had a hand in the civil action brought today by New York Attorney General Eliot Spitzer: Two articles written in 2000 were cited in Spitzer's complaint against Canary Capital Partners to explain how fund investors were taken advantage of by a hedge fund.

Both articles, written by Mercer Bullard, a former assistant chief counsel at the

Securities and Exchange Commission

and a then-contributor to

, were used by Spitzer's office to explain "Time Zone Arbitrage."

In a footnote on page 8 of the

complaint, it says, "A particularly striking example of time zone arbitrage is described in a

June 10, 2000, article in"

The footnote later goes on to cite another article by Bullard, which we published on July 1, 2000,

"International Funds Still Sitting Ducks for Arbs."

This kind of reporting is what we do every day: Report news and research that can help you, the individual investor, avoid being taken advantage of by the big money on Wall Street.

We've reprinted both articles below:

Your International Funds May Have the 'Arbs Welcome' Sign Out Front

Would you invest in a fund with a sign out front that said: "Arbitragers welcome." I hope not. Arbitragers prey on pricing discrepancies. When those pricing discrepancies involve mutual fund shares, shareholders are their victims.

Surprisingly, a number of funds have standing invitations to arbitragers to line their pockets at the expense of shareholders. These funds sometimes use stale prices to calculate their

net asset value or NAV, thereby giving arbitragers an opportunity to buy shares at prices that they know will rise the next day. You might call this unfair. But it can and does happen in the heavily regulated world of mutual funds, where it goes by the civilized name of "dilution."

A fund's board of directors is responsible for preventing dilution. The directors are charged with ensuring that the fund's NAVs rise or fall to reflect changes in the value of the securities in its portfolio. Accordingly, funds usually base their NAVs on current market prices.

Some funds, however, use stale market prices. For example, funds whose portfolio securities trade on the

Hong Kong Stock Exchange

, which stops trading at 3 a.m. ET, typically value their portfolios at 4 p.m. ET. This is harmless as long as the value of funds' portfolio securities does not change between 3 a.m. and 4 p.m. But in this age of global markets and frictionless communication, 13 hours is an eternity. If these funds do not adjust their NAVs to reflect intervening events, shareholders may suffer dilution, or in plain English -- big losses.

Asian Crisis an Arb Opportunity

This is more than a theoretical possibility. On Oct. 28, 1997, on the heels of a 10% decline in the U.S. stock market, Asian markets dropped precipitously. By 4 p.m. ET, however, the U.S. markets had recovered. To anyone following the Asian markets, it was clear that those markets would follow suit when they opened for trading.

Unfortunately, this was not so clear to some mutual funds that invest in securities traded in Asian markets. These funds calculated their NAVs at the lower, 13 hours' stale closing prices on the exchange. Many arbitragers, knowing the funds' next-day NAV would rise, stood ready to exploit this pricing discrepancy.

Barry Barbash, then the director of the

Securities and Exchange Commission's

Division of Investment Management, reported that "large numbers" of arbitragers made a risk-free killing at the expense of other shareholders. They poured money into Asia/Pacific funds and sold them the next day, pocketing a one-day profit of around 10%. This profit came directly out of the pockets of the remaining shareholders.

How much did shareholders in Asia-Pacific funds lose because the funds used stale prices to value their portfolios? Not surprisingly, the funds aren't talking. But based on methodology suggested by the SEC, shareholders in many of these funds would have seen their accounts drop up to 2.5% overnight. Estimates of losses suffered by some funds are provided below.

Notwithstanding these losses, Barbash insisted that using stale prices was consistent with SEC rules, even though the rules require that funds price securities at fair value if market quotations are not readily available, as was the case for Asian securities on Oct. 28, 1997. According to Barbash, funds that used stale prices argued that fair-value pricing involved "complicated judgment calls" and was too costly in light of the small risk that significant dilution would result from a failure to fair value.

In some cases, these arguments might hold water. But when the difference between old closing prices on a foreign exchange and current market values exceeds 10%, the judgment call is simple, and the potential for significant dilution is self-evident. Barbash promised a "comprehensive review of pricing issues" by the SEC in 1998.

Two years later, the SEC has finally reconsidered its position. In a letter to the fund industry issued last December (for which I was a contributor as a member of the SEC staff), the staff stated that under certain circumstances, funds were required to fair-value their portfolio securities. For example, the staff said that after an earthquake closed the

Taiwan Stock Exchange

for a number of days in September 1999, mutual funds were required to fair-value securities in their portfolios that traded on the exchange.

Arb Events On the Rise

The volatility that rocked October 1997 prices of Asian securities is not an isolated occurrence. Potential arbitrage events include unexpected occurrences, such as trading restrictions imposed in Malaysia in January 1999, an earthquake in Turkey last August, and the unscheduled closing of the Philippine stock exchange in March, as well as expected events, such as scheduled holidays in foreign countries on days when U.S. funds price their portfolios.

