Fair Value Pricing in International Funds

October 09, 2003

Market timers often attempt to exploit time zone differences, and this can harm long-term investors. A number of index fund managers comment on the problem.

San Francisco - October 9, 2003.  The Spitzer investigation has thrust into the spotlight a problem that has plagued mutual funds that invest in international stocks for years. 

Long-term investors can be unknowingly harmed by market timers who attempt to profit by exploiting 'stale' prices in international funds.  Due to time zone differences, international stock exchanges close hours before U.S. markets, which means that international fund shares trade while the underlying markets are closed.  When U.S. stocks surge on positive news late in the afternoon, it's a good bet European markets will open higher the next day.  Traders who buy the fund and sell the next morning can make a quick profit at the expense of long-term investors, who end up footing the expenses and taxes that result.  Obviously, this is a problem domestic funds don't face, since the closing net asset value (NAV) is simply the aggregate of its U.S. stock holdings.

One way a fund can thwart arbitrageurs is by using fair value pricing - a practice supported by the SEC.  Essentially, the fund does not use the closing prices of its stocks - rather it estimates the NAV based on models of what a stock's price would be if the international exchange were open.  Fair value pricing is designed to prevent the 'late trading' scandals that have surfaced in the fund industry.

"We've been very aggressive with using fair value pricing in our international funds for years," said Gus Sauter, Vanguard's chief investment officer.  "We monitor how ADRs and various country funds are performing throughout the day.   We also look at the U.S. market for any developing news.  If the closing price in a country doesn't reflect the current prices, then we'll make a fair value pricing adjustment."

Vanguard also discourages traders with redemption fees.  "We charge a 2% redemption fee for short term trading, which in our view is two months round trip.  That 2% fee far exceeds any transaction costs we may incur - it's intended to be punitive," said Sauter.  (Spitzer has accused other fund firms of waiving redemption fees for certain hedge funds to increase fees, to the detriment of other fund investors.)

Michael Sapir, CEO of ProFunds, says his firm allows international fund investors to be as active or as passive as they want to be.  ProFunds manages a broad European index fund, an Asian index fund, and a fund that attempts to double the Japanese Nikkei 225 Stock Average.

"Everything we're investing in is traded in the U.S. during the normal hours," said Sapir.  "We're using ADRs and futures contracts that trade here until 4 pm.  So when we price our international funds it's reflecting actual market input until 4 pm.  The price that shareholders get at 4 pm reflects anything that has occurred in the marketplace between the close of the foreign market and the close of the U.S. markets."

Lee Kranefuss, head of intermediary investor and ETF business at Barclays Global Investors, says exchange-traded funds offer a unique solution to the problem.

"International or domestic, ETF transactions take place on the secondary market between investors - not between investors and the fund," said Kranefuss.  "The transactions are taking place on an exchange; investors are not interacting with a fund that may be using stale prices.  The price of an ETF share is updated throughout the day, and is determined by competitive market forces."

Kranefuss said iShares are not hamstrung by large amounts of cash moving in and out of a mutual fund because the trades are in-kind.

"The problem with a traditional international mutual fund is that you may get a high volume of orders at the end of the day after the underlying markets are closed," said Kranefuss.  "The fund manager has to wait until the next morning to buy the stock, yet the price of a fund share has to be priced at 4 pm that day."

In traditional mutual funds, traders and buy-and-holders often get in each other's way - in the ETF structure traders can in fact subsidize, rather than exploit, more conservative investors.  "Long-term investors can coexist side by side with the more aggressive traders, whether they're hedge funds, day traders, etc.," said Kranefuss.


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