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Arbitrage pricing occurs when funds use out-of-date prices to value their portfolios.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.
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."
Last January, many of you who shared my belief that arbitrage pricing is illegal asked the SEC to require funds to use fair-value pricing when the occasion calls for it (see my
Jan. 2. column). Your efforts have paid off.
Papering the File
The SEC's new policy will require immediate changes at a number of funds. First, the prospectus. Even though fair-value pricing is now required, a fund can't fair-value price unless it says it might in its prospectus.
Pay-to-Play in America, Part 1
Pay-to-Play in America, Part 2: The Subtle Side of the Game
Pay-to-Play in America, Part 3: 'Money Rarely Raises Its Voice'
Pay-to-Play in America, Part 4: The SEC's Proposal for Regulating Pay-to-Play
Many fund prospectuses do not provide that the fund may fair-value price. So these funds could not comply with the SEC's new position even if they wanted to.
Look for funds whose prospectuses don't permit fair-value pricing, like the
Merrill Lynch Dragon Fund, to file amendments soon.
Even funds that say they may fair-value price don't necessarily do so. Last July, I estimated losses incurred by funds that did not reserve the right to fair-value their portfolios after an "arbitrage event" the previous April. On Friday, April 14, 2000, the
S&P 500 dropped 5.78%, and the Asian markets experienced a similar decline on Monday. After the S&P 500 rallied with a 3.25% gain on Monday, it was clear that Asian markets would follow suit.
For funds that fair-value priced, the Asian rally was reflected on their NAVs on Monday. The NAVs of funds that did not fair-value price stayed depressed on Monday, providing a buying opportunity for arbitragers who then sold on Tuesday, when the market rebound was finally reflected in the funds' NAVs.
Funds whose prospectuses did not reserve the right to fair-value price their portfolios lost an average of 0.52% to arbitragers in a single day. But funds that
reserve the right to fair-value price lost an average of 0.80% to arbs.
Perhaps the funds in the second group should spend less on prospectus-reviewing lawyers and more on pricing personnel. The SEC's new policy will undoubtedly create more work for both.
From the Frying Pan Into the Fire
A second effect of the SEC's new position is that it will ignite a new debate, this time about the reliability of fair-value prices.
Fair-value pricing is as much an art as a science. Factors that funds will have to monitor range from familiar economic data, such as futures on foreign indices, to other, noneconomic forces that often drive markets, including major weather events, political turmoil, wars and general acts of God.
But don't expect funds to be forthcoming about the particular ingredients they use when brewing fair-value prices. When
fair-value priced shares of some of its funds last January after a
Fed rate cut sparked large gains in the
Nasdaq and S&P 500, it refused to identify the funds or explain how it had determined the prices. Vanguard probably was concerned that shareholders would second-guess its pricing methodology and find an underemployed plaintiff's lawyer to file a nuisance suit.
The fund industry's pricing anxieties will intensify now that the SEC has mandated fair-value pricing. No fund has ever been sued for losses resulting from a failure to use fair values because the SEC has not required fair-value pricing. Now that fair-value pricing is mandated, it's only a matter of time before the plaintiffs' bar will make a fund complex or two pay handsomely for using stale prices.
In fact, the SEC's new policy may make lawsuits more likely. When only a few funds fair-value priced and arbs had plenty of victims from which to choose, the losses were spread across a large number of funds. As more funds fair value their portfolios, arbitrager activity will become increasingly concentrated on a few stragglers, thus magnifying the losses to those funds.
Some funds, such as the
GAM Japan Capital and
Kinetics Asia Technology, avoid the pitfalls of fair-value pricing by pricing their shares at the time Asian markets close. If you buy shares in these funds on Monday, your purchase won't be priced until early morning Tuesday. This may seem inconvenient, but it's probably worth it to prevent the fund from being systematically drained by arbs.
To avoid the administrative burdens and potential liability created by fair-value pricing, more funds may follow suit and price their shares at the time the exchange on which their portfolios trade closes, as opposed to waiting until the close of the
New York Stock Exchange
Whatever approach funds take, it looks like the arbitrage welcome signs will be coming down. And those of you who lobbied the SEC deserve some of the credit.
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