A recent study suggests that it doesn't take a major arbitrage event to cause substantial losses to shareholders. Two

Yale School of Management

finance professors, William Goetzmann and K. Geert Rouwenhorst, and a Yale graduate student, Zoran Ivkovic, considered the effects of mispricing on 116 international mutual funds during the 17 months ending in June 1998. They estimate that trading on stale prices cost shareholders about $1.5 billion during this period, or 0.44% of the funds' assets.

The increasing globalization of financial markets, coupled with faster access to market information, will increase the frequency of arbitrage events and the awareness of the opportunities presented by mispricing practices. This will lead to more opportunities for arbitragers, and mounting losses to long-term shareholders. In this light, it is difficult to understand why the SEC has not clarified that fair-value pricing in certain situations is not optional -- it's legally required.

Will the SEC expressly require fair-value pricing any time soon? Paul Roye, the current director of the Division of Investment Management, says that "it's an issue that we recognize is out there, and we will be thinking about it as we continue to evaluate our policies on pricing and the need for further guidance in this area."

Steps Investors Can Take

Until the SEC sets funds straight, what can you do to protect yourself? It is not hard to spot funds with an "arbitragers welcome" sign out front. Look for funds that invest primarily in foreign markets in distant time zones, and that price their portfolios long after the exchanges in those markets close (usually at 4 p.m. ET).

Next, check the funds' prospectuses. Stay away from the ones that do not clearly state that they may use fair-value prices instead of closing exchange prices if events occurring after the close of the markets have affected the value of the fund's portfolio securities. Of the Asia/Pacific funds listed above, only the

T. Rowe Price



funds have learned their lessons and adopted this policy. Of course, reserving this option does no good unless the funds' directors ensure that the funds take advantage of it.

In contrast, the registration statement for the


Merrill Lynch Dragon fund not only fails to reserve the fair-value option, it goes out of its way to confess that "events affecting the values" of its securities may occur between the closing of the exchange and the time they are priced, and these events "may not be reflected in the computation of the fund's net asset value." Now there's an invitation that no true arbitrager could pass up.

TheStreet Recommends

If you are already invested in a haven for arbitragers, don't panic. There is a simple solution.

First, write to the fund's directors. Ask them to consider basing the fund's NAV on the next closing prices on the relevant exchange after the close of U.S. markets. Or ask them to change the fund's pricing policy to permit it to update its NAV when market prices are stale. The fund should prominently feature this policy in its prospectus. This will help deter arbitragers, whose trading can be costly to a fund even if its NAV is accurate.

If your directors opt for fair-value pricing, ask them to develop contingency pricing procedures to deal with extreme volatility, exchange closures, earthquakes and other potential market-shaking events. The directors may complain that this will increase the fund's compliance costs. Don't buy it.

First, this is what management fees are for -- saving you money. Second, these plans need not be perfect, nor should they try to be. They need only ensure that, following a major event, the fund's NAV is not so out of line as to risk significant dilution.

And while you're at it, if you were a shareholder of a fund invested in the Asian markets in October 1997, you might ask its directors whether the fund fair-valued its Asian securities on Oct. 28. If the answer is no, ask them how much of the fund's assets walked out the door in the pockets of arbitragers. And don't forget to ask them how they plan to make you whole.

International Funds Still Sitting Ducks for Arbs

A few weeks ago, I

took foreign funds to task for hanging out an "Arbs Welcome" sign. These funds use stale prices to value their portfolios, thereby allowing arbitragers to make easy profits (at other shareholders' expense) by buying shares they know will rise with U.S. markets the next day.

I showed that shareholders in a dozen of these funds could have lost up to 2.5% of their assets overnight during a volatile two-day period in October 1997.

Since '97, some of these funds have removed the "Arbs Welcome" sign by improving portfolio valuation procedures, restricting frequent trading in fund shares and imposing redemption fees. But anecdotal and empirical evidence suggests that some of these efforts are half-hearted or ineffective and that the only solution to this problem may be regulatory action.

The most effective antidote to arbs is fair-value pricing. When closing market prices become stale because of events occurring after foreign exchanges have closed, portfolio managers should update the price, or

net asset value, of their funds by using their own best estimates of fair market value. But critics of fair-value pricing say its subjective nature can give rise to a new set of abuses.

This debate is not simply academic. You need look back only to April to find a prime example of how an arbitrage opportunity can hurt shareholders. On Friday, April 14, the

S&P 500

index fell 5.78% in U.S. trading. Asian markets followed suit the following Monday. Later that day, long after Asian markets closed, the S&P 500 rallied for a 3.25% gain. By 4 p.m. ET, when almost all funds price their portfolios, it was clear that Asian markets would rally on Tuesday.

How did some Asia-Pacific funds respond to these market events? They lighted up their "Arbs Welcome" signs in neon, using the lower, now-stale closing prices on Asian exchanges to value their portfolios.

