Nothing Fair About Fair-Value Pricing

Would you buy a car if the price were to be set by the salesman after you left the showroom? Would you take on a mortgage that let the lender set the interest rate any way he wished?

You’re probably shaking your head. Only a fool would buy a pig in a poke, right?

Ah, but millions of mutual fund investors do it all the time. Call any fund company at 9 a.m. with an order to buy or sell, and it will be filled at the net asset value, or share price, based on the 4 p.m. closing prices for the securities in the fund.

But the market can swing hundreds of points in just a few hours, so the bargain you thought you were buying early in the day could evaporate by the time the order is filled.

Most days, this brief price uncertainty doesn’t matter very much. But many investors were startled last week to learn an order to buy or sell fund shares cannot be rescinded. If the market suddenly changes direction, you’re stuck. With a stock investment, in contrast, you can issue a limit order that specifies the trade be completed only at a specific price and you can cancel an order any time until it’s executed.

Now we find the ground for fund investors can be shakier than even the most savvy had realized.

Fidelity Investments recently dispensed with the standard practice of basing funds’ prices on closing stock prices. Instead, Fidelity briefly priced its Hong Kong & China fund according to Fidelity’s view of the “fair value” of the stocks the fund contained.

Fidelity explained the closing prices on Hong Kong stocks, which had dropped an average of 14 percent that day, were obsolete by the time Americans were making investing decisions half a day later, when the Hong Kong market was closed. Fidelity, assuming Hong Kong stocks would follow U.S. stocks and rebound, priced the fund according to indicators such as current trading in U.S. markets of closed-end Hong Kong funds.

As a result, the Fidelity fund’s price rose 2 cents a share rather than falling.

That surely would have pleased those who sold that day, giving them more than they would have expected. But it was a dirty trick on anyone who bought expecting a bargain.

Fidelity said the move protected long-term investors from the effects of short-term “speculators.” Quick in-and-out trading increases a fund’s costs and can create realized profits that produce tax bills for all shareholders, including long-terms who just sat through the gyrations.

But there are other ways to deter speculators. Some funds limit the number of transfers an investor can make in a year or charge penalties if an investor sells a fund’s shares soon after buying them.

Vanguard Group uses such deterrents and consequently says it turns to fair-value pricing only on rare occasions, usually to compensate for an extreme swing in currency exchange rates after a foreign stock market has closed. Fair-value pricing is not used to deter market timers, Vanguard says.

Most fund investors are in for the long haul and don’t have to worry about the rare occasions fair-value pricing is used. Still, small investors have a right to buy on the dips and sell on the peaks. They can’t do that if the fund company switches pricing methods without notice.

The Securities and Exchange Commission is examining fair-value pricing and, hopefully, will ban or discourage it - or at least demand better disclosure.

For the time being, though, your only defense is to be forewarned. Check your funds’ prospectuses to see whether fair-value pricing is allowed. It is, unfortunately, not clear how widespread the practice is.