What is fair value pricing?

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.

 

 

 

 

a new Morningstar study: expense ratios a better performance indicator than stars?

Morningstar, the mutual funds research service famous for its star ratings of funds, apparently issued a press release over the weekend that details a study of its star ratings vs. other fund selection criteria.  I say “apparently” because both the Wall Street Journal and the Associated Press carried the story, but I’ve been unable to locate either the press release or the research document on the Morningstar website.

Two aspects of the WSJ account of the study struck me as interesting.

It’s not the study itself.  From what the press accounts indicate, Morningstar compared the performance of 1-star funds with that of 5-star funds over the five-year period from 2005-March 2010.  The conclusion?–in a majority of cases, an investor who chose funds that charged the lowest fees would have done better than one who used the Morningstar stars.

Although Morningstar has skillfully build a business that generates about $500 million in annual revenue from its star ratings, that fact that they may not have predictive value should come as no surprise. The company itself is careful not to claim that they do.  And there have been academic studies from time to time that have raised the same issue.  Nevertheless, it’s a powerful psychological fact that when faced with highly complex decisions, people are invariably drawn to mechanisms that seem to distill the decision down to a small number of easily understood choices–like “Do I want one star or five?”

What did I find striking?

–the WSJ story notes that 1-star international equity funds outperformed 5-star funds over the study period.  Despite this, just about half of the 1-star funds were closed down during the half decade.  Not only that, but the best performing funds appear to have been the ones that shut their doors.  According the WSJ, the performance situation is reversed when considering funds that survived the entire time period.  5-star survivors outdistanced 1-star survivors.

Why would a fund company shut down a fund that’s outperforming?  Because it can’t get anyone to buy shares.  Why would that be?  My bet is that good performance is not enough to overcome the stigma of a low star rating.  To me this illustrates how powerful Morningstar has become in individual investor behavior.

–as presented in the WSJ, this is a pretty weird study.  Morningstar has over 25 years of data on mutual funds.  Why choose a five-year-and-three-month period?  It should be very simple to see if the same patterns hold over longer time frames.  Did Morningstar look? If so, what did it find?  How did the 2- 3- and 4-star funds, which represent the large bulk of the funds rated, fare?  Did the lowest-cost 5-star funds outperform the highest-cost funds?

Anyway, there are lots of questions the WSJ could have asked that could have provided analysis and insight.  The fact that it didn’t shows what the WSJ has become over the last few years.

Jones v Harris Associates: the Supreme Court on mutual fund management fees

Jones v Harris Associates

Jones v Harris Associates, a lawsuit that  has been going on for a while, finally took what may be a terminal turn when the Supreme Court issued guidelines and sent the case back to an appeals court for a last tuneup.

a strange lawsuit

The suit struck me from the first as a bit odd.  The plaintiffs, shareholders of Oakmark mutual funds managed by Harris, claim to have been damaged, by Harris.  Suing a money manager isn’t the strange part.  The reasoning is.

The “damage” was caused, the plaintiffs contended, not by the funds performing poorly or losing them money, but by the fact that Harris also manages money for institutional clients like corporate pension plans and charges lower fees to the latter.

I can see that the lawyers for the plaintiffs could have enjoyed a huge payday if their suit were successful–and that they would have clients of other fund management groups falling all over themselves signing on for similar litigation.  Of course, the big recession has doubtless put a big dent in their other, hopefully more useful, legal work.  But really…

pricing in the real world

At the risk of providing more fodder for the law profession, everyday life is filled with instances where individuals pay different prices for identical products.  For example:

–airlines, and now busses, practice “yield management,” which typically means that  the price of a seat rises progressively from the first passengers to book to the last.  Most large corporations have arrangements with airlines that get them very deep discounts over what private individuals pay.

–my wife and I booked a beachfront hotel room in Florida through Hotwire recently.  We paid $110 a night for a room the hotel would have charged us $199 for–and which it probably sold to Hotwire for $85.

–almost every automaker has a premium brand–Acura, Cadillac, Infiniti–that is uses to rebadge a vehicle and sell it for thousands of dollars more than the equivalent with a Chevrolet, Honda or Nissan label.

–household goods makers manufacture private label products for Wal-Mart in the same factories, with basically the same ingredients and same processes as the price of getting shelf space for their (much higher-priced) brand name goods.

–and what about the Early Bird Special for senior citizens, or what about the process of buying a car?

I’m sure you could add dozens of items to this list.  And remember, in the case of mutual fund and institutional investment management services, it’s not clear that they are the same product.  More about this below.

questioning the board of directors actions

The plaintiffs didn’t just point out that the fees were different.  They also asserted that the boards of directors of the Oakmark mutual funds were so under the influence of Harris that they would agree to any fee Harris asked for.  It’s not clear whether this was simply name-calling or they offered some evidence.

The initial trial judge agreed that this was not much of a case.  He did the equivalent of laughing it out of court by issuing a summary judgment in favor of Harris.

