what it is:  two meanings

The overall idea is to price a mutual fund or an ETF using up-to-date prices.  The two meanings:

1.  The less important:  Mutual funds and ETFs price their holding every day.  If the fund owns a security that hasn’t traded on a given day–maybe it’s highly illiquid, or maybe it’s suspended an hour before the close pending an important announcement–a committee meets to determine, as best it can, what the proper closing price should be.  That’s one kind of fair value pricing.

2.  The more important:  The US stock market is open from 9:30 am until 4:00 pm, Eastern time.  Europe is open from around 4:00am until noon Eastern.  The Pacific opens at around 6:00 pm and closes around 2:00 am Eastern.

International or global mutual funds and ETFs are priced at the New York close at 4:00 pm Eastern time.  But the closing price for the securities it holds may have been at 2 am or at noon Eastern.  A lot of stuff that’s important to a stock’s price may happen between closing in the local market and the New York close, however.

The same is true of the currency of the local country, which probably trades twenty-four hours a day, around the world.

For many years, mutual funds used the local market close and possibly the local market currency value in calculating the daily net asset value of the fund, the figure at which shares are bought and sold through orders placed up until 4pm Eastern that day.

In other words, you could buy stocks at 4 pm whose prices were set at 2 am, without adjustment for any information that might have entered the market in the intervening time.

What kind of information?  …earnings reports from European or American firms, government economic announcements, or the rise or fall of western hemisphere stock, bond or currency markets.

This practice gave rise to a kind of time-zone arbitrage, that was most pronounced in the case of a US-based Pacific Basin fund.  Let’s say the US market was up 2% at 3 pm on a given day.  Chances are high, just on that basis, that Pacific markets would be up significantly that night as well.  But you could still buy shares of the fund at last night’s prices. On the other hand, if the European and American markets tanked, you could sell the Pacific funds you held at yesterday’s higher prices.

But market levels aren’t the only information you’d have access to.  You could see trading of Pacific securities in London and in New York.  You could see currency and interest rate movements.  And you could see the Nikkei futures (Japan) traded in Chicago.  So you could create a relatively sophisticated set of buy/sell signals, all predicated on the idea that you could in effect transact at yesterday’s prices.

As interest in foreign markets rose, and as more people worked out that this arbitrage could be highly profitable, mutual fund organizations began to experience significant numbers of shares being aggressively traded in and out of their foreign-oriented fund.  This created a severe technical problem for a portfolio manager in remaining fully invested, while at the same time raising and investing cash to match the individuals and organizations doing this time zone arbitrage.  More important, the trading activity was highly lucrative, meaning that to some degree these profits were being earned at the expense of the large majority of fund shareholders who were not constantly trading the fund shares, and who were likely unaware that this kind of activity was going on.

No-load funds had this problem before their load brethren.  No-loads pioneered the solution.  They hired third parties–S&P and the Financial Times are two of them–that had developed predictive software that determined what the New York closing price of any foreign security should be if the local market had access to financial information that emerged between the local close and 4pm New York time.  They also developed decisions rules that determined when to use local closing prices and when to use those generated by the third-party.  A typical rule would be that if the S&P 500 closed with up or down .5% vs. the previous close, the third-party implied quotes would be used.

Using fair value pricing has been the norm for US-based funds for years.  True, some fund groups required a nudge from the Attorney General of New York or of Massachusetts before falling in line.  But the “shooting fish in a barrel” arbitrage has been eliminated.

My firm used the FT figures.  In volatile markets, they would be used quite frequently instead of the local close figures.  Although I’ll admit to being skeptical at first, I was pleasantly surprised–maybe shocked is a better word–at how accurately the FT numbers mirrored the opening trade for the securities that night.

why is this important?

I own shares in an international mutual fund in an IRA.  I’ve been gradually selling my position down and replacing it with individual stocks.  I surprised myself on Monday–the US was down sharply when Europe closed but recovered to end just below breakeven at 4pm–by thinking for a minute that I shouldn’t sell shares that day but should wait to see if the better US close caused a sympathetic rebound in Europe on Tuesday.  Then I realized that the potential rebound is already priced in, thanks to fair value pricing.  One more thing neither you nor I have to worry about.