During a week where the buzz on the buy side is all around market-timing, mutual funds are searching for techniques to keep themselves out of trouble. Illegal acts of alleged late trading have brought market-timing to the forefront of Wall Street.
While fair-value pricing won't keep traders from illegally dealing after-hours, it is one tool that helps investment firms to prevent market timing. 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.
Although market timing is not illegal, its 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 Financial Insights. "It also skews cash positions, forcing fund managers to figure out how to retain the client mandate, which adds transaction costs."
JP Morgan 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 enable their funds to derive fair-value estimates for foreign securities held in their mutual-fund portfolios.
FT Interactive Data's service assigns estimates for international equities that lack readily available market quotations due to market events occurring after the local market close, but before a funds' daily net-asset-value calculation. The fair-value price is derived by adjusting the individual prices of securities in a fund, instead of the portfolio as a whole, using multiple modeling factors, explains Brendan Potter, a vice president of infrastructure development for JPMorgan Fleming Asset Management.
Kim explains that 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 in the New York morning. 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.
JPMorgan Fleming's Potter notes, "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."
Most firms depend on some sort of fair-value pricing, either using internally developed models, or those offered by vendors on the market such as FT Interactive Data and the New York-based vendor ITG, Kim notes. However, many use the fair-value process conservatively, as fair-value prices are derived from predictive modeling.
"Traditionally, asset-management firms use fair-value pricing on the occasion when they think that market conditions warrant it," 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 entirely prevent global-market timing. "You can't predict with perfection what that adjustment should be," he says. "The New York market closes at 4 p.m. and the first overseas market, Japan, opens at 8 p.m. EST. There are four hours of time when things can happen and you've already struck your prices for the NAV. But we have to do the best we can."