SEC to Mutual Funds: Take Down 'Arbitrage Welcome' Signs

As predicted in my Feb. 6 article, the Securities and Exchange Commission has finally laid down the law on arbitrage pricing. Earlier this week, the SEC issued a letter banning mutual funds from using stale prices to value their portfolios.

Arbitrage pricing occurs when funds use out-of-date prices to value their portfolios. When a fund's securities trade on foreign exchanges, especially those in the Far East that close up to 13 hours before the 4 p.m. ET pricing deadline used by most funds, the market price may be overtaken by events during the day. Earthquakes, power outages, even major market swings, can have a substantial effect on the value of foreign stocks after an exchange has closed for the day.

But many funds have ignored events occurring after the close of a foreign exchange and used stale, 13-hour-old closing prices to value their portfolios. This permits arbitragers to buy shares of funds that haven't updated their net asset values , or NAVs. These arbs cash out their shares the next day to pocket a risk-free one-day profit that comes directly out of the pockets of fund shareholders. ...