CHICAGO - Despite the wave of technological advancements and outsourcing expertise in recent years, fair value pricing remains a tough nut to crack, according to mutual fund industry leaders attending the annual Investment Company Institute Tax & Accounting Conference held here last week.
In this day of heightened regulatory scrutiny, fair value pricing - the term for calculating the net asset value of a fund when the price of its underlying securities may not be readily available - has emerged as a key deterrent to market timers, who take advantage of stale prices to arbitrage mutual fund shares. If, for example, a significant world event were to occur before a fund's fair value could be re-calculated, a market timer could buy or sell off shares to the detriment of everyday investors.
So when the Securities and Exchange Commission ordered mutual fund complexes to install a chief compliance officer last year, it also suggested that firms take stock how they calculate fair value and how often they review the quality of that process.
As such, fair value pricing has also emerged as a dangerous pitfall for fund accountants and, ultimately, fund CCOs. Any slight slip up or momentary lapse of focus - by either the fund itself or its pricing service - could raise red flags at the SEC and risk the chance of a costly, regulatory nightmare.
But as much progress as has been made in ensuring accurate fair value pricing, said Alexander Ramos, vice president of fund accounting at The Bank of New York, it's surprising how many money managers aren't taking advantage of that information frequently enough.
"I think, for the most part, folks are relying definitely on the reporting they'll get from fair value vendors and a lot of that is quarterly," said Ramos, whose group accounts for more than $100 billion in assets. "Whether or not people can do more than just quarterly, which coincides with board meetings for the most part, is a bit of an open question, [but] folks certainly have the means to look at information the day after a fair value event. It's simple enough as pulling information off your accounting system or perhaps pulling prices off of Bloomberg.
"Some people might be hesitant to look at the data because they're afraid of what they might find, but I think that's the idea," Ramos continued. "You should be looking at your prices more frequently than the quarterly reporting that you may be doing right now."
Question the Numbers
Quality checks, however, are about more than just crunching a few numbers, added Richard J. Thomas, senior vice president and treasurer at Federated Investors, a $205 billion money manager in Pittsburgh. When the fund scandal pushed the topic of fair value pricing to the forefront two years ago, Thomas recalled, fund firms were scrambling to determine how they might install some sort of internal process for calculating fair value. Now that two major service providers have taken over pricing, however, firms could be running the risk of paying too little attention to the figures these vendors provide.
"We should be looking for trends," said Thomas, who characterized himself as "skeptical" of the current process for calculating fair value pricing. "We're working off only a year, or a year and a half of data, [so] at the end of the day, your portfolio manager should be looking at the prices from their standpoint of reasonability. They're the experts in the market and know what's going on in their markets, and if they feel they need to challenge these prices they should. But I think there is still a lot of work to do in analyzing this."
Thomas suggests that funds assign a representative to the pricing service vendor to review exactly how the vendor arrives at their calculation.
"We do that with all of the other pricing services, so I think we should approach this in the same manner," he said.
Mark Osterheld, the assistant treasurer at Boston-based Fidelity Investments, agrees. He said the industry has generally moved from the tendency of taking a pricing feed and not pricing the fund beyond that to now receiving the fair value price and not thinking beyond that figure.
"And neither answer is a good answer from our perspective," he remarked.
That's why Fidelity, encourages its people to evaluate the information they're receiving. Not just in terms of fair value pricing, either, but information received from general pricing services, as well.
"Only those who really questioned and probed service providers found out exactly what's going on," Osterheld continued. "It's very important that you do not just take the fair value service [price] and go on your merry way. You must evaluate on a regular basis how they arrive at their prices and make sure that their methodology is consistent with your [pricing] policy."
There are limitations, however, Osterheld warned. For example, when reviewing the accuracy of a fair value pricing, don't lose sight of the fact that the price that's being used to perform the back-check the next morning may be impacted by the hours that expired since the last close. For Asia it might only be a few hours, but for Europe it's six hours, and if there's a foreign holiday, then you're talking upwards of 36 or even 48 hours.
"You have to set aside those days as outliers," he offered. "You don't turn your policies and procedures upside down for one day, or if there's been a world event that's gone on geopolitically. That's one you want to use some judgment on."
Keep an eye on your shareholders flows, too, Osterheld added. Fund accounting executives should be asking whether a big day in the market correlates with a big day of flow activity. Fidelity, for instance, runs mock arbitrage strategies against its own funds to determine areas of softness or places were it might need to focus on pricing.
Brian Bullard, chief accountant in the SEC's division of investment management, said fair value pricing, particularly as it applies to international funds, is high on the regulator's radar. But at the end of the day, SEC examiners just want to see that funds are exercising best practices when it comes to calculating and reviewing fair value pricing.
"There's an awful lot of attention placed on fair value in international securities," Bullard said. "That's where the problem lies. But there's a general thought that [funds] need to be aware of this for all their products. People just need to and need to keep their guard up and need to be looking for this stuff."
Funds-of-hedge funds pricing is another area that's drawing scrutiny from the SEC.
"We'd like to emphasize that you need to understand exactly how the pricing service is arriving at its price and how much is dependent on the information your organization is giving to the service itself," he said. Bullard added that the regulator would also like funds to provide investors with greater disclosure when it comes to their valuation processes, a topic that struck a chord with Federated's Thomas. During reviews of financial statements in accordance with Sarbanes-Oxley regulations, Federated has received commentary from the SEC asking for greater disclosure of fair valuation, but Thomas said the firm is afraid of "putting a road map out there for arbitrageurs."
"I'm not sure what lengths the SEC is looking for us to go," he said.
Without commenting on Federated specifically, Bullard replied that the regulator is looking for more than the "boilerplate" that most fund firms provide in their prospectus. And while the SEC is "trying to come to a resolution" over the extent of that disclosure, he said that in the meantime, fund firms are welcome "to call us up and talk to us about it."
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