- About Us
- Products & Solutions
- Industry Solutions
- Thought Leadership
- News Room
- Contact Us
|
By Ryan Bailey Mutual funds and their investors rely on publicly available benchmarks as relevant comparison tools for performance measurement. Funds that hold international securities often use a fair value pricing model to better estimate the value of those foreign securities whose markets closed prior to the close of the U.S. Market when funds strike their daily net asset value. Most often, index providers do not recalculate the benchmarks they produce using a fair value pricing model. The variance in pricing methodology creates short term distortions in performance returns. To alleviate these relative return distortions, some index providers have begun using fair value pricing models to value the foreign securities in their benchmarks but the trend has been limited. The Issue – Market Timing Mutual Funds have long had to combat the issue of timing between the close of foreign markets and the 4 p.m. EST close in the United States for the strike of daily Net Asset Values. The stale prices of international securities held by funds may create an arbitrage opportunity for market timers. In cases such as Japan, there can be as much as a 15 hour difference between the close of the market and the 4 p.m. U.S. market close. This gives market timers the chance to purchase mutual fund shares at the end of the U.S. day, having already taken into account material events in foreign markets whose securities prices are stale, but will immediately react to the prior day’s events as soon as the market opens. This presents short-term arbitrageurs a legal opportunity to profit from something as simple as time zone difference. Consider this example offered by Alan Lavine in Financial Advisor Magazine. “On Friday, April 14, 2000, the S&P 500 index declined 5.78%. Asian markets declined the following Monday. After the Asian markets closed, the S&P 500 rebounded 3.25%. By 4 p.m. EST, when funds priced their portfolios in the United States, it was clear the Asian markets would rally on Tuesday. A number of foreign funds lost assets when the S&P 500 rallied on Monday and the arbitrageurs took profits. Some of the funds included ABN AMRO Asian Tigers Fund, which lost 0.81% of assets; Chase Vista Japan, which lost 0.73% of assets, Invesco Pacific Basin, which lost 0.72% of assest; and Merrill Lynch Dragon, which lost 0.67% of assets.” Market timing negatively effects mutual fund performance, creates expenses for the fund, and causes cash management issues. Mutual funds have tried to use minimum holding periods and transactions fees to discourage market timing with little success. Beginning in 2001, the SEC began allowing funds to use fair value pricing in order to counteract the negative effect of market timers. This change allows mutual funds who hold shares in a foreign market that experiences a significant after-hour event, to adjust the price of those securities to an estimate of what they would be valued given an active market to trade in. From the SEC’s view, this is an extension of the Investment Company Act of 1940, whereby funds must make a good faith determination of the value of the securities held in the fund. For the funds the benefit therefore is twofold, it complies with the recommendations of the SEC and alleviates a good portion of the risk funds face from arbitrage by using fair value pricing. Performance Concerns From an investor’s perspective, fair value pricing creates issues for performance measurement. Investors measuring excess return against a benchmark and using tracking error as evaluation tools encounter a lack of consistency between funds that use fair value pricing and public indexes that often do not. Comparing the price-adjusted securities of the fund with the stale security prices in the index creates the false appearance of relative risk. Consider the following example: Fund 1 and Fund 2 are identical Emerging Markets Funds. For 2009, Fund 1 used a fair value pricing model, while Fund 2 and the underlying benchmark for the funds did not. The 2009 return for both funds was 79.82% compared with the benchmark return of 79.02%, producing an excess return of 0.80%. At the same time, the daily tracking error over the year for Fund 1 was 0.65% while the tracking error for Fund 2 was 0.48%. The excess return for the funds is the same but it appears that Fund 1 was a higher risk investment. Investors are going to shy away from the additional perceived risk in Fund 1 since it does not produce any additional return over the “safer” Fund 2. In reality, these funds are comprised of identical securities; there is no increased volatility in Fund 1, just a valuation methodology difference between the fund and its benchmark. The problem appears even more exaggerated when evaluating daily excess returns for index funds that are expected to track relatively close to a given benchmark. An example of the variance to the benchmark an index fund can experience occurred on March 22 of this year. On that day, the SSGA Daily MSCI EAFE Index Fund price was $16.43 – this gives the fund a daily performance return of 0.1768% versus the MSCI EAFE (Net) Index return of 1.0207%, a variance of 84 basis points. For a fund expected to track very close to its benchmark, such a discrepancy raises questions for investors. While the effects of a fair value event should correct themselves the following day, the short term performance analysis issue remains. While it is estimated that around 95% of funds are using some form of a fair value pricing model, a consistent method for evaluating performance when events occur is needed. This becomes more necessary as we encounter greater market volatility, increasing the occurrence of significant events that will trigger fair value pricing. Exhibits 1 and 2 displays the number of days annually the MSCI EAFE and MSCI Emerging Markets Net return changed by 100 bps or more from 2005 - 2010. Exhibit 1 – MSCI EAFE (Net)
One solution is for index providers to offer fair value adjusted indexes. Index providers can adopt a fair value pricing model the same way funds do, applying similar price adjustments to the securities comprising the index that the funds make to the securities they hold. In March 2010 Russell began partnering with Interactive Data to produce monthly fair value adjusted data for select global indexes. Russell currently provides fair value data for 12 of its indexes and is speaking with clients to gauge the appetite for increasing the service from monthly to daily and expanding to include additional areas. This of course is not a perfect solution - differences in fair value models and the arbitrary nature of what funds consider significant events versus what the index deems significant will still create variances from the benchmark and between peer group funds. However, as Dr. Ananth Madhaven notes in his Fair Value Adjusted Indexes article for the Journal of Indexes, “most distortions arise from not using a fair value model at all, the use of different thresholds across funds is unlikely to be the source of significant distortions.” Some index providers note that fair value methodology is only needed in times of great market volatility such as 2008 and 2009. When markets are fairly stable, there is minimal demand for such benchmarks. Add that to the increased cost and intensive labor necessary to calculate duplicate indexes and as a result, many providers have opted against issuing fair value benchmarks. Conclusion Mutual funds and investors use benchmarks to evaluate fund performance and relative risk through tracking error. This industry practice is seriously handicapped when funds and their benchmarks are using different valuation methodologies to arrive at returns. The use of fair value adjusted index benchmarks is the best solution for mutual funds and investors alike. While currently limited to a handful of indices and even fewer service providers, one can only assume with increased demand Index providers would see the value to their clients and begin calculating fair value indexes. Incorporating the use of fair value adjusted indices offers mutual funds and investors a publically available, effective tool to continue meaningful evaluation of fund performance and risk analysis versus consistently calculated benchmarks.
|
|
print