Whether funds like it or not, their "Arbitragers Welcome" signs will be coming down in 2001. At a conference last month, the
Securities and Exchange Commission
announced a long-overdue move to prevent funds from using the kind of stale pricing methods that arbitragers feed on.
Arbitrage pricing occurs when funds use out-of-date prices to value their portfolios. This happens most often when a fund's securities trade on foreign exchanges, particularly exchanges in the Far East that can close up to 13 hours before the 4 p.m. ET closing of major U.S. exchanges.
A major event can drastically affect the value of stocks on a foreign exchange after they've stopped trading for the day. But many U.S. mutual funds will ignore the impact of such events and price these securities at 4 p.m. ET as if nothing had happened in the interim. That leaves the door open to arbitragers, who swoop in and buy shares of funds that haven't updated their
net asset values, or NAVs. The arbs then cash out their shares the next day for a risk-free, one-day profit that comes directly out of the pockets of their fellow shareholders.
Arbitragers can cost a fund's shareholders up to 2% to 3% of their assets in a single day, as I pointed out in previous columns on
June 10, 2000, and
July 1, 2000.
To date, the SEC's position has been that funds may --
but are not required
-- to update their NAVs when events change the value of their portfolios after a foreign exchange has closed. This is known as "fair-value pricing."
I've argued that stale pricing is illegal and encouraged readers to ask the SEC to require funds to use fair-value pricing when the occasion calls for it.
(See my Jan. 2 column, Make 2001 the Year You Become an Activist Shareholder.) It appears the SEC is finally taking notice.
SEC Will Take Action
Douglas Scheidt, chief counsel of the SEC's funds division, recently announced that the staff will issue a letter requiring funds to fair-value securities when events after the close of the exchange on which they trade renders their prices obsolete.
SEC action can't come too soon. Over the past few years, mutual fund arbitrage has moved from Wall Street back offices to Main Street living rooms. Personal finance magazines have run articles explaining how to arbitrage fund prices, while Internet bulletin board participants debate the morality of exploiting long-term fund shareholders.
"Karl," a frequent participant in the bulletin board at
FundAlarm.com, recently boasted of making a 6.34% profit in a single day using pricing arbitrage, or what he and his fellow arbitragers call "datelining." After being referred to one of my articles, and thanks to some persuasion by "Cynicus," Karl foreswore exploiting stale prices and promised "never to mention ARBing on this board again."
But most participants in the discussion saw nothing wrong with picking their fellow shareholders' pockets, with one citing
Gordon Gecko's motto, "Greed is good," as his justification.
Fair Value Pricing in Practice
shareholders, the giant fund firm recognizes the threat posed by arbitragers. Vanguard fair-valued a number of its funds after the
Fed cut interest rates by 0.5% on Jan. 3, sparking a record one-day 14% rise in the
Nasdaq Composite Index
and a 5% gain in the
According to Dan Wiener, investment adviser and editor of
The Independent Adviser
, a newsletter on Vanguard funds, investors poured tens of millions of dollars into Vanguard's foreign funds, with many hoping to exploit stale prices that were sure to rise the next day. The most popular target, reports Wiener, was
Vanguard International Growth fund. Unlike many of Vanguard's funds, International Growth can be traded by phone.
Vanguard spokesman John Demming confirms that Vanguard fair-value priced a number of its funds on Jan. 3. Fair value pricing "protects the interests of long-term shareholders," he explained. "It's not fair for
arbitragers to be able to game the fund based on that particular information and capture a 4% to 5% gain in a single day at the expense of the other shareholders."
While quite forthcoming about Vanguard's motives, Demming was tightlipped about the identity of the fair-valued funds and the difference between the funds' NAVs before and after being fair valued. He also would not disclose on what basis the funds' securities were priced.
One reason for Demming's reticence may be Vanguard's concern that the subjective nature of fair-value pricing might not withstand close scrutiny. Before battening down the hatches, one Vanguard executive confessed to syndicated columnist Eric Tyson that Vanguard priced its international funds using "exchange-traded funds and futures prices, as they represent prices long-term investors are willing to pay."
T. Rowe Price
apparently believes that these securities may not always be accurate indicators of market value. T. Rowe Price fair-valued its funds' Japanese securities on Jan. 3, but did not fair-value other foreign securities because they "did not have good proxies for those markets," according to Forrest Foss, a T. Rowe vice president and counsel.
When a major event occurs after foreign markets close, such as Taiwan's earthquake in September 1999 and Malaysia's currency reforms a year earlier, funds are caught between a rock and hard place. Either they fair value, using subjective proxies for market prices, or they use stale prices. Either way, shareholders may pay inaccurate prices.
Kinetics Asia Technology fund solved this dilemma by pricing fund transactions based on closing prices on foreign exchanges the next day. Investors who purchase their shares on Monday, for example, will not get a price until 3 a.m. ET Tuesday -- the end of the next trading day in Asia. By that time, Asian market prices will have digested Monday's U.S. market news.
Kinetics' approach solves the foreign fund pricing problem. It prevents arbitrage because prices reflect changes in U.S. markets. And it ensures accurate NAVs because they are based on actual market prices.
uses a slightly different approach that may be equally effective. It prices its four Asia funds at 9:30 a.m. ET based on closing Asian prices at 3 the same morning. Although it uses stale prices, the prices are 6 1/2 hours fresher than funds that price at 4 p.m., and arbitragers can't trade the fund's shares based on U.S. market movements during the day.
Why doesn't every fund follow Kinetics' lead? At least one fund executive complained that this approach was impractical, because funds would not be priced in time to send their NAVs to the newspapers, and fund supermarket and pension plan systems might not be able to adapt to an overnight delay in finalizing transaction prices.
Lee Schulteis, chief operating officer at
Kinetics Asset Management
, disagreed, noting that the Asia Technology fund is available in
OneSource supermarket (as are Investec's Asia funds), and arguing that getting an accurate price is more important to investors than being able to check their funds' prices in print. Not to mention the protection against arbitrage.
The industry may see the light once the SEC requires fair value pricing. When the SEC issues a clear mandate, purportedly insurmountable technical problems often have a way of suddenly becoming solvable.
Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md. He welcomes your feedback at