The plaintiffs appealed.

The appeals court wound up even further in the Harris camp, by ruling that the plaintiffs would have to show that in negotiating with the directors of a mutual fund about fees, Harris had both:

–received an absurdly high fee with no relation to the services rendered, and

–defrauded the directors into agreeing to such a fee.

The plaintiffs apparently did neither, and they lost a second time.

The plaintiffs appealed again, and the Supreme Court said it would hear the case.  It recently put its two cents in and returned the case to the lower courts.  The SC’s comments:

1.  It’s not obvious that institutional products and mutual fund products are identical.  Even if they are, it’s not necessary to have the same prices.

2.  It’s not the courts’ job to second-guess the boards of directors of mutual funds, nor to get into the business of setting investment fees.

3.  Comparing one fund family’s fees with other fund families’ is irrelevant, since it begs the question of whether the fees in the comparison group have been set fairly.

Are the products different?

As someone who has managed both kinds of money, my answer is that they are.

–as the plaintiffs in Jones v Harris Associates contend, the fees are different.  Mutual fund management fees are higher than institutional, by a factor of about two.  An international manager might charge mutual fund clients 80-110 basis points a year, and pension fund clients 45 or 50.

–the money flows are different.  Institutional clients may give a portfolio manager $10 million to manage.  Provided the performance is satisfactory, that money could stay with the manager for ten or twenty years–or even longer.  At the moment, retail investors are turning over a third of their stock mutual fund holdings a year.

As a result, the mutual fund can require constant tweaking of the portfolio to adjust for money flows.  This implies having a larger trading room and a more complex record keeping apparatus.  The mutual fund requirement for daily pricing (officially done by the custodian bank) also necessitates not only coordination with the bank, but also a parallel pricing mechanism to verify that the bank’s pricing is correct.  Why do this?  –to ensure that buyers and sellers on any given day receive either the correct number of mutual fund shares or the correct amount of money.

marketing is different.  Institutional investors typically rely on a small number of pension consultants for decisions about hiring/firing managers and for analysis of results.  This makes marketing and communication relatively easy, and relatively inexpensive.

Retail clients, on the other hand, are extremely difficult.  They have very high, and unrealistic, expectations.  Even reaching them as potential clients is hard.  In the no-load world, fund management companies may have to rebate, say, 25% of the management fee simply to appear on the websites of the major discount brokers.  A load fund may have to rebate a similar amount just to gain access to the sales force of a retail broker.

Retail marketing also involves expensive marketing materials, a public relations effort to cultivate the media, and at least in the load-fund case a network of wholesalers to make the fund company’s case to retail financial advisors.

Mutual funds, as specialized corporations, have boards of directors.  This means preparation for, and possible portfolio manager attendance at, quarterly meetings of the board.

In short, although gross fees for mutual funds are higher, gathering and retaining assets is also much more difficult, expensive and time-consuming.

Are mutual fund boards so bad?

I don’t think so.  They certainly can’t be any worse than the boards of the big commercial banks!!

Yes, they’re typically nominated by the management company and, yes, they do have liability insurance.  They also get much of the information on which they base their decisions from briefing papers and oral presentations by the management company–which, naturally, frames the issues in a favorable light.  But this is no different from what happens on any other kind of American corporate board.

On the other hand, the structure and functioning of  a fund management company isn’t overly complex technically.  And there’s been enough litigation suggesting board members can be held personally liable for especially poor decision-making that a board has to take its responsibilities seriously.

My impression is that fund boards have more members with deep knowledge of the corporate business than the boards of industrial or banking companies.  Once elected, board members have an enormous amount of power, since they must periodically vote to renew the advisory contract of the fund management company.  Just the suggestion that this might be a problem is enough to get a management company to make any changes a board might want.

Why target Harris Associates? The short answer is that I don’t know.  I suspect that it has little to do with Harris itself.

You’d think the target firm would have to be successful, or otherwise it wouldn’t have an institutional business.  And the assets under management (about $50 billion at yearend 2009 for Harris) would have to have a certain minimum size so that the payoff from a successful suit would be large enough.  Within these parameters, I’d think a law firm would pick a relatively small, independent firm.  The the high cost of defending oneself might make the company amenable to a settlement, and the potential loss of future legal business from other parts of the firm or its suppliers/customers would be minimal.

The ultimate outcome?

I think we’ve seen it already.  No changes to today’s practices.  I also think that’s the right result.


Who owns mutual funds in the US?

Who owns mutual funds?

The Investment Company Institute, the trade association for mutual fund management companies, has done two pieces of recent research on this topic.

One seeks to create a picture of the typical mutual fund holder in the United States.

The second tries to figure out how fund holders behaved during the financial crisis.  It does this in two ways:

by surveying the holders themselves, and

by surveying the administrators of work-related defined benefit retirement plans about the behavior of plan members.

The owners Continue reading