As Barry Barbash, director of the SEC’s division of investment management, told reporters, “Those investors who said they didn’t know about fair-value pricing probably didn’t look at their prospectuses.” Under present rules, any fund is “permitted but not required” to use fair-value pricing.

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