Fair or Foul?

Recent buzz on the buy side is all around market timing, and mutual funds are searching for technologies to keep themselves out of trouble. Market timing is a strategy where investors profit on short-term investing while the market moves up, and pull out of the market as it moves down.

Market timing is not illegal. However, it's often frowned upon by many mutual funds, especially those with long-term investment strategies. "It adds operational costs for clearing and settling the share purchases of the mutual fund," explains Gene Kim, a senior analyst with Framingham, Mass.-based Financial Insights. "It also skews cash positions, forcing fund managers to figure out how to retain the client mandate, which adds transaction costs."

Mutual funds have various options when combating market timers. They can assign fees each time a short-term transaction is made, as well as monitor the funds daily for short-term trading activity. One other method that is picking up momentum is fair-value pricing of mutual funds, either manually or using predictive technologies.

Fair-value pricing assigns estimates for international equities that lack readily available market quotations. This is caused by market events occurring after the local market close, but before a funds' daily net-asset-value calculation.

Tom Muscarella, vice president and director of mutual-fund operations at the San Diego-based investment firm Nicholas-Applegate, emphasizes that fair valuation helps prevent market timing. "If we step in and say that a foreign closing price doesn't reflect true fair value, and we make a management decision to increase that value to a fair value, then we've foiled the arbitragers," he says.

Eric Zitzewitz, an assistant professor of economics at Stanford University's Graduate School of Business, says while some firms don't use technology to address this issue, many firms have developed proprietary models or turned to one of the two major vendors on the market, FT Interactive Data or ITG, to implement technological solutions.

"It makes sense to use some sort of algorithm instead of ad hoc adjustments," says Zitzewitz, adding that manual intervention leaves opportunity for corruption or manipulation.

Bottoms Up

One methodology that is gaining popularity is bottom-up valuation. This method allows mutual funds to derive fair values by adjusting the individual prices of securities in a fund, instead of the portfolio as a whole. Bottom-up valuation uses multiple modeling factors, explains Brendan Potter, a vice president of infrastructure development for JPMorgan Fleming Asset Management.

JPMorgan Fleming Asset Management, a global firm with $511 billion under management, and Boston-based Eaton Vance Management, whose assets total $70 billion, have recently recognized the importance of fair-value pricing for their mutual funds. The two firms have implemented Bedford, Mass.-based FT Interactive Data's Fair Value Information Service to derive fair-value estimates for foreign securities held in their mutual-fund portfolios.

Potter explains, "It's important to our shareholders that we try to prevent market timers. Market-timing activity will increase portfolio turnover and transaction costs for the fund, which affects the shareholders."

Financial Insights' Kim explains market timing can be prevalent in global markets, due to the variation of market-closing times. For example, he says, a stock can close at a certain price on the London Stock Exchange when it is still morning in New York. If a significant event positively impacted the worth of that stock before the close of the New York day, a market timer could buy shares of the mutual fund holding that stock, with share prices reflective of the stock's closing London price. Then the market timer could quickly sell, once the value of the fund changed on the London market as a result of the positive news.

This disconnect between the price the fund would have used to value its portfolio, and the actual value of the security, would enable a sure profit for a market timer. Fair valuation would prevent market timing by assigning the London stock with an estimated price that reflected that market movement before the New York market-close time, and the fund's NAV calculation.

Take it from the Top

While a vendor solution is the right fit for some firms, others develop their own bottom-up models or opt for an entirely different predictive analysis dubbed as "top-down."

Nicholas-Applegate, with $18.6 billion in assets, opts to fair-value mutual funds using a manual process.

Charles Field, the firm's deputy general counsel and chief compliance officer, says Nicholas-Applegate has adopted procedures to deal with a significant event. He says actions such as a security being halted, an exchange closing down or even considerable U.S. market moves qualify as significant.

"We have a pricing committee made up of people from across the firm, which includes both Tom (Muscarella) and me, as well as people from the trading, portfolio-management and operations departments," he says. "Once it is determined that we need to meet, we will determine whether the securities we have priced in foreign markets are still good or if we have to fair value."

Nicholas-Applegate's "top-down" methodology includes examining news and interviewing traders and portfolio managers. The firm will also call sell-side brokers to understand their outlook on the value of the security.

Field concedes the firm has looked into technology that could do bottom-up analysis, but notes, "It's a very expensive piece of software and we're not convinced yet that it is worth it. I think we're doing a pretty good job now."

Muscarella agrees, adding, "If that software was perfect, people would be using it as an investment model, not a fair-valuation model." While Muscarella asserts that Nicholas-Applegate uses its fair-value process as often as needed, many firms err on the conservative side, as fair-value prices are derived from predictive modeling, not true values.

"Traditionally, asset-management firms use fair-value pricing on the occasion when they think that market conditions warrant it," Financial Insights' Kim says. "They would like to rely upon actual market-set prices because fair-value is ultimately an estimation based on an interpretation of what's going on in the market."

T. Rowe Price's Ken Fuller, a vice president in the equity division, adds that even fair valuation cannot prevent global market timing. "You can't predict with perfection what that adjustment should be," he says. "The New York market closes at 4:00 p.m. and the first overseas market, Japan, opens at 8:00 p.m. EST. There are four hours of time when things can happen and you've already struck your prices for the NAV."

Fair valuation may not be an exact science, but there is no doubt among buy-side executives vigilance is necessary to avoid regulators knocking at the door. "The SEC has sent out letters to many firms in the mutual-fund industry," says Nicholas-Applegate's Field. "Most people take this pretty seriously. But, if what comes back from those letters is that the industry is not paying attention to (fair valuation), then you're probably going to see more regulation."

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THE EVOLUTION PROCESS

Fair valuation of funds has been practiced on some level at most mutual funds since the Investment Company Act of 1940. This tenet of the buy side stated that a fund must price its assets each business day based on their current value, and if a price isn't readily available, a fair value should be determined by the fund's board of directors. In an April 2001 letter to the Investment Company Institute, the SEC further recommended that funds take into account "significant events" when fair-value pricing.

Yet, while the investment community readily agrees that fair valuation is necessary, the methods of its pursuance vary from firm to firm, especially when considering the definition of a "significant event."

An August 2002 survey, conducted by the Investment Management Services Group of Deloitte & Touche, notes that correlation triggers for market fluctuations vary, especially among firms with less than $75 billion in assets. Less than one quarter of these firms engaged in "the use of correlation analysis and triggers to monitor and determine if a significant market fluctuation has occurred."

However, Paul Kraft, a partner in the Investment Management Services Group at Deloitte & Touche, adds that over 80 percent of the firms surveyed (which included firms larger than $75 billion) had some fair-valuation procedure in place. "The fact that they are monitoring their fair-value results and continuing to analyze and tweak their methodologies is more important than what the methodology is," he says.