Not all of the funds mentioned above are equally vulnerable to arbs, however. Class B shares for the Chase Vista Japan and Flag Investors Japanese Equity funds carry stiff 5% deferred commissions payable upon redemption -- enough to preclude arbitragers from profiting in just about any arbitrage scenario. Similarly,


Invesco Pacific Basin charges a 2% fee on shares redeemed within three months of purchase, and class C shares for the Delaware New Pacific, GAM Pacific Basin and


Merrill Lynch Dragon funds carry a 1% sales charge payable on redemption. Many funds also track frequent trading in order to identify arbitrageurs and deny them purchasing privileges.

But none of these deterrents solves the problem of the daily dilution of fund assets caused by transactions occurring at inaccurate prices. Every time a shareholder buys fund shares at a stale price, other shareholders eat the difference. As money flows into and out of funds over time, the affect on shareholders as a group is negligible. But that's little solace to individual shareholders who, unknowingly, were on the short end of the bargain.

Some Funds Fair Value

If you want to invest in Asian markets and protect yourself against arbitrager-friendly funds, there is hope. There are at least 15 Japan and Asia-Pacific funds that state in their prospecti that they may fair value their portfolio securities if market prices become stale because of intervening events.

But whether funds that reserve the right to fair value actually do it is another question. For example, the


Ivy China Region fund, which has one of the best fair-value statements, shot up 0.87% from April 17 to April 18; the

(USCOX) - Get US Global Inv China Region Opport Report

U.S. Global China Region Opportunities fund rose 1.89%. If these funds were fair valuing, the price rise should have shown up a day earlier. In fact, funds that claim to use fair-value pricing gained an average of 0.70% from April 17 to April 18, a full 18 basis points more than for the non-fair-value funds listed in the table above. Fair-value funds may not have an "Arbs Welcome" sign out, but arbs may be more than welcome once inside.



Guinness Flight China & Hong Kong fund has taken a different approach to the problem of arbitragers. It values its portfolio at 9:30 a.m. ET, which slices the 13-hour time lag between the close of the Hong Kong and New York exchanges to seven hours. Jim Atkinson, a director at

InvestecGuinness Flight

, believes this fresh pricing approach is superior to the admittedly subjective process of fair-value pricing.

Editor's note: since publication of this story, the Guinness Flight China & Hong Kong Fund has changed its name to Guinness Atkinson China & Hong Kong Fund, and Jim Atkinson is now a director of Guinness Atkinson Asset Management.

But K. Geert Rouwenhorst, a

Yale School of Management

finance professor who co-authored a study on the topic, disagrees. "Our analysis showed that using prices that were as little as seven hours old would still allow an arbitrager to make a killing. Arbitragers could simply use information gleaned from European markets, which would already have been open for five or six hours at 9:30 am ET, to game the system," he says.

The April example provides some support for Rouwenhorst's analysis. At 9 a.m. ET April 17, electronically traded S&P 500 futures contracts were up 1.2%, thus portending a positive day for trading on the S&P 500. In theory, an arb could have invested in the Guinness fund at 9:30 and enjoyed a tidy 1.09% one-day profit.

Still, early-morning S&P 500 futures are weak indicators of the U.S. markets' performance that day. Guinness' fresh pricing approach, coupled with its 2% redemption fee, is likely to be far more effective at keeping arbs away than the efforts of funds whose fair-value policies are merely cardboard sheriffs.

Rouwenhorst argues that funds should fair value every day. He and his Yale colleagues, William Goetzmann and Zoran Ivkovic, found that one could trade foreign stock funds based solely on whether the S&P 500 had climbed or fallen during the day, and do more than twice as well, taking half the risk, as the funds' long-term shareholders.

Rouwenhorst says, "If we all agree that using NAVs based on stale prices is not a good idea, then the industry should develop fair value practices. There are approaches to fair-value pricing that would require very few computations and are based on a fairly simple model that captures most of the fair value adjustment." In fact, Rouwenhorst and his colleagues have developed such a model, which is described in his


Fair Value Faulted

Meanwhile, Atkinson argues that fair-value pricing is inferior to his approach, in part because such a subjective determination of a fund's net asset value creates the potential for abuse. For example, a fund might misprice its portfolio under cover of a fair-value policy to reduce the volatility of its share price. Or it could use fair-value pricing on Dec. 31 to get an end-of-year boost in its performance. Atkinson is correct, but there's no escaping the fact that Guinness is still using stale prices.

It may be that the only effective solution to the problem of stale prices is to prohibit them. The SEC's current position is that a fund may -- but is not required to -- fair value portfolio securities when events that materially affect the value of the securities occur after the closing of the foreign exchange on which they trade. Last December, the SEC issued its first guidance on fund pricing in 30 years, but failed to prohibit the use of stale prices. Let's hope that the SEC doesn't wait another 30 years to fix the problem.

David Morrow is editor-in-chief of In keeping with TSC's editorial policy, he doesn't own or short individual stocks, though he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send it to

David Morrow.

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