Some funds do little to foul market timers

When federal regulators speak, apparently not all mutual funds listen, especially when it comes to fair-value pricing.

The controversial practice is designed to thwart market timers who exploit differences in the opening times of stock markets around the world to jump in and out of mutual funds, making huge profits in some cases.

After mulling the issue for nearly four years, the Securities and Exchange Commission told the industry in an April letter that fund companies must adopt some method of fair-value pricing for international funds.

But at least one market timer says he’s identified a handful of Japanese-stock funds that don’t use fair-value pricing, or do so only on a limited basis.

If he’s right, those funds, and many more that industry experts say are suspect, may be courting an SEC crackdown.

tidy gains

Paul Charbonnet, a founding partner of Investors FastTrack, a Baton Rouge, La., mutual fund analysis service, hopes the SEC doesn’t crack down too hard on errant funds.

After all, market timers use them to get the most out of the difference between time zones, he says.

For example, if the stock markets in the United States close up on Wednesday, short-term investors may decide to invest in a fund that buys Japanese stocks.

That’s because Japan’s market will open for business on Thursday just a few hours after the U.S. market closes on Wednesday, and will likely mirror its run-up.

If that happens, short-term investors sell the fund when the U.S. market opens on Thursday and pocket a tidy gain, with little risk.

Market timers are taking advantage of a law that requires mutual funds to price their shares at the close of each business day.

The SEC approved fair-value pricing in 1981 to let funds take into account material events after the market closes.

But the commission left it up to funds to develop their own system of establishing fair value.

The issue came to a head in 1997 when Asian markets crashed, causing an uproar among market timers who bought and sold funds only to learn that some companies, such as Fidelity Investments, were using fair-value pricing.

Steering clear

Mr. Charbonnet says he’s identified a few funds that he believes steer clear of the practice, or at least use it sparingly.

He uses a computer program to compare a fund’s daily return with the average for that class and the Dow Jones Industrial Average.

The funds closest to the average on days in which there are big moves in the U.S. stock market most likely use fair-value pricing sparingly, if at all, he says.

Between Dec. 4 and Dec. 5, for example, the Dow Jones rose 3.21%, and the category average for the 26 Japan funds tracked by FastTrack was down 0.11%.

The $13 million TCW Galileo Japanese Equities Fund, offered by the TCW Group Inc. in Los Angeles, was down 0.84%.

That shows that there probably was no attempt to use fair-value pricing, Mr. Charbonnet says.

On the other hand, the $231 million T. Rowe Price Japan Fund, offered by T. Rowe Group Inc. in Baltimore, used fair-value pricing. It went up 2.66%.

Forest Foss, associate legal council with T.Rowe, says the fund group has had a fair-value pricing strategy for about five years. Over the course of a year, he says, the company has adjusted the value of the Japan fund a “handful” of times.

Mr. Foss says market timers complain occasionally, but discouraging them only helps long term investors.

Philip Hall, associate general council with TCW, says Mr. Charbonnet’s numbers don’t reflect the whole story.

Mr. Hall says TCW uses fair-value pricing when a big market shift takes place. For example, he says, fair- value pricing would probably kick in with an 8% shift.

Other industry experts also warn not to read too much into the numbers, saying they could reflect any number of factors.

With the exception of T. Rowe and TCW, no other fund company contacted returned calls seeking comment about fair-value practices.

Their reticence stems from various fears, say industry experts.

Funds that don’t implement fair-value pricing, or do so only on a limited basis, fear attracting market timers, they say. And those that do implement fair-value pricing may be afraid of lawsuits from market timers who may not agree with how a fund determines fair value.

“It’s hard to know, because the funds don’t come out the next day and announce they’ve used fair market value,” says Gregg Wolper, a senior analyst with Morningstar Inc.

Mr. Wolper says that may change now that the SEC is taking a stronger stance. The letter sent by the SEC to the Investment Company Institute in Washington on April 30 states: “When market quotations for a portfolio security are not readily available, a fund must calculate its [net asset values] by using the fair value of that security, as determined in good faith by the fund’s board.”

But even the degree to which a fund group implements fair-value pricing is an issue.

While most funds reserve the right to implement fair-value pricing, some do it more often. That is an additional factor for funds to review in light of the SEC’s stance.

Barry Barbash, a former director of the SEC’s division of investment management who is now a partner in the Washington office of New York law firm Shearman & Sterling, says the SEC appears to be taking a stronger stand on the issue.

“I’d argue that it takes fair-value pricing into a little bit of a different direction,” Mr. Barbash says. “I’m not sure that people in the industry would have thought that this was required.”