Stale Pricing Hurts Mutual Fund Savers

BLAME IT ON GLOBALIZATION: That stock markets around the world are both more volatile and more closely correlated in their up-and-down movements than ever before is clear. Notably since the onset of the Asian economic crisis in 1997, followed by the Internet bubble collapse in 2000 and the Sept. 11 aftershocks, global equity markets have swung faster, farther, and in closer tandem than ever. That this volatility presents greater risks to market players attempting to stay ahead of the curve is no surprise.

What is shocking is the extent to which such volatility, combined with the standard industry practice of pricing mutual funds just once daily, has allowed arbitrageurs to profit handsomely—to the tune of $4 billion annually in dilution—at the expense of long-term investors. Worse yet, this problem has been known for at least two decades, while little has been done about it.

In a new study, assistant professor of strategic management Eric Zitzewitz says the problem lies with the industry practice that he calls “stale” pricing. Mutual funds typically calculate their net asset value (NAV) using market data as of 4 P.M. Eastern Time. Long after the closing bell in Tokyo or Frankfurt, foreign stock prices and the relative values of U.S. funds holding them are in flux, but their NAVs have already been set; thus, the opportunity to profit by daily trading.

A few years ago, Zitzewitz noticed that prices on some high-yield bond funds he owned were following predictable patterns—rising for seven days and then dropping for seven days, rising for five days only to drop for five. “Market theory says that returns are supposed to be random. Clearly these returns were anything but,” he says.

His interest piqued, Zitzewitz delved into data for a broad sampling of mutual funds. He was able to show how daily returns are predictable enough in certain asset classes, most notably region-specific international funds, to permit a significant arbitrage opportunity. By taking advantage of time zones to trade daily in and out of certain international funds as foreign prices rise and fall in response to the U.S. market, regardless of fixed NAVs, arbitrageurs could earn excess annualized returns of 35 to 47 percent.

For example, on Oct. 28, 1997, in the midst of the Asian economic crisis, Asian markets closed sharply down following a 9 percent drop in the S&P 500. However, after those markets closed, Wall Street rallied by 10 percent from its morning low. Most U.S.-based Asian funds had set their NAVs according to Asian closing prices—allowing arbitrageurs to earn one-day returns of 8 to 10 percent.

Zitzewitz adds that there are smaller but still significant returns to be had in domestic small-cap equity and convertible and high-yield bond funds, which tend to trade less often than large-cap stock funds. Their relative illiquidity means their prices also can be stale.

“The fact is, no one arbitrages in small caps, because if they know about the [illiquidity] problem there, they know about the international funds. And you can make more money in the international,” he notes. “But 10 years from now, when they fix the problem in international funds, there’s going to be a problem in small-cap funds too.” Meanwhile, the cost to long-term shareholders, whose investments are diluted by these market-timers’ inflows and outflows, is as much as 2 percent annually, adding up to a whopping $4 billion.

Stale pricing has been known in the industry for some 20 years. Only a few funds have taken any steps to correct it, and those measures are only partially successful. The most common solution is the imposition of short-term trading fees ranging from 0.25 to 3.5 percent. The net result of such fees, Zitzewitz has found, is that they lessen, but do not eliminate, large profits.

From the long-term investors’ perspective, their dilution in funds with short-term fees in place is 50 percent lower than in funds without them, but still not zero. Short-term fees also can be difficult to apply in 401(k) plans and impossible in certain variable annuity products where the annuity contract was signed prior to imposing the fees and rules prohibit modifying the existing contract. Other funds use American Depository Receipt (ADR) prices to set foreign security prices in determining fund NAVs. Zitzewitz says that most ADRs are fairly illiquid, so this is a partial solution at best.

The only satisfactory solution, Zitzewitz argues, is fair-value pricing—updating prices to take into account market-moving events. Some funds do a partial, top-down variant of this—more of an ad hoc adjustment to the overall portfolio value. A better approach is to fair-value each security; fair-value NAVs will thus fully reflect recent portfolio changes. Vanguard’s Pacific Index fund is one of the few that seems to be correctly adjusting its NAV, in conjunction with aggressive monitoring of short-term trading.

Until fair-value pricing becomes standard, the best way individual investors can protect themselves is to seek out funds with low expense ratios and a healthy proportion of outsiders on the board of directors—both signs of good fund management, according to Zitzewitz. He has found that funds with one or both of these attributes are most likely to have partial remedies like trading fees in place. And if investors are still determined to hold international funds for diversification’s sake, he suggests sticking to broad global funds rather than region-specific ones, not least because a global fund will be half U.S. stocks and thus less attractive to arbitrageurs.

In another 20 years, the industry may get around to fixing the problem. In the meantime, long-term buyers beware.

—ANDREA HAMILTON

Who Cares About Shareholders? Arbitrage Proofing Mutual Funds? Eric Zitzewitz, GSB Research Paper #1749, March 2002