What is fair-value pricing and what is its connection to non-U.S. markets?
DefinitionFair-value adjustments, as they apply to mutual funds, were devised to correct the pricing of U.S.-based mutual funds which trade at the U.S. market close but hold stocks that trade across many foreign investment markets in many different time zones. In these vehicles, the fair value of the security may not be accurately captured by the closing price from several hours earlier, as it does not reflect market information that occurred before the close of the U.S. markets but after the close of the foreign market. To correct for this, fair-value adjustments use historical pricing relationships to adjust the prices of these foreign securities, with the goal of replicating the impact of market events that occur after the close of the respective foreign markets.
For example, the Japanese markets close long before the U.S. markets open. Suppose we know, based on past data, that a Japanese stock’s opening price typically rises 0.6% for each 1% rise in the U.S. markets on the preceding day. When we determine the closing value of the mutual fund, we reflect this relationship via a “fair-value adjustment” to the Japanese security’s closing price (closing price)*(1+ .6* change in U.S. markets).
In reality, this process is much more complex than our simple example. It is based on examining a wide variety of data elements and how they are related across markets.
Why use fair-value adjustments?Say a Japanese equity fund trades during U.S. market hours and did not fair-value adjust. Historically, large movements in the U.S. market are reflected by similar movements in the next day’s Japanese market returns. On days when the U.S. markets are strongly up, a savvy trader could buy at the U.S. market close knowing that Japanese markets tends to rally when the U.S. market closes up for the day. As a result, this trader gets in at the lower price and expects to see a pop in price the following day.
Great move, right? Well yes, but this is a form of arbitrage, which unfairly advantages investors who move in and out of the fund versus those who are longer term investors. Fair-value pricing was introduced to prevent this type of scenario and keep the playing field even between investors currently in the fund and those entering or exiting the fund.
Impact of fair valuation on benchmarkingOne oddity is that while mutual funds use fair-value adjusted pricing, the benchmarks for international equity funds do not. This causes a mismatch when looking at excess returns versus a benchmark, which can meaningfully change the performance optics for a fund. Unfortunately, this “apples to oranges” comparison can result in not only large short-term deviations, but can also persist over surprisingly long periods. By providing fluctuating adjustments to closing prices, fair value can meaningfully distort a mutual fund’s performance track record.
The bottom lineFair-value pricing was introduced to solve one set of investor problems, but has, in turn, introduced a second set of problems. By eliminating stale prices when calculating their NAVs, funds have prevented their clients from being the victims of arbitrage. However, fair-value adjustments have led to a mismatch between fund and benchmark returns. This mismatch can result in investment results being misunderstood and makes it challenging to appropriately set excess-return expectations.
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Tim Atwill, PhD, CFA, Head of Investment Strategy (emeritus)
Tim led the Investment Strategy Team at Parametric, which is responsible for all aspects of Parametric’s investment strategies, until his retirement in 2019. He also held investment responsibilities for Parametric’s Emerging Markets and International Equity strategies as well as shared responsibility for the firm’s Commodities Strategy